How Will Health-Care Reform Impact These Funds?

The U. S. House of Representatives just passed the health-care reform bill already passed by the Senate, along with a companion bill of changes that the Senate later approved. When President Obama signed the main bill into law, it put a cap on a long, contentious political fight over reforming the U.S. health-insurance system.

Health care is likely to remain a hot political issue for a while, but much of the uncertainty that has hung over the health-care sector for the past year is gone. That uncertainty was one of the factors that caused health-care stocks to underperform the market in 2009's rally. Once it became clear that the bill was likely to pass and the market saw more details, many health-care stocks rose modestly in a "relief rally."

Going forward, though, investors still need to evaluate what the reality of health-care reform means for individual stocks in the sector, not all of which will be affected in the same way. Earlier this week, Morningstar stock analysts Matthew Coffina (in this note) and Alex Morozov reviewed the new law's provisions and discussed what they may mean for various types of health-care stocks. Pharmaceutical and biotech companies are likely to be the biggest beneficiaries, as newly insured patients will be able to afford more drugs and biologics get stronger patent protection. Drugstores and medical distributors will likely also benefit from higher volume, but it looks like a more mixed bag for medical-device makers and health insurers. Even after the stocks' recent gains, health care looks like one of the cheapest sectors, with plenty of stocks trading well below Morningstar analysts' estimates of their fair values.

Some smart mutual fund managers agree that there are attractive opportunities in health-care stocks. A couple of months ago, we looked at funds with the most prominent stakes in health insurers, which stood to be affected most directly by reform. Now that reform is a reality, we've taken a broader view to look at good funds with especially heavy health-care exposure. The following are all topnotch funds that keep at least 20% of their stock holdings in health care, although they differ in which specific areas and industries they find most attractive.

Fairholme FAIRX
Manager Bruce Berkowitz has achieved a fantastic long-term record (and been named Morningstar's Domestic-Stock Manager of the Decade) by running a concentrated, flexible portfolio that consists of solid businesses trading at cheap prices, along with some bonds and a significant cash stake. Berkowitz has seen good values in health care for a while. As of Nov. 30, 2009, about 25% of the fund's stock assets were in the sector, with health insurers Humana HUM and WellPoint WLP soaking up more than 10% of total assets. Berkowitz remained fans of those two stocks as the health-care debate raged, reasoning that they still looked attractive even if the most likely health-care reform plans passed. He sold most of his stake in former top holding Pfizer PFE last year after the stock inched up a bit, but he still has a significant weighting in another pharma name, Forest Laboratories FRX.PAGEBREAK

Vanguard Primecap VPMCX
The Primecap management team uses a contrarian growth strategy that's similar to Berkowitz's in some ways, but different in others. It has long had big health-care weightings in all six of its funds, because it strongly believes the market has been too pessimistic about the sector's problems. This fund had 22% of its stock portfolio in health care as of Dec. 31, 2009, while Primecap Odyssey Growth POGRX and Primecap Odyssey Aggressive Growth POAGX, which are smaller and more nimble, had more than 35% in the sector. The managers are particular fans of big pharmaceutical names such as Eli Lilly LLY and Novartis NVS, biotech firms such as Amgen AMGN, and medical-device makers such as Medtronic MDT, all of which are top holdings in this fund. In Primecap Odyssey Growth, their top holdings also include smaller niche health-care firms such as Conceptus CPTS, Immunogen IMGN, and Cepheid CPHD. They've generally avoided health insurers.

Dodge & Cox Stock DODGX
This is more of a classic-value offering than either Fairholme or the Primecap funds, with a bottom-up approach that seeks out good businesses that are trading cheaply. In keeping with the managers' contrarian bent, 23% of the fund was in health care as of Dec. 31, 2009, about twice the large-value average. Most of that exposure came via pharmaceutical stocks such as Novartis, Merck MRK, and GlaxoSmithKline GSK, all of which are among the top 10 holdings. Health insurers WellPoint and UnitedHealth UNH are also among the top 20 holdings, but the managers were trimming both of those stocks throughout 2009, while ramping up their pharma exposure.

Jensen Fund JENSX
This fund's managers will only consider stocks that have earned returns on equity of at least 15% in each of the past 10 years. From that exclusive club of about 150 stocks, they choose 25 to 30 stocks that are attractively valued, and they tend to hold on to them for years. Quite a few health-care stocks meet the managers' strict criteria. Their two pharma holdings are Abbott Laboratories ABT and Johnson & Johnson JNJ, neither of which is held by the above three funds except for a small Johnson & Johnson position in Vanguard Primecap. Other than that, Jensen holds medical-device makers Medtronic and Stryker SYK and medical instrument makers C.R. Bard BCR and Waters WAT, of which only Medtronic is held by any of the other three funds. If nothing else, this example shows that there are a range of potentially attractive stocks in the health-care sector, and that good managers can and often do disagree about which stocks in the sector are most attractive.

David Kathman is a mutual fund analyst with Morningstar.