Health Care: 3 Picks in a More Expensive Sector

• Even though several years have passed since the worldwide economic downturn, overall health-care utilization remains tepid. But we see early signs of improvement partly spurred by health-care reform in the U.S., and we don't see the U.S. Supreme Court striking down the reform.
• Mergers and acquisitions still continue at a rapid pace, as large conglomerates are looking for growth avenues and opportunities to cut costs, partially through lowering taxes.
• Drug development in specialty-care areas, such as oncology, is increasing the productivity of drug and biotech companies, with several recent launches with very high prices reminding the investment community of the strong moats of large pharmaceutical and biotech firms.

In aggregate, the valuation of the health-care sector has risen to slightly exceed our fair value estimates. However, we still see several stocks that offer attractive valuations across the different industries. In the table below, we highlight a few of our top picks. However, we believe the current environment for health care continues to lend itself to a stock-pickers' market rather than a focus on industries.

Although the economic downturn passed several years ago, health-care utilization remains tepid, but recent signs are pointing to a pickup of the market. Historically, a lag of a couple of years tends to follow a recession before health-care spending returns. However, the magnitude of the recession and increasing cost-sharing with patients has delayed a sharp rebound in health-care use. The increase in U.S. hospital admissions starting in the second quarter of 2014 suggests a turning point in health-care usage; U.S. health-care reform is likely driving part of the uptick. With the mandated health-care insurance and expanded government insurance in the U.S., more people are seeking treatment. We expect a continual, gradual increase in demand for health care, but probably not a return to 2007 levels anytime soon.

Much has been written about the recent U.S. Supreme Court case challenging the Affordable Care Act on grounds that the federally run insurance exchange violates the ACA language, which says exchanges should be run by the state. We don't think the court will overturn that key provision because: 1) the spirit of the ACA language is not violated by the federally run exchanges, and 2) the four plaintiffs supporting the challenge have shown questionable, if any, harm by the federal exchange.

If the challenge wins, about 3% of the U.S. population could lose insurance, which would probably force the U.S. government to step in with some sort of support. However, if no support was implemented, the industries most negatively affected would be hospitals and managed care organizations. To a lesser extent, all the other health-care industries would be hurt, too, but the magnitude would probably be less than a 1% hit to sales for the majority of health-care companies.

In the pharmaceutical and device industries, companies are acquiring and merging to increase their growth potential through creating scale, cutting costs, and focusing on key strategic areas. We see this trend with the pending acquisition of Allergan by Actavis. This trend is also evident with

Turning to innovation in health care, the focus of drug companies is shifting toward specialty-care areas, which should increase drug-development productivity and strengthen the moats for drug companies. The pipelines of the major biotech and pharmaceutical companies are focused on smaller patient populations in areas such as oncology. Further, despite treating smaller patient populations, these indications can turn into major blockbusters.

Baxter

BAX

Although competition is increasing for Advate, Baxter's highly profitable hemophilia A product, we think this diversified firm's competitive advantages remain strong and the stock looks undervalued. We think Baxter has earned a wide economic moat, stemming from economies of scale in plasma processing, injectable therapies, and dialysis products. Intangible assets--like Baxter's strong brands, patent protection, and pipeline productivity--also allow the firm to remain remarkably profitable in tough industries. More than 70% of Baxter's sales come from products with market-leading positions, and the safety and quality of its biologic therapies allow it to charge a price premium over competitors.

Elekta

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We believe Elekta is well-positioned in the radiotherapy market, which has tremendous growth potential as improvements in technology, increasing awareness of the clinical benefits, and a favorable cost/benefit proposition should dramatically increase global adoption over the next decade. Further, we feel that Elekta carries a wide moat based on a solid position in a market that is characterized by high barriers to entry, high switching costs, and strong intellectual property. This field has evolved into a duopoly over the past decade with virtually no new entrants, and the main two players, Elekta and

MRK

Despite some upcoming patent loses, we believe the market undervalues Merck's strong pipeline, led by cancer drug Keytruda. We project peak sales for Keytruda of $8 billion, well ahead of consensus expectations. Further, we expect several other pipeline drugs to develop into significant blockbusters, more than offsetting minor patent losses over the next five years. Further, several recently launched drugs are addressing therapeutic areas that have increasing demand trends, including diabetes, where Merck's leading DPP-IV is well-positioned to treat the growing disease.

More Quarter-End Insights

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• Credit Outlook: Demand Rises for Higher-Yielding U.S. Dollar-Denominated Debt
• Basic Materials: China Will Keep a Lid on Most Commodities
• Consumer Cyclical Investors: Shop Carefully in 2015
• Consumer Defensive: Attractive Companies, Top-Shelf Valuations
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• Financial Services: Bank Worries Are Overdone
• Industrials: A Few Bargains Still Remaining
• Real Estate: REITs That Can Weather a Rising Rate Environment
• Tech and Telecom Sectors: Time to Be Selective
• Utilities: Bloody February Brings Valuations Back In Line