Our Outlook for the Health-Care Sector
We see some compelling values in pharmaceuticals and medical devices.
Stock Strategist
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Merger mania continued in the health-care sector in the first quarter of 2007, and we don't expect it to abate anytime soon. We have seen acquisitions in just about every corner of the health-care sector in recent quarters, from pharmaceutical firms buying biotechnology companies to consolidation and buyouts in the hospital industry. This quarter, some of the biggest deals were in various areas of health-care services. Caremark has finally agreed to be acquired by CVS (CVS), hospital firm Triad (TRI) is being bought out by a group of private investors, and health insurer United Health (UNH) has announced plans to buy Sierra Health (SIE), just to name a few.
In general, we value firms as stand-alone entities, and most of these deals have been at significant premiums to market prices and our fair value estimates. We think this is a function of the cost savings that firms expect to generate in acquisitions and buyouts, and in some cases a willingness to pay a significant premium on the part of the acquiring firm. Although we do expect acquisitions and buyouts to remain a prominent part of the landscape in the health-care sector, we don't plan to change how we value firms. We will continue to incorporate our assumptions for a firm's business, and unless we have a strong reason to believe a takeout is imminent, we typically do not forecast cost savings or other benefits we don't think the firm could achieve on its own.
Valuations by Industry
We continue to think the median health-care stock is slightly overvalued, but we still like the prospects for growth in the sector. In addition to some of the broader market issues that affected stocks in the first quarter, the health-care sector has been a popular target of the new democratic Congress. Many proposed legislative changes look negative for health-care firms in general. While that may have negatively impacted the stock prices of some firms, unless generic biologics become a reality (which we think is several years away in the U.S.), we're not expecting the changes currently being pondered in Congress to significantly affect our valuations of individual firms anytime soon.
| Health-Care Valuations by Industry | |||
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| Segment | Average | Average Price/Fair Value | Stocks Covered |
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| Diagnostics | 3.33 | 1.01 | 3 |
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| Drugs | 2.96 | 1.06 | 57 |
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| Biotechnology | 2.88 | 0.98 | 59 |
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| Medical Goods & Services | 2.80 | 1.07 | 10 |
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| Medical Equipment | 2.79 | 1.05 | 45 |
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| Physicians | 2.57 | 1.07 | 7 |
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| Research Services | 2.56 | 1.05 | 9 |
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| Home Health | 2.50 | 1.11 | 4 |
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| Hospitals | 2.50 | 1.09 | 10 |
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| Managed Care | 2.27 | 1.16 | 16 |
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| Assisted Living | 1.00 | 1.30 | 2 |
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| * Data as of 03-15-07 |
We like the diagnostics industry, as we think this group should benefit from a wave of new technology in molecular diagnostics, which we expect will improve the quality of diagnostic tests over time. We're bullish on the prospects for pharmaceutical firms, as we think this industry group is undervalued relative to the rest of the health-care sector. Leading industry players like Johnson & Johnson (JNJ) and Novartis (NVS) have very strong prospects, but we think the market has been focused on the short term, and both of these stocks have 5-star ratings right now. We also think biotechnology stocks hold promise, with firms like Amgen (AMGN) rated 5 stars. The market is focused on some risks surrounding some of Amgen's anemia drugs that we think are overblown, and we think the firm's pipeline will help it continue to generate returns on capital well in excess of its cost of capital.
Health-Care Stocks for Your Radar
In line with our industry observations noted above, our favorite stocks in the health-care sector are in the pharmaceutical and biotechnology industries. We think these firms will generate strong returns on capital well into the future thanks to their wide economic moats, and with each trading in 5-star territory, the valuations look attractive to us as well.
| Stocks to Watch--Health Care | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | P/FV |
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| Amgen |  | $83 | Wide | Average | 0.73 |
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| Boston Scientific | | $25 | Wide | Average | 0.62 |
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| Johnson & Johnson | | $76 | Wide | Below Avg | 0.80 |
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| Medtronic | | $64 | Wide | Below Avg | 0.78 |
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| Novartis | | $73 | Wide | Below Avg | 0.78 |
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| Data as of 03-22-07. |
Despite recently reducing our fair value estimate, we still think Amgen represents a compelling value at today's prices. The firm has been hit with a slew of negative trial results that have damped our outlook for sales growth this year, but we continue to feel confident that Amgen will maintain its leadership position in anemia drugs. The firm's deep pipeline of new drugs should help it generate strong returns well into the future.
Medical device firms Boston Scientific (BSX) and Medtronic (MDT) are also among our top picks in the health-care sector. We think these firms are well-positioned to benefit from increased demand for devices like drug-coated stents and implantable cardioverter defibrillators, which we think will be of increasing benefit to an aging population in the U.S. Boston and Medtronic are leaders in their fields when it comes to innovation, which we think will keep them at the lead in these growing areas.
Finally, we like the revenue and profit diversity we find at Johnson & Johnson and Novartis. J&J offers investors the opportunity to participate in pharmaceuticals, medical devices, and consumer health-care products--in fact, J&J is sometimes referred to as a health-care mutual fund for its breadth. Novartis, on the other hand, is involved in the manufacture and sale of generic pharmaceuticals in addition to branded products. We think Novartis' branded portfolio is top-tier among pharmaceutical firms, and its Sandoz generic drug division is the second-largest generic drug firm in the world. We'd be happy to own any of these topnotch health-care firms at current prices.
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