Our Outlook for the Health-Care Sector
Political winds could cast a cloud over health-care companies.
Quarter-End Insights
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Even though it seems like health care has bottomed out in the second quarter and despite the sector's usual status as a safe haven during turbulent times in the market, we believe the prospect of changing political winds could cast a dark cloud over many companies in our sector. Health care is a perennial on nearly every politician's list of key priorities. Granted, there's always some level of chatter around reforming our systems for health-care financing and delivery, and scholars of public health who have tracked the cycles of interest in health-care reform readily admit that very little change comes of all the talk. However, we think the next few years could become tougher for health-care companies due to the convergence of several key issues.
First, there is a distinct likelihood that we may see both a Democratically controlled Congress and White House going into 2009, which would set the political stage for raising the priority of health-care issues and the likelihood of legislation passing. Second, it is becoming more evident that our current system for financing health care is not sustainable in the longer run, as medical technologies lead to premium pricing at the same time that an influx of baby boomers will start landing on the Medicare rolls. Third, there is more and more data that strongly suggest Americans have not gained greater life expectancy for all the excess spending we've poured into health care.
Lastly and importantly, it seems like the collective appetite and political will to truly wrestle with the messy issues are building up steam. We see evidence of this in various individual states that have attempted to march ahead and address the health-care situation in the absence of any initiatives from the federal government, such as Massachusetts' ambitious plan to mandate health-care coverage for all. Another hint comes in the form of proposed policies that dive into fundamental reforms (e.g., achieving universal coverage, upending the fee-for-service incentive system), rather than simply tinkering around the margins with our existing system (e.g., consumer-directed care, electronic medical records). All of these factors lead us to believe the time is ripe for some far-reaching changes in how our health-care systems are configured.
As much as there seems to be a perfect storm brewing to fuel health-care reform, we hasten to point out that despite similar conditions when the Clinton administration set out lofty goals to remake health care, nothing fundamentally changed in health care with that earlier effort. However, the uncertainty of potential changes held shares of many health-care companies down for several years in the early to mid-1990s. We are mindful that a replay of history could be in the cards over the next few years as legislators wrangle with very costly biologic therapies, a growing shortage of physicians, greater numbers of uninsured, and the many moving parts that need to be coordinated in order to slow the rise in medical costs.
Valuations by Industry
After taking a dip from our fair value estimates in the first quarter, most health-care industries have held steady during the second quarter. Notably, hospitals and home health have both seen some considerable upward movement and now hover close to our fair value estimates. While most health-care industries are not quite as attractively priced as in the first quarter, we still see some individual companies that appear to offer compelling buys.
| Health-Care Valuations by Industry | |||
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| Segment | Current Median Price/Fair Value | Three Months Prior | Change (%) |
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| Assisted Living | 0.80 | 0.82 | -2.4 |
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| Biotechnology | 0.90 | 0.87 | 3.5 |
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| Diagnostics | 0.80 | 0.79 | 1.3 |
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| Drugs | 0.82 | 0.79 | 3.8 |
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| Home Health | 1.05 | 0.90 | 16.7 |
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| Hospitals | 0.99 | 0.79 | 25.3 |
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| Managed Care | 1.00 | 1.00 | 0.0 |
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| Medical Equipment | 0.88 | 0.86 | 2.3 |
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| Medical Goods/Svs | 0.84 | 0.92 | -8.7 |
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| Physicians | 0.96 | 0.92 | 4.4 |
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| Research Services | 1.02 | 1.05 | -2.9 |
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| * Data as of 06-13-08 |
Health-Care Stocks for Your Radar
Even though a number of health-care companies have moved closer to our fair value estimates over the last three months, there are still quite a few that remain attractively priced. The range includes some high-quality companies with moats, as well as more speculative firms that could offer substantial upside for investors who have a higher tolerance for risk.
| Stocks to Watch--Health Care | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ |
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| Vanda |  | $17 | None | Very High | 0.37 |
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| UnitedHealth | | $60 | Narrow | Medium | 0.45 |
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| Alnylam | | $49 | None | Very High | 0.53 |
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| Schering-Plough | | $31 | Wide | Medium | 0.60 |
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| Advanced Med Op | | $33 | Narrow | Medium | 0.62 |
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| Data as of 06-20-08. |
Vanda Pharmaceuticals (VNDA)
For investors with a higher tolerance for risk, we like Vanda, which is awaiting regulatory approval of its lead drug for schizophrenia this summer. Vanda acquired iloperidone after Novartis had already conducted Phase III trials that led to mixed results. However, Vanda has identified a subset of patients with certain genetic profiles for whom this drug would be efficacious. There is also a great deal of switching that takes place in this category of anti-psychotic drugs because efficacy tends to be idiosyncratic. We currently project 70% probability of iloperidone receiving approval.
UnitedHealth Group (UNH)
UnitedHealth offers a narrow moat at very attractive prices. Although the shares have been depressed following corporate governance issues, fears of a cyclical downturn in the industry, and an overhang of political uncertainty, we think the firm's underlying scale advantages still hold true. UnitedHealth wields the bargaining power of 70 million U.S. customers, which allows the company to extract the most favorable prices from doctors and hospitals and to build out very extensive networks of service providers. UnitedHealth also has the luxury of spreading its fixed costs across its large revenue base, which leads to fatter profits.
Alnylam Pharmaceuticals (ALNY)
Alnylam remains a risky investment, but it's on the leading edge of what could be the next revolutionary leap in biotechnology: RNA interference, a recently discovered mechanism that can silence overexpressed genes that lead to cancer or viral infections. Though the firm is still in its early days, we think it has a shot at becoming a leader in biotech. Others in the field clearly see the potential we've seen, as heavy-hitters Novartis (NVS), Medtronic (MDT), Roche (RHHBY), and most recently Takeda have all signed sizable, high-profile partnerships with Alnylam. The firm's lead candidate is still in Phase II trials, so Alnylam still has a ways to go before achieving profitability. However, we wouldn't be surprised if Alnylam is acquired before it reaches that point.
Schering-Plough
Schering remains one of our favorite big pharma companies. Not only are shares on sale, but the firm has one of the best late-stage pipelines right now. Though shares have taken a beating following the release of unfavorable data from the ENHANCE study on key drugs Zetia and Vytorin, we are anticipating more favorable data to emerge from an upcoming clinical study on the same products that should moderate the negative effect of the earlier study.
Advanced Medical Optics
This firm holds a dominant position in LASIK vision correction surgery but also maintains respectable franchises in cataract surgery and consumer eye care products that all add up to a narrow moat. Despite its exposure to the elective (and thus cyclical) vision correction market, the firm has delivered solid performance so far in 2008. We also expect the firm to chip away at its debt as the year progresses, which would leave it in a stronger position once consumer confidence eventually revives and patients seek laser vision correction.
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