10 Health-Care Stocks to Consider Buying Now

By Bradley Meeks | Stock Analyst

Much as we had noted during an early run-through of the holdings of several of our Ultimate Stock-Pickers last month, health care continues to be an area of focus for our top managers. Given that the sector is one of the few areas where our analysts are still finding value, with 19 out of the 49 stocks we currently have rated 5 stars coming from the health-care sector, it didn't come as too much of a surprise. As you may recall from our recent overview of  Vanguard PRIMECAP's (VPMCX) holdings, health-care stocks have been under pressure for much of this year over concerns about the impact that a government-sponsored health-care plan could have on the industry's profitability. The question for investors, though, has been whether or not these near-term issues will derail the long-term positive impact that the aging of the baby boomers is expected to have on the industry. Judging from the recent purchases by our Ultimate Stock-Pickers, the answer appears to be no.

While it would be easy to focus on only the top 10 health-care holdings of our top managers, which currently include 5-star names like  Johnson & Johnson (JNJ),  Pfizer (PFE), and  Merck (MRK), we thought we'd look a little bit deeper into the most recent high-conviction purchases made by our Ultimate Stock-Pickers in the sector. Despite already being the largest health-care holding of our top managers coming into the most recent period, Johnson & Johnson continues to be purchased with conviction, with at least one manager making a new money purchase in the stock. Merck and  Novartis (NVS) are two other top health-care holdings that continue to draw the attention of our Ultimate Stock-Pickers, albeit with slightly less conviction than other purchases in the sector. This leaves us then with seven names that aren't in the top 10 health-care holdings, with almost all of them trading at levels below our Consider Buying price.

10 Health-Care Stocks to Consider Buying Now
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	Number of Fund Owners
Johnson & Johnson (JNJ)		Low	Wide	60.70	0.76	15
Covidien, Ltd.		Medium	Narrow	40.35	0.62	6
Becton, Dickinson and Co. (BDX)		Low	Narrow	68.68	0.74	7
Abbott Laboratories (ABT)		Low	Wide	46.35	0.68	7
Merck & Co., Inc. (MRK)		Medium	Wide	30.93	0.67	4
Medtronic, Inc. (MDT)		Low	Wide	36.74	0.77	9
Bristol-Myers Squibb Co. (BMY)		Medium	Wide	22.33	0.80	4
Novartis AG (NVS)		Low	Wide	48.70	0.67	2
Genzyme Corporation		Medium	Wide	56.41	0.69	4
Zimmer Holdings, Inc. (ZMH)		Medium	Wide	52.46	0.67	3
Stock Price and Morningstar Rating data as of 09-24-09.

Each of these seven stocks stands out not only because it was a high-conviction buy during the most recent period, but because each had new money committed to it by at least one of our top managers.  Abbott Laboratories (ABT) had the most activity, being purchased by four managers and having seven of them hold positions in the name at the end of the second quarter.  Genzyme  was also purchased by multiple managers during the period, although we did note that one manager completely eliminated his stake in the biotech firm.  Bristol-Myers Squib (BMY),  Medtronic (MDT), and  Zimmer (ZMH) all benefited from high-conviction new money purchases during the quarter, but all of these names still paled in comparison to the activity seen in both  Becton, Dickinson (BDX) and  Covidien .

Covidien's a Company Warren Buffett Would Love
As you may recall, we sat down back in June with Alex Morozov, the associate director of stock analysis for the Morningstar health-care team, to talk about Becton, Dickinson after it turned up on our list of new money purchases during the first quarter of 2009. As it turned out Alex wasn't the only person who liked Becton, Dickinson, as Warren Buffett's  Berkshire Hathaway (BRK.A) (BRK.B) stepped up during the second quarter and made a big new money commitment to the name. While Alex continues to believe there's upside in Becton, Dickinson, we wanted to get his thoughts on Covidien, another medical device firm he covers, which had three significant purchases during the quarter, two of which were new money investments. Having just returned from Covidien's Investor Day, Alex had plenty of fresh insight to offer us.

Alex, can you please give us a quick overview of Covidien's business?

Covidien was formerly the health-care unit of  Tyco International . The company develops, manufactures, and distributes medical and imaging devices, pharmaceuticals, and other health-care products to medical professionals worldwide. Through its predecessors, Covidien has an operating history that spans 140 years and boasts a direct sales presence in more than 50 countries worldwide.

What's the basis for the company's narrow economic moat? Does it have the potential to expand its moat?

Covidien's moatiest businesses can be found in its medical devices segment, where it enjoys the advantages of brand recognition, technological innovation, and substantial scale. Of particular note is its high-end medical device/surgical instruments business, where it essentially shares the market with Johnson & Johnson's Ethicon business. The areas of the surgical instruments field where Covidien competes are relatively sticky--especially in sophisticated surgical tools, where surgeons require constant training and switching costs are high.

The company also has a presence in lower-end basic surgical products, like sutures and syringes, where its scale and tight cost control offset a lack of differentiation, allowing Covidien to maintain its returns on capital. Covidien's recent market share advancements in the surgical devices area came at the expense of both its smaller competitors and Ethicon. As the company commands a greater presence in the operating room, its position is becoming defensible, given the significant technological and administrative hurdles its competitors would have to overcome in order to replace Covidien.

With its legacy pharmaceutical business, Covidien boasts a leading position in the production of controlled substances. As the manufacturing process for these products is tightly regulated by both the FDA and the DEA, the company's long history of dealing with both agencies represents a sizable barrier to entry.

While the company still has its share of businesses that lack substantial competitive advantage (contrast agents in imaging, medical supplies), their presence as a percentage of revenue has been gradually dwindling. The firm has also been actively pruning what we consider to be no-moat businesses and product lines, such as retail (divested), specialty chemical (for sale), and sleep diagnostics (sold), further enhancing its returns on invested capital. While we feel that Covidien's moat might be widening as a result of the improvements in its operations overall, regulatory uncertainty regarding competitive bidding and the impact of health-care reform on future hospital spending have precluded us from assigning it a wider moat.

Covidien seems to have been investing heavily in research and development, an area where you think that the company's efforts are finally bearing fruit. Where do you see the company getting the most bang for its research buck these days?

Covidien's investment in medical devices is yielding a number of promising product launches and technological advancements. The company's R&D prowess that had wilted under Tyco is starting to flourish again, with Covidien re-establishing itself as a powerhouse in surgical tools. The particular focus has been on providing products for procedures where favorable secular trends--such as the expansion of minimally invasive surgical applications based on their economic attractiveness, the adoption of new technologies that simplify and improve the quality of procedures, and the rapidly growing market for metabolic surgery--should fuel strong growth in the future.

What makes you believe Covidien is a good value at the current stock price?

Covidien's earnings should receive a significant boost longer term from its sales momentum and margin expansion, driven by favorable product mix and operational and financial leverage. The firm should see some improvement on its P&L as it benefits from a shift to higher-margin devices, leverages its general and administrative expenses, and lowers its tax rate. The boost to earnings will not, however, come at the expense of R&D, while improvements in gross margin due to product mix are likely to be offset somewhat by unfavorable foreign exchange given the firm's largely domestic manufacturing base. There are also some near-term earnings head winds as segments outside of devices, particularly pharmaceutical and imaging, face challenges, but at this point Covidien's EPS forecast for 2010 is in line with our projections. The firm's ongoing commitment to invest in the areas where it enjoys competitive advantage (as well as its willingness to de-emphasize product lines that don't generate sufficient returns on capital) solidifies our take on Covidien's ability to strengthen its competitive position in the long run.

How's the financial health of the company?

Covidien sports a healthy balance sheet and has commenced paying both a dividend and buying back shares. Further, given its strong cash flow from operations, Covidien should be able to maintain its current cash position without dialing down its acquisition strategy. To reiterate this point, management stated during the Investor Day that it plans to maintain its cash balance at its current level, which means that more than $1.5 billion in annual free cash flow will be dispersed for acquisitions, dividend payments, share buybacks, and debt reduction. Our average projected debt/capital ratio over the next five years is approximately 20%.

While Covidien might not be as clear-cut a story as Becton, Dickinson, Alex continues to believe that the stock represents an appealing long-term investment opportunity. He feels that Covidien's strong product pipeline, management team dedicated to maximizing returns on investment, and favorable secular trends bode well for its future prospects. With several of our top managers making new money purchases in the name during the most recent period (and six of them now holding positions in the stock), we feel he might be on to something here.

Disclosure: Bradley Meeks does not own shares in any of the companies mentioned above.