Health Care: A Strong Run, but Some Stocks Still Look Undervalued

• While we view the health-care sector as slightly overvalued in aggregate, some stocks still look undervalued, including the pharmacy benefit manager (PBM) industry.
• Mergers and acquisitions continue at a rapid pace, as large conglomerates are looking for growth avenues and opportunities to cut costs, partially through lowering taxes for U.S.-based companies.
• Drug development in specialty-care areas, including virology and 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.
• 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.

Over the past few years the valuation of the health-care sector has risen to slightly exceed our fair value estimates in aggregate. 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 lends itself to a stock-pickers' market rather than a focus on industries.

In the pharmaceutical and device industries, companies are acquiring and merging to create scale and focus in key strategic areas, in addition to deploying their previously trapped overseas cash, as is the case with the pending acquisition of

Turning to innovation in health care, the focus of drug companies is shifting toward specialty-care areas, which should increase drug-development productivity. The pipelines of the major biotech and pharmaceutical companies are focused on smaller patient populations in areas such as immunology, virology, and oncology. We believe these areas offer unmet medical need, which should lead to better approval odds and stronger pricing power. Further, despite treating smaller patient populations, these indications can turn into major blockbusters.

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 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 out treatment. We expect a continual, gradual increase in demand for health care, but probably not a return to 2007 levels anytime soon.

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 this diversified health-care firm 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

(

) (Sweden)

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

Sanofi

SNY

Despite some weakness in pricing for insulin drugs, we expect Sanofi's key narrow- and wide-moat divisions (emerging markets, diabetes, vaccines, consumer products, rare-disease drugs, and animal health treatments) to continue to post steady gains. Further, based on our view that the investment community underappreciates Sanofi's strong competitive advantages and improving growth profile, we believe Sanofi trades significantly below our fair value estimate. The company’s strengths in patents, but also from branding, cost advantages, and efficient scale areas give it a wide moat that is supported by the majority of Morningstar's moat sources.

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