While Health Care's Bounce May Not Last, Sub-Sectors Can Benefit

Nov. 22, 2004 -- Although President George W. Bush's reelection provided a nice jolt to U.S. health care stocks, it may only be a short-lived bounce since the sector is facing a multitude of problems, some experts in the field caution.

These include the drying-up pipeline of new drugs from the major pharmaceutical companies, a flurry of patents due to expire, and the specter of the U.S. government allowing the reimportation of cheaper generic drugs from Canada and elsewhere, among other woes.

Year-to-date through October, Standard & Poor's Health Care Sector Index declined 5.3%, while the S&P 500 Composite Index edged up 1.6%. In calendar 2003, the health-care sector rose 16.0%, underperforming the index, which climbed 26.4%.

However, the health care industry is diverse enough to make it difficult to apply blanket assessments. In 2004, for example, managed health care (HMOs), health care supply, and medical device stocks have delivered robust gains, while health care distributors, health care facilities and pharmaceuticals have lagged.

One of the brightest spots in health care have been medical device/technology, which have performed particularly well. "Wall Street views this sub-sector as having no reimbursement headwinds now," said Arnold Douville, portfolio manager of the American Century Life Sciences/Inv (ALSIX). Indeed, leading companies like Medtronic (MDT) and St. Jude Medical (STJ) enjoy strong pricing power and high demand for implantable cardio-rhythm devices.

"Medical technology stocks still offer opportunities for significant growth, especially for investors seeking accelerating earnings and revenue growth," Douville said.

Standard & Poor's believes that medical device stocks should outpace the market in 2004 and 2005, aided by new product launches in cardiology, orthopedics and diagnostics, said Robert Gold, Standard & Poor's Group Head for the health-care sector. "In our view, there is a good possibility that merger and acquisition activity will accelerate, providing some valuation expansion throughout the device group."

Within the medical-devices sector, Gold said, Standard & Poor's has a 5-Star ranking (strong buy) on Hologic (HOLX); and 4-Star rankings (buy) on Kinetic Concepts (KCI), Edwards Lifesciences (EW), Cytyc (CYTC), Given Imaging (GIVN), Boston Scientific (BSX), Inamed (IMDC) and Stryker (SYK).

Another strong performing sub-sector in the industry has been health maintenance organizations. "HMOs have performed very well this year, despite the occurrence of two key negative events," noted Douville. "One is the long-delayed merger between Anthem Inc. (ATH) and Wellpoint Health Networks Inc. (WLP) [which the California Insurance Commissioner just approved]; and the other was the investigation by New York Attorney General Eliot Spitzer of east coast medical insurers."

Douville thinks it's now widely believed that HMOs aren't the real culprits in the insurance scandal, which has allayed investors' fears. Otherwise, he noted that managed care stocks have been strong. "The premium rates negotiated by HMOs came in line with Wall Street's estimates," he said. "Plus, the victory by Bush and the Republicans is seen as a big positive for managed care companies."

"Also, HMOs could be clear winners under the Bush administration, although the stocks here are getting a bit expensive," Douville added. Gold notes that Standard & Poor's has a neutral outlook on the HMO group, reflecting its belief that operating margin expansion will begin to abate in 2005.

The drug industry group comprises the most well-known and largest sub-sector within health care, and the picture there is quite murky.

"The big problem with evaluating drug stocks is the reliability of earnings estimates going forward because of so much uncertainty," Douville said. "The sector is facing a number of major issues. I think the fears over the prospect of the importation of prescription drugs is becoming more likely; not even the Republicans will be able to head off debate on this subject since drug costs and drug usage continue to escalate. Also, the product pipeline from the major pharmas is slowing down."

As a reflection of the group's woes, in late September, Merck (MRK) had to recall its blockbuster arthritis drug Vioxx due to evidence it raised the risk of stroke or heart attack. Merck's shares dropped by more than 25% in just one day. Douville said he thinks that ongoing concerns about drug safety and side-effect profiles will compel the FDA to slow down the drug-approval process even further in the near future.

Other major pharmas have issued disappointing revenue estimates or unfavorable late-stage clinical trials data. Pfizer (PFE), the biggest drugmaker in the world, is confronting patent expiries on some of its biggest-selling products and does not have enough new drugs in the pipeline to offset these losses.

With respect to drugs, Gold said "although we find some interesting valuations in the branded drug area, our neutral stance on these stocks reflects our concerns regarding heightened competition in key therapeutic categories, as well as patent expirations. We believe revenue and earnings growth will moderate to the high single digits in 2004 and 2005. Medicare drug benefit proposals could boost volumes, but we think that any gains would likely come at the expense of industrywide operating margins."

Two of the very best long-term performing mutual funds in the health-care sector are specialty portfolios from Fidelity -- the $157-million Fidelity Select Medical Delivery Portfolio (FSHCX) and the $762-million Fidelity Select Medical Systems & Equipment Portfolio (FSMEX).

The Medical Delivery Portfolio invests primarily in HMOs and hospital management companies. With significant stakes in stocks like UnitedHealth Group Inc. (UNH), Humana Inc. (HUM) and WellChoice Inc. (WC). This fund's top ten holdings accounted for a whopping 77.1% of total assets as of September 30.

The Medical Systems & Equipment Portfolio invests in a smattering of medical services companies, including makers of medical devices/equipment, medical technology firms and medical research entities, among others. Top holdings currently include Medtronic Inc. (MDT), St Jude Medical Inc. (STJ), Boston Scientific Corp. (BSX) and Zimmer Holdings Inc. (ZMH).

Looking ahead to 2005 for health care overall, Standard & Poor's recommends a "market weighting," said Gold. "In our opinion, the group faces challenging comparisons through 2005, and we think stock moves may be restricted by industry-wide pricing pressures, patent expirations, rising litigation risks in the pharmaceutical sub-sector, and prospects of reduced foreign currency tailwinds," he said.

Five Best Health Care Funds For One-Year Period (through 10/29/04)
Fund

Return (%)

S&P Star Ranking

Expense Ratio (%)

Fidelity Select Medical Delivery (FSHCX)

29.1

4

1.24

Schwab Health Care Focus Fd (SWHFX)

27.9

4

1.04

Jennison Health Sciences Fund/Z (PHSZX)

27.0

5

1.17

Fidelity Select Medical Systems & Equipment (FSMEX)

14.0

5

1.15

Alger Fund:Health & Sciences/A (AHSAX)

13.7

5

2.36

Five Best Health Care Funds For Three-Year Period (through 10/29/04)
Fund

Annualized Return (%)

S&P Star Ranking

Expense Ratio (%)

Fidelity Select Medical Systems & Equipment (FSMEX)

13.0

5

1.15

State Street Research:Health Science Fund/S (SHSSX)

12.6

5

1.25

Fidelity Select Medical Delivery (FSHCX)

11.4

4

1.24

ICON Healthcare (ICHCX)

8.2

4

1.34

Jennison Health Sciences Fund/Z (PHSZX)

6.9

5

1.17

Five Best Health Care Funds For Five-Year Period (through 10/29/04)
Fund

Annualized Return (%)

S&P Star Ranking

Expense Ratio (%)

Fidelity Select Medical Delivery (FSHCX)

18.6

4

1.24

Fidelity Select Medical Systems & Equipment (FSMEX)

18.0

5

1.15

Jennison Health Sciences Fund/Z (PHSZX)

16.3

5

1.17

ICON Healthcare (ICHCX)

15.5

4

1.34

Munder Funds Healthcare/Y (MFHYX)

15.1

4

1.89

Source: Standard & Poor's. Total returns include reinvested dividends. Data as of 10/29/04.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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