Health Care: Part Of A Balanced Diet
These days, looking for attractive health-care stocks feels like trolling the dregs at the bottom of a fruit stand — every apple has a couple bruises.
The S&P 1500 Health Care Sector Index has returned 3.8% over the past year, versus a loss of 1.6% for the broader index. But the average health-care stock in the index posted a negative return of 5%. The outperformance of the market-cap-weighted index was driven by a fairly small number of large stocks — most notably those in the drug and biotechnology groups, which combine to make up nearly 60% of the sector's stock-market capitalization.
Over the last year, the average drug stock in the index returned 17%, while biotech stocks delivered 6% returns. In all but one of the other health-care industries, stocks averaged negative 12-month returns.
Patent expirations, regulatory roadblocks, and declining reimbursement rates drag on the health sector. Wall Street's concerns are legitimate but don't negate long-term, overarching themes that still lean in the sector's favor: the aging population, longer life spans, and a rising emphasis on diagnosing diseases early.
Historically, a value-oriented approach has worked best with health-care stocks. In 12-month periods since 1994, the top one-fifth of S&P 1500 health stocks as measured by QuadrixÂ® Value score outperformed the average stock in the sector by an average of 2.3%. No other Quadrix scores delivered such outperformance.
But the picture has changed over the last two years, with Momentum, Earnings Estimates, and Performance scores enjoying strong predictive power. In the last 24 rolling 12-month periods, the top quintile of health-care stocks in the S&P 1500 Index by Overall score has outperformed the average stock in the sector by an average of 4.9%, while portfolios of top scorers in five of the six category scores delivered at least 1% outperformance.
While both growth and value metrics currently work in health care, investors need not use just one strategy. Many health-care stocks, including most of those in the table below, offer solid growth potential at an attractive valuation.
As the table below shows, health-care industries vary greatly in their investment appeal. The two top-performing groups over the last 12 months (drugs and biotech) average Quadrix Overall scores above 60, but Value scores below 50. In contrast, several groups with weak 12-month returns (such as managed care, facilities, distributors, and services) earn above-average Overall and Value scores.
The health sector doesn't look particularly impressive based on operating momentum or earnings-estimates revisions. But we're not buying the whole sector. All 10 of the health-care stocks in the table below are expected to grow profits at double-digit annual rates over the next five years.
The table below features names from the Forecasts and our sister publication, Upside, which focuses on small-company stocks. Managed-care companies look particularly appealing, and three are reviewed below.
Aetna ($40; AET) has slumped 18% since declaring March-quarter results April 26. The insurer posted its strongest sales growth in nine quarters, while per-share operating earnings rose 18% and operating cash flow surged 78%. A modest rise in utilization rates squeezed profit margins in the quarter, driven by an uptick in outpatient procedures and visits to physician offices. Management had been cautioning investors that utilization would eventually climb back to historical norms. The reversion may be happening more quickly at Aetna than at UnitedHealth Group, which said, "utilization trends remain moderate."
Perhaps in response to rising utilization, Aetna did not release any reserves in the quarter, as some analysts expected. Such releases have accounted for much of Aetna's positive profit surprises over the last two years and may have been built into the March-quarter consensus the company did not match. Perhaps the reserves reflect expectations of higher medical costs, and perhaps Aetna is just being conservative. It is too early to assess whether the higher utilization (mostly in January and February, not March) is a blip or a trend.
At the same time it declared earnings, Aetna reiterated its 2012 profit guidance and suggested it might pursue a more aggressive buyback strategy than previously planned for the last nine months of the year. The company expects to add 300,000 customers this year, bringing membership to 18.2 million.
The pullback leaves shares looking cheap at just eight times trailing earnings, 22% below their five-year average P/E ratio and 20% below the median for managed-care stocks in the S&P 1500 Index. Earning a Value score of 93, Aetna is a Focus List Buy and a Long-Term Buy.
UnitedHealth Group ($56; UNH) enjoys an attractive blend of strong operating growth, improving outlook, cheap valuation, and favorable share-price action. All six Quadrix category scores are above 55, while both sector-specific ranks exceed 96.
With 39.8 million members, the insurer is a steady grower, producing eight straight quarters of at least 6% higher sales. Operating cash flow has advanced in 12 of the last 15 quarters. UnitedHealth enrolled 1 million new customers in the March quarter — roughly in line with the company's prior expectations for the full year. Now UnitedHealth sees membership up by 1.7 million to 1.9 million in 2012. Rising analyst estimates project 2012 earnings of $4.98 per share, implying 5% growth. The consensus projects sales growth of 8% for the June quarter and the full year.
Shares have rallied 10% so far this year. At 11 times estimated 2012 earnings, the stock trades 19% below the median for S&P 1500 health-care stocks. UnitedHealth Group is a Buy and a Long-Term Buy.
WellCare Health Plans ($56; WCG) is positioned to benefit if the Supreme Court upholds health-care reform in its current state. As proposed, the mandatory insurance would extend coverage to an additional 30 million people, split about evenly between Medicaid and commercial plans. A provider of managed-care services with more than 2.5 million members, WellCare draws about 60% of its revenue from Medicare and 40% from Medicaid.
Sales growth has accelerated in five consecutive quarters, including a 21% jump in the March quarter, helped by a 6% increase in membership. Management said utilization rates remain moderate, helped in part by a milder flu season. Per-share profits doubled to $1.32, well above the $0.54 consensus, and the company raised its 2012 profit range to $5.20 to $5.40, up $0.80.
Last month, WellCare agreed to pay more than $137 million to settle lawsuits related to overbilling Medicare and Medicaid; the company does not expect the settlement to have a material effect on its 2012 profits. In the wake of the settlement, WellCare may look more attractive to a larger managed-care company seeking to boost its exposure to Medicare and Medicaid. However, we don't expect much takeover activity in the group until a Supreme Court ruling on the Affordable Care Act, expected in June or July.
The stock's Overall score and both sector-specific ranks exceed 95. WellCare shares have returned 6% so far this year. Despite the gain, the stock is still attractively valued at eight times trailing earnings, 40% below its three-year average and 17% below its peer-group median. With a market value of $2.42 billion, WellCare is an Upside Best Buy. The stock is volatile, and more risky than the typical Forecasts recommendation.