Your Money : Health Stocks May Be in Recovery--but Take It Slow

Two days’ worth of big merger deals in the health care industry may be whetting some investors’ appetites for stocks in this long-unloved market sector.

Consolidation alone won’t spur a new bull market in this group, of course. There have been several waves of health care mergers in recent years, but the stocks have mostly just continued to drop. With federal health care reform still uncertain in timing and scope, many investors can’t find a good reason to dive into these stocks.

Even so, for bargain-hunting investors health care may not be a bad place to shop. Many of the stocks are now in their third year of decline, and quite a few are selling for nominally cheap prices relative to earnings. Not all of these companies are headed for Chapter 11 after all--reform or no.

Edward Owens, manager of the Vanguard Specialized Health Care fund in Valley Forge, Pa., says Monday’s $5.3-billion takeover bid for drug giant Syntex, by Switzerland’s Roche Holdings, is a vindication of sorts for his fund’s 28% weighting in major drug company stocks.

While conventional wisdom on Wall Street is that the drug companies will be among the biggest victims of health care reform, Owens sees it differently. The companies’ pricing power isn’t what it used to be, he concedes, but in the long run, he argues, the truly innovative firms should still be able to realize significant payoffs--worldwide--for their research efforts.

“This has always been a business where the real wealth is created by the discovery of important new drugs,” Owens says. Syntex has lagged in new discoveries recently, but Roche evidently saw enough potential in Syntex’s pipeline to warrant a rich takeover price, Owens says. “The message is that the value in pharmaceutical companies is in the pipeline,” he says.

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If the market takes a brighter view of drug firms for that reason, Pfizer and Johnson & Johnson should benefit, Owens says. Pfizer’s research-stage drug for rheumatoid arthritis “could be a blockbuster,” he says, while J&J;, best known as a maker of over-the-counter medical supplies, “is becoming more and more a drug company.” Both are major holdings in Owens’ fund.

Likewise, biotech stocks, many of which have plunged again this year, may begin to attract more interest if the market’s focus turns to the long-term value in research-stage drugs. About 10% of the Vanguard fund’s $582 million in assets are in biotech shares, including Biogen, Genetics Institute and Alliance Pharmaceutical. “I think biotech is more attractive than it has been in a long time,” Owens says.

Meanwhile, a set of deals announced Tuesday may have highlighted hidden value in another major health sector. SmithKline Beecham agreed to buy United HealthCare’s drug management division, while Pfizer launched a joint venture with another managed care firm, Value Health.

The managed care companies are the controllers at the delivery end of the health care system, advising businesses on how to structure health plans and how to get the right prescriptions into plan beneficiaries’ hands at the best price. The drug companies have increasingly felt the need to either move right into distribution themselves (note Merck’s decision last year to buy Medco Containment, a mail-order drug firm) or to strike deals with managed care providers, who direct an increasingly large share of health care spending.

Along the same lines, Barry Kurokawa, manager of the $460-million Invesco Health Sciences fund in Denver, says some of the best stock values in health care remain the service providers such as HMOs and the largest of the hospital chains.

The major hospital stocks, such as Columbia/HCA Healthcare and Healthtrust, were rediscovered by Wall Street last year, but Kurokawa argues that “they’re still selling for reasonable valuations” of 13 to 15 times estimated 1995 earnings per share. He believes the companies are capable of 20% annual earnings growth, as their increasing size and power provide them with greater leeway to demand price concessions from makers of medical equipment and supplies.

Companies that specialize in home health care, such as infusion services for the elderly and others, also deserve more respect on Wall Street, Kurokawa contends. He sees a place for them under health care reform and believes that “a lot of them are attractively priced now.” Two that he owns are Caremark International and T2 Medical.

Still, Kurokawa concedes, the next true bull market in health stocks may have to wait until investors lose their fascination with industrial, technology and other issues that benefit most from the burgeoning economy. That means patience is still a requirement in health care investing.

Waiting for a Turn

Most mutual funds that specialize in health care stocks are on their way to a third bad year--unless investor sentiment toward the industry is turning. How the major health funds have fared:

Total return: Fund ’92 ’93 ’94 Fidel. Sel. Medical Deliv. -13.2% +5.5% +5.3% Merrill Lynch Healthcare NA -2.6 -0.8 Fidelity Sel. Health Care -17.5 +2.4 -1.4 Vanguard Spec. Health -1.6 +11.8 -1.9 Putnam Health Sciences -10.7 nil -1.9 GT Global Health -13.5 +2.6 -3.3 Invesco Health Sciences -13.7 -8.4 -3.9 Dean Witter Health NA +5.6 -4.3 Oppenheim. Glo. Biotech -22.9 -0.7 -13.4 Avg. genl. stock fund +8.9 +12.5 -3.4

NA: Not available (fund was too new)

1994 data through Monday

Source: Lipper Analytical Services