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By David Sterman

It's an old investing axiom that you can make money when stocks are hated. The rule also applies to the broader stock market and beaten-down sectors. It always pays to check out stocks and sectors that have sharply fallen to see if emotion-based selling has pushed them so far down that they have become true bargains.

This year's poster child for investor loathing is the home health sector, which has been dogged by Securities and Exchange Commission investigations, profit-sapping reimbursement changes from Medicare, and management teams that appear flat-footed. Yet looked at in another context, the home health care sector should hold great appeal, thanks to the rapid aging of our society and the fact that treating patients in their home is always far more cost-effective than treating patients in a hospital. It's quite possible that near-term pain may well yield some impressive long-term gains for these unloved shares.

These stocks include Amedysis (Nasdaq: AMED), Gentiva Health (Nasdaq: GTIV), LHC Group (Nasdaq: LHCG) and Almost Family (Nasdaq: AFAM). All of these stocks have lost -35% to -55% of their value in the last six months. Their troubles began in late April when The Wall Street Journal reported that some home health-care providers -- most notably Amedysis -- were pushing for extra home care visits in order to meet a Medicare-induced threshold that awarded bonus reimbursement fees. Two weeks later, the Senate invited company executives to come and testify.

That was followed up with a July 1 announcement of a SEC investigation. As a final kicker, Medicare announced that it would cut reimbursement for home health care visits by roughly -5% in 2011 and by a similar amount again in 2012.

For investors, it's time to separate the one-time problems from the long-term impacts. In the near-term, the SEC may issue some pretty steep fines for overbilling. Amedysis appears to be the most egregious violator, and could face the steepest fines. And Medicare is likely to change reimbursement rules in order to remove the incentive for too many home health care visits. As it stands, Medicare is taking much longer to re-certify patients that have already been receiving home health care visits. That could have a fairly immediate impact on near-term results, although it's curious to note that 2011 profit forecasts for these firms have barely budged in the last 90 days. Forecasts will need to come down before these stocks are safe to buy.

For some investors, those -5% reimbursement cuts in 2011 and again in 2012 are the main reason to avoid this sector. Those cuts may seem onerous, but still leave ample room for profit. These providers can bill roughly $250 for each visit, though it only costs them about $80. So they can easily handle some price cuts. These companies typically had 55% gross margins and 15% operating margins. Gross margins in the high 40s and operating margins may become the "new normal." That's still fairly impressive -- especially when you consider that demographic changes should lead to steadily higher patient volumes. And these companies have ample means to buy their way into growth as this remains a very highly fragmented industry with roughly 10,000 players.

The sharp fall in sector shares means that all of these stocks now sport single-digit price-to-earnings (PE) ratios. Yet there's no reason to rush out and buy shares simply because they are cheap -- especially since we haven't heard the last of the SEC investigations. Instead, this is a sector to watch and prepare to move in when the time is right.

As noted, Amedysis looks to be the most egregious violator of billing practices, and its shares should probably be avoided, no matter what. Gentiva Health may also see more troubles as it may be unable to raise the funds to pay for its May, 2010 $1 billion acquisition of Odyssey Health care.

In contrast, Almost Family looks fairly appealing thanks to its 50% revenue concentration in increasingly geriatric Florida, apparently cleaner billing practices, and a relatively strong balance sheet which should fuel acquisitions. LHC Group is also seen as a relatively clean operator and management has a strong track record of garnering strong returns on invested capital. Both of these firms trade for about eight times projected 2011 profits.

Whenever a sector has been badly bruised, you have nothing to gain by being the first one to wade back in. Instead, I prefer to see these shares start to rebound a bit -- perhaps +10% to +15% above current levels. Sure you're leaving some upside on the table, but at least you avoid waiting for several quarters before seeing your investment start to appreciate.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.
Source: Which Out-of-Favor Home Health Stocks Are the Best Buys?