As The Supreme Court Mulls Health-Care Reform, The Sector Looks Cheap

| About: Health Care (XLV)

By Robert Goldsborough

This week, the nine justices of the U.S. Supreme Court began hearing three days of oral arguments on what undoubtedly will be one of the most watched cases on the court's docket in decades: President Obama's health-care law.

The court's ruling on whether some or all of the president's hotly debated Patient Protection and Affordable Care Act is constitutional isn't expected for at least several months. In fact, we'd guess it would be one of the final opinions that the justices issue before they head off on their three-month-long summer vacation.

Before and during the court's oral arguments, there of course has been much public debate over the constitutionality of the law--and for that matter, whether it is good or bad public policy. However, every bit as important of a question for health-care investors--particularly those holding or considering investing in health-care-themed exchange-traded funds--has to be this: What is the market currently pricing into the valuations of health-care companies and, by extension, health-care ETFs?

After All the Noise, the Law Likely Will Be Upheld
We believe that the Supreme Court will uphold the law's individual mandate, which requires all Americans to have health insurance starting in 2014. While it is no guarantee that the law will be upheld, the four justices appointed by Democratic presidents are widely expected to view the law as being constitutional. By contrast, only one justice appointed by a Republican president--Clarence Thomas--is widely expected to deem the law unconstitutional. That leaves four other justices' votes in play, with Chief Justice John Roberts and Justice Anthony Kennedy and Justice Antonin Scalia all possible votes upholding the law's legality.

Certainly, passions are high on both sides of the political fence, and good cases can be made about how the rest of the court's conservative justices will rule. However, despite many opportunities that both Scalia and Kennedy have had over each of their 24 years-plus on the court, neither justice has ever questioned Congress' power to regulate interstate commerce. That's what is at the heart of the debate over the constitutionality of the law. And two noted Republican-appointed, conservative federal appeals court judges, Jeffrey Sutton (a former Scalia law clerk) and Laurence Silberman, have written opinions that have acknowledged the law's constitutionality--opinions that many observers believe are blueprints for how some of the conservative justices will rule.

Morningstar's equity analysts who cover the health-care sector agree, maintaining estimates on health-care companies that are largely based on the law's individual mandate staying in place. Since its passage two years ago, the Affordable Care Act has been a modest net negative for the earnings of most health-care companies, but with the addition of 32 million uninsured patients, the law's individual mandate--if upheld--swings to a widespread positive for the health-care sector come 2014. Indeed, the law enjoys fairly broad support within the health-care industry.

A Buying Opportunity
If there's one thing the market hates, it's uncertainty. And the uncertainty over whether the health-care law will remain in place has been one of the factors conspiring to weigh on the share prices of health-care companies--and as a result, health-care ETFs--in recent months. Certainly other factors also have been at work to constrain health-care firms' share prices--including mandatory government budget cuts taking effect in January 2013. For investors, the bottom line is that the health-care sector is reasonably priced right now--in fact, it's tied with the financials sector for the second-cheapest of all major equity sectors, with only the energy sector trading at a larger discount to what Morningstar's equity analysts believe is its fair value.

In addition, the health-care sector enjoys some powerful secular trends that should help its long-term growth. As America ages, demand for health care is expected to rise. And even in the short term, health-care companies have been enjoying slow but clear demand growth over the past few quarters, with personal health-care expenditures having exceeded sequential gross domestic product growth during the second and third quarters of 2011.

ETFs to Consider
For investors who are considering investing in the health-care industry but who want to avoid single-stock risk and benefit from diversification, there is no shortage of ETFs that fit the bill. Far and away, the largest and most liquid of the broad-based health-care ETFs is Health Care Select Sector SPDR (NYSEARCA:XLV). With a broad portfolio of high-quality, large-cap U.S. health-care names--along with a rock-bottom, 0.18% expense ratio--XLV also is a great choice for exposure to the sector. In addition, XLV, which holds 52 companies, trades at an attractive 90% of the weighted aggregate fair value of its holdings, as computed by Morningstar's equity analysts. By contrast, the S&P 500 Index--embodied in an ETF as SPDR S&P 500 (NYSEARCA:SPY)--trades at a slightly more expensive 94% of its fair value at present.

Another option is iShares Dow Jones US Healthcare (NYSEARCA:IYH), which holds 119 companies and offers exposure to a much broader swath of the health-care sector. IYH trades at 91% of fair value and charges 0.47%. A still even broader alternative is Vanguard Health Care ETF (NYSEARCA:VHT), which holds almost 300 U.S. health-care companies and charges a very inexpensive 0.19%.

For investors seeking a fund with exposure to global health-care companies, the most suitable choice is iShares Global Healthcare (NYSEARCA:IXJ), which holds 84 global health-care names. Close to 40% of the fund's holdings are heavyweight firms based outside the U.S. and thus not held in many other health-care ETFs, such as Novartis (NYSE:NVS), Roche Holding, and GlaxoSmithKline (NYSE:GSK). IXJ charges 0.48% and trades at 93% of fair value.

Finally, for subsector-level exposure, investors might consider a pharmaceutical ETF, given that pharmaceutical firms make up 40%-50% of the assets of large health-care ETFs. One appropriate option is Market Vectors Pharmaceutical ETF (NYSEARCA:PPH), which is a 25-stock, market-cap-weighted portfolio of Big Pharma firms that trade on U.S. exchanges (but can be based either in the U.S. or abroad). PPH charges 0.35% and trades at 93% of its fair value. Another possibility is iShares Dow Jones US Pharmaceuticals (NYSEARCA:IHE) (0.47% expense ratio), which also is a market-cap-weighted fund that holds 37 pharmaceutical firms based in the United States. IHE trades at 94% of its fair value.

If the Law Is Repealed...
For those who believe that the Supreme Court will overturn some or all of the health-care law, one compelling investment option might be a global health-care ETF such as IXJ, which invests almost 40% of its assets in companies based overseas and devotes more than three fourths of its assets to large-cap pharmaceutical companies. Another possibility is SPDR S&P International Health Care Sector ETF (NYSEARCA:IRY), which charges 0.50% and holds only health-care firms domiciled outside North America.

Health-care reform was particularly bad for managed-care organizations, although we believe that many of the negative effects that they are facing--owing to Medicare Advantage reimbursement cuts--are ones that would have occurred even without a comprehensive health-care bill. And managed-care organizations currently stand to benefit from the bill's increased membership in Medicaid and individual insurance products. Thus, we contend that investors who believe that the law will be invalidated should avoid ETFs heavy in managed-care organizations; some such ETFs are iShares Dow Jones US Healthcare Providers (NYSEARCA:IHF) and PowerShares Dynamic Healthcare (NYSEARCA:PTH). (Health-care providers and services firms generally comprise between 15% and 25% of the broad health-care ETFs such as XLV, IYH, and VHT.)

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.