7 Healthcare Stocks for a Sick Market

One of my favorite movies in high school was “The Warriors”. This 1979 story of gangs in NYC has a lot of parallels to the market today. The “truce” is off – we are in a bear market. Everyone is on their own to bop their way through this year. After year-end efforts by investment managers who have a vested interest in propping up prices in order to boost fees and by analysts who hold off on downgrades until after the calendar turns lest they alienate their favorite clients, the selling and telling began in earnest this week (was anyone else astonished to see so many downgrades on Wednesday morning???). One of the songs from the movie that has forever stuck in my mind is entitled “Nowhere to Run”. I always think about it in bear markets, which has only been three times fortunately, because it isn’t a good song! Well, while there aren’t very many places in my opinion to hide, I do believe that one potential haven is Healthcare, which should be immune to the weakening consumer and contracting credit conditions. I own five of the names I discuss below and have my eyes on the other two for purchase at a slightly lower price.

Healthcare is a very diverse economic sector, with different industries performing quite differently. I tend to look at the overall sector as consisting of Biotech, Pharmaceuticals, Hospitals/Providers, Insurance Companies/Benefits Managers, Analytical Tools Providers, Service Providers to the Industry, Devices and Diagnostics. Clearly, there is tremendous diversity. Over the past few years, smaller names have performed better than larger names in general, with the S&P 500 up just 33% cumulatively since 2002 and the Mid-Cap (S&P 400) and Small-Cap (S&P 600) more than doubling (click all charts to enlarge):

In general, though, the sector has not really been the place to be during the bull market, with Large-Cap Health lagging the S&P 500 by 20% cumulatively over the five years (rather consistently). Small-Cap Health surged this year relative to the deteriorating overall S&P 600, more than wiping out the small deficiency over the prior 4 years. Mid-Cap Health, bolstered by acquisitions over the past few years, came back from a tough 2006 and has outperformed the S&P 400 by 9% cumulatively. In the smaller two capitalizations, earnings growth has been strong throughout the time period. In terms of valuation, the median PE for all 75 of the Healthcare names in the S&P 600 is 20 (a PEG ratio of 1.1), while the 51 names in the S&P 500 have a median PE of 16.4 (PEG of 1.2). The table below shows the relative difference to the respective benchmarks over time for the sector:

Most of the issues that plague the sector are big but well known: Hospitals are inefficient and can’t get paid, large drug companies have more drugs facing patent expiration than new drugs coming out of the pipeline, the FDA is a bottleneck, safety is a real issue, Medicare is facing insolvency next decade, device manufacturers have questionable business practices in their “consulting” relationships, etc. There are some great themes – companies that take cost out of the system, personalized medicine, the aging population and others, but most of these ideas have been picked over. Each of the names that I suggest merit a look shares one major factor: They are all in long-term bullish trends but not extended at all. Beyond that, there are no major common themes – just stocks with limited downside and potentially high upside in my opinion.

Allergan (AGN) (62.07, $19 billion, S&P 500) is a safe way in my opinion to participate in the sector. While the stock trades at a somewhat high absolute PE, its growth justifies it. It is one of the few aesthetic-related stocks that I trust – no one will give up their Botox! The company’s eye care franchise isn’t very sensitive to reimbursement threats or to generic substitution. The company is well managed, has a strong balance sheet and has the potential to enjoy higher margins over time as they leverage their high investment in SG&A and R&D. I wrote about the company in February and then again later in a review of the aesthetic space. The stock has rallied subsequently, but it trades at a slightly lower forward PE multiple today. I believe that the stock could rally to as high as 87 over the next year (28X the $3.10 2009 consensus). To do so, it will have to hit numbers during a period in which I expect that many companies will fail to do so. Technically, I see support in the 60 area.

After watching Celgene (CELG) (49.65, $19 billion, S&P 500) in disbelief for years, I recently invested at about 47 near the end of the year. While known mainly for its cancer drug, Revlimid, it also has an oral psoriasis drug in its pipeline (big underserved market). The rather sharp pullback is related to several factors (most recently concerns about rival Velcade), but they all basically address the question of how fast can it grow. Everybody is always looking for the next Amgen (AMGN) or Genentech (DNA), both of which peaked at about $100 billion market cap, and CELG could be the one. This stock is very oversold now, as many investors bailed late in the year. Clearly, investors don’t believe the analyst numbers, as 31 PE is too low for a company expected to post earnings growth in excess of 40% in each of the next few years. This is my riskiest pick, but the potential reward is great. Very conservatively, I estimate that the stock could get to 67 in 2008 by just holding its multiple. Of course, if the perceived risks fail to materialize, the stock could easily break to an all time high of 75 and still be well below its recent valuation and its growth rate. Controlling risk is essential, and I do so by maintaining a 44 sell-stop and keeping the position size relatively low.

I thought HealthExtras (HLEX) (26, $1.1 billion, S&P 600) was timely in early June, but it has pulled back (in line with the Russell 2000) to support. Earnings estimates have been negatively impacted by the exit from a slow-growing high margin business. For those not familiar with HLEX, it is a unique PBM, differentiated from its larger peers by its higher level of service and its relative transparency. 7 months ago, I discussed a year-end target of 39 based on a 30 multiple of 2008 estimates. While I think that multiple is realistic for a young company with plenty of open road ahead, I am scaling it back to 26X 2009 – still 39. This is one of just two stocks in which I have invested my children’s educational funds. I see downside support at 25 and beneath it at 23.

Lincare (LNCR) (34.69, $1.5 billion, S&P 400) is the best house in what appears to be a terrible neighborhood. As I wrote in May, investors have seemingly priced in some pretty bad scenarios for reimbursement to the oxygen providers. If those cuts don’t take place, the stock will soar instantly. If they do, the stock’s hit should be limited as investors contemplate the higher long-term growth rate. Unfortunately, I expect that the stock will be in limbo possibly for the next year, as I don’t believe that Congress will address this until after the election, though there is a chance that there is a decision in the summer. Technically, I see support at 32. Estimates for 2009 are all over the place due to Medicare reimbursement uncertainty. In an optimistic case, I believe that the stock could reach 45 or higher. I believe that Congress will not risk stranding senior citizens who need oxygen and will ultimately not kill the industry. In the meantime, the stock should be uncorrelated to the overall market and thus has appeal to me.

Surmodics (SRDX) (52.48, $950mm) is sitting right where it was when I wrote about it in late October, which isn’t bad in this market (R2000 down 12% since then). The stock seemingly broke out afterwards but pulled back on “disappointing” earnings and then has worked its way back up. This is the other stock I own for my kids. Why? Lots of shots on goal, a huge misdirected (in my opinion) short-interest, a seemingly high valuation that in fact is distorted by a massive R&D spend and a lack of following due to perceptions of it being a “one-trick pony” (coated stents). Their technology for delivering drugs to the eye, validated by their massive licensing deal with Merck (MRK) is probably reason enough to own the stock, but there are several other interesting things going on. Bottom-line, this one too is totally uncorrelated to much of anything. Downside technically appears to be 49-50. Target? Very difficult to determine precisely, but I will be disappointed if the stock doesn’t trade to 70 over the year (39X the current calendar 2009 estimate). I view this as a call option on top of a strong balance sheet that cranks out free cash flow despite large investments in growth.

Wellpoint (WLP) (87.57, $50 billion, S&P 500) has performed well after an initial weakness following my article in February. I believe that the whole health insurance group is generally attractive, as fears of major changes after the election are exaggerated. WLP is my favorite due to its unique Blue Cross/Blue Shield alliance nationally. The company is a consistent grower. One risk is that unemployment shoots up, reducing the number of insured. Despite being quite bearish on the economy, I expect that unemployment will not surge as companies will absorb lower margins rather than torture themselves trying to find qualified workers when the economy recovers. Technically, the downside is in the 80 area. I am hoping for a pullback to 83-84 for an initial entry. A reasonable year-end target of 15-16X would suggest a range of 110-117.

Zimmer (ZMH) (66.5, $15.6 billion, S&P 500) is one of a handful of large players in the orthopedic space. The stock has suffered due to disappointment over its gender-specific hips, the surprise departure of its highly regarded CEO and a cloud of uncertainty surrounding business practices (doctors being paid as consultants). Long-term, this is a terrific industry in some regards – demand should be solid (we are getting older and fatter as a nation). It does bother me that despite their protests otherwise, the companies essentially sell a commodity. ZMH is my rebound play, though I haven’t bought any yet. On the first sign of good news, I believe that there will be a stampede into the name. I would like to buy it closer to 64. I think that 60 should serve as good support. On a break of 69, it is off to the races in my opinion. I believe that the stock could trade at 18X the 2009 estimate, which is 86. I believe that it is very cheap relative to the more diversified but lower-margin Stryker (SYK).

I have offered 7 very different ideas, ranging the gambit in market cap, industry and valuation. Perhaps I am too aggressive on my potential upside expectations, but I expect that most of these names will hold in much better than the market as investors crowd into names viewed as less risky with respect to the deteriorating economy. I believe that all of these companies have strong management teams and decent to excellent balance sheets, another potential attraction to investors looking for somewhere to run, somewhere to hide…

Disclosure: Long AGN, CELG, HLEX, LNCR and SRDX