Healthcare Reform: Why Wall Street Is Bullish

| About: Health Care (XLV)
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If reforms out of Washington are poised to wreck the healthcare industry, somebody forgot to tell the stock market—including hundreds of professional investors who own healthcare stocks and get paid to assess their prospects.

Many opponents of healthcare reform fret that deeper government involvement in the healthcare system will strangle free enterprise. The biggest worry is a possible federal healthcare plan—the "public option"—that might outcompete private plans, thanks to unfair advantages that come from government power. It's certainly true that stronger regulation, usually intended to correct abuses, tends to depress the profits of the firms being regulated. But if stock prices are any indication, investors are less concerned about healthcare reform than critics rallying to the cause of free enterprise.

To measure the market's reaction to the reform proposals percolating in Washington, I analyzed stock-price data provided by Zacks Investment Research. Here's the median stock performance over the past 12 months for three industries that would be directly affected by reform:

  • Hospitals and health insurers: Up 34 percent
  • Drug manufacturers: Up 2.5 percent
  • Medical products: Up 12 percent
  • S&P 500: Up 27 percent

Health insurers arguably stand to lose the most from reform. At least that's the rhetoric. Most reform proposals would end controversial practices like refusing coverage because of pre-existing conditions and putting caps on benefits for those who end up getting sick and needing care. Some critics worry that a powerful government plan could undercut the big insurers on price, like a healthcare version of Wal-Mart (NYSE:WMT), while taking advantage of rules rigged to snuff out private competition. The eventual result: an Orwellian government takeover of the entire healthcare industry.

Sounds spooky, but before you flee to a less despotic nation, consider the reasons that insurers are likely to survive—and maybe even thrive. Any new costs borne as a result of reform will probably get passed on to customers, as they usually do. Insurance companies may even get more customers, thanks to a new requirement that every American have health insurance, which is part of every major proposal Congress is debating.

If a government healthcare plan materializes, it might actually generate more work for insurance companies. A new government program would probably subcontract much of its administrative work to existing insurance companies—which is what Medicare does. Since government coverage might be basic, supplemental insurance offered in the private market would probably spring up, which also happens with Medicare. "Under most scenarios, health insurer top-line growth should accelerate," says David Rubenzahl, president of the Maxon Companies, which administer healthcare programs for companies that are self-insured. The only outcome he foresees that could threaten insurance companies is a government plan that's empowered to set low rates for doctors and other providers, which could undercut private insurers and draw customers away from them.

That's the doomsday scenario for insurance companies—but political opposition, public unease with government-run healthcare, and many other factors stand in the way. So instead of plunging in value, which is what usually happens to the stock price of an endangered company, insurance stocks have generally kept up with the market as a whole. They significantly outperformed the S&P 500 late last year, when the overall market was collapsing, since healthcare in general is considered a "defensive" sector that's more stable in turbulent times. They've underperformed this year, which is also consistent with the way defensive stocks perform in a market rally, when investors favor growth stocks more likely to surge. "The market is not screaming, 'This is the end of the world,' " says Dirk van Dijk, director of research at Zacks. "This won't be that punitive to the industry."

The drug and medical device industries have performed below average over the past 12 months, but there are factors besides healthcare reform that might explain why. In the drug industry, stock-price declines are usually linked to the loss of patent protection for highly profitable name-brand drugs, which means cheaper generics will come on the market and cut into profits. That's happening at several firms. Two big drug-industry mergers have highlighted the need for consolidation in an industry with steep research-and-development costs. The medical device industry, unlike the pharmaceutical sector, has generally opposed congressional healthcare reform efforts from the start and may end up paying a higher share of new industry fees as a result. Stock prices may reflect that.

Overall uncertainty is probably depressing healthcare stocks as well, since it's always possible that politicians could do something wacky and trigger regulatory Armageddon. That means stock prices could rebound once a health reform bill is passed, as long it doesn't contain unforeseen provisions. But for now, healthcare stocks are relatively cheap. The price-to-earnings ratios of many healthcare firms, for instance, are lower than average, which means those stocks may be undervalued relative to the profits the companies are likely to generate. Here are some more figures from Zacks, covering median P/E ratios based on earnings projections for 2010:

  • Hospitals and health insurers: projected P/E ratio of 12.8
  • Drug manufacturers: 11.0
  • Medical-products manufacturers: 14.1
  • S&P 500: 13.8

Some big healthcare companies even have single-digit P/E ratios, which is unusually low for large, healthy companies. WellPoint's 2010 P/E projection is about 8.9, according to Zacks; UnitedHealth's is 9.1. That could mean the market is pessimistic about those companies' future. Or it could represent a terrific bargain on a quality stock. (Or both.) "This is a really nice opportunity to buy these companies," says van Dijk. "Either way, I suspect they'll end up rising, because they'll benefit from less uncertainty." Won't we all.

Disclosure: no positions