HEALTH CARE: Slowly Getting Well

A Wall Street truism says that consumers might eliminate nonessentials during periods of financial uncertainty, but they'll take care of medical problems no matter what.

That's a major reason investors who were worried about an economic slowdown in the third quarter turned to the health-care sector, particularly pharmaceutical stocks, analysts say.

Wall Street calls such thinking a "defensive" stock play. That's when investors buy shares in industries they believe will do well, or at least less poorly, than others because demand for their products will remain relatively steady. Other defensive stocks include those for makers of consumer staples such as toilet paper and toothpaste.

"When people get sick, they do what they need to get better, and they will do that whether the economy goes up or down," said Jack Caffrey, an equity strategist at J.P. Morgan Private Bank in New York.

The health-care component of the Standard & Poor's 500-stock index rose 9.8 percent in the three months ended Sept. 30, nearly double the 5.2 percent gain of the S&P 500 as a whole. Some analysts predict demand for health-care stocks will continue to grow in 2007, producing double-digit price gains in the mid to high teens, as a softening housing market and high energy prices continue to rattle investors.

Health care's performance in the third quarter was fueled largely by drug industry stocks, which account for nearly 54 percent of the S&P's health-care category and were up 12 percent for the quarter. In addition to viewing pharmaceuticals as a consumer staple, investors saw drug company shares as a bargain that had been overlooked after several years of lackluster performance and bad news, said Brad Sorensen, director of sector research at brokerage Charles Schwab & Co.

Though the S&P 500 climbed 8.99 percent in 2004, the health-care sector gained only 0.23 percent and pharmaceuticals fell 7.43 percent. In 2005, health care's growth of 4.85 percent outpaced the S&P 500's 3 percent gain, but pharmaceuticals fell 3.36 percent.

Investors had soured on the drug industry for several reasons, analysts said. Companies had fewer significant new drugs in the pipeline. Liability cases abounded amid well-publicized problems, such as Merck & Co.'s having to pull its top-selling painkiller, Vioxx, from the market because of a possible link to heart attacks.

But in the third quarter of this year, investors began to think that drug stocks were undervalued and that the industry's ability to innovate and win lawsuits had been underestimated, analysts said.

For example, Merck will face an estimated 40,000 claims against it in connection with Vioxx, fewer than half the number that had been estimated a year ago. And so far, it has won five Vioxx cases and lost four. Two of the rulings in Merck's favor came down during the third quarter -- one in mid-July and another two weeks ago. Merck's stock, which had hovered at or below $37 a share for the first half of July, jumped to more than $40 a share by month's end. By the end of September, it was hovering in the $41 to $42 range.

The stock of fellow drug giant Pfizer Inc., which is facing increasing competition on its cholesterol-lowering drug Lipitor, jumped from a quarterly low of $22.41 a share on July 17 to nearly $26 a share two weeks later on news the company's directors had ousted chief executive Henry A. McKinnell. During McKinnell's five-year tenure as chief executive, the company's spending on research increased by more than 50 percent, but its stock price fell 40 percent. By the end of September, the company's stock was trading just above $28 a share -- a 27 percent increase from mid-July -- where it has held steady.

Jim Reddock, a health-care analyst specializing in biotechnology at Friedman Billings Ramsey Group Inc., an Arlington-based investment firm, said big, traditional drug companies as a group fared better than most biotech firms, which tend to be smaller, but they too did well, spurred in part by deals like the one announced in early June involving Rockville-based biotech Human Genome Sciences Inc.

Under terms of the agreement, drug giant Novartis has the license to market a potential new treatment for chronic hepatitis C now under development by HGS. During the quarter, shares of HGS rose nearly 8 percent to $11.54. FBR does not buy or sell shares in either company for its own profit.

Another part of the health-care sector that did well was the S&P 500 "facilities" group, which rose 13.7 percent, more than double the S&P 500 as a whole. Much of the gain came from HCA Inc., the nation's largest for-profit hospital chain, which in July announced it had agreed to a multibillion-dollar leveraged buyout by an investor group that includes big-name Wall Street players like Kohlberg Kravis Roberts & Co. The deal -- which pushed HCA's shares from under $44 a share in early July to between $49 and $50 share by September's end -- will take the company private, a move that analysts say boosts confidence in the industry.