If, on some dark street, I am accosted by a stranger with a gun who tells me gruffly that I can invest in only one business sector and demands to know what it is, I will blurt out, "Don't shoot! Health care!"
An unlikely scenario, I know. Luckily, none of us has to choose a single sector, and all of us should spread the contents of our stock portfolio widely. But health care -- in all its various aspects -- is my past, current and future favorite.
For five reasons: (1) As people get richer, satisfying most of their material needs, they will spend more and more money to stay alive longer; (2) technology is spreading innovation and efficiency faster in health care than in any other part of the economy; (3) technology notwithstanding, many parts of the sector are backward and ripe for improvement; (4) the continual threats to health care firms from regulators and lawyers keep stock prices reasonable; and (5) there are many superbly managed firms in the sector.
On that last point: Business Week just published its annual list of the 50 best-performing businesses among the large corporations that make up the Standard & Poor's 500-stock index. The magazine used such criteria as sales and earnings growth; increases in profit margin and return on equity; debt-to-capital ratios; and stock-market returns. "The industry that emerges as the biggest winner this year," said Business Week, "is the health-care sector."
That's an understatement. Health care accounts for seven of the top 10 companies, nine of the top 20 and 18 of the 50. In other words, while only one-tenth of the companies in the S&P 500 are health-related, such firms make up 36 percent of the Business Week Fifty.
They are all over the lot: Forest Laboratories (FRX), No. 1 on the list, is a pharmaceutical company that has made a huge success of licensing drugs developed by foreign manufacturers; WellPoint Health Networks (WLP), No. 2, and UnitedHealth Group (UNH), No. 3, are managed-care providers; Johnson & Johnson (JNJ), in fourth place, makes prescription drugs such as Procrit for anemia, over-the-counter remedies such as the analgesic Tylenol, personal-care products such as baby powder, and medical devices such as spinal implants.
AmerisourceBergen (ABC), sixth, and McKesson (MCK), 24th, are drug distributors; Biomet (BMET), 32nd, makes hip and shoulder implants; Walgreen (WAG), 38th, is the largest drugstore chain; AFLAC (AFL), 41st, is a specialized health insurer; and Quest Diagnostics (DGX), 48th, performs testing for doctors and hospitals. And there are more on the list, including drug giants Merck (MRK), "the sole company to grace the BW50 in each of its seven years," in 20th place, and Pfizer (PFE), in eighth.
Also, in its weekly ranking of 98 industries for "timeliness," the Value Line Investment Survey currently puts pharmacy services in fourth place, medical supplies in fifth, medical service 10th and drugs 12th. The main reason is consistent revenue and profit growth in the double digits -- at a time when most companies are elated to see their sales and profits rise at all. As Value Line analyst George Rho puts it, "Significantly, demand for health care products, be it Abbott Labs' cholesterol- lowering drug, a Medtronic pacemaker or Johnson & Johnson's soon-to-be-launched drug-eluting [extracting] stent, is seldom impacted by the state of the economy."
J&J is a good example. Last year, its earnings per share rose 18 percent; the year before, 13 percent. Analysts expect an average annual increase of 17 percent over the next two years.
I will admit to a love affair with this company. Its balance sheet is gorgeous -- just $4 billion in debt and more than $7 billion in cash and bonds. Its history of earnings growth is dazzling -- from $977 million to $6.6 billion in a decade. And, according to Bill Staton, the Charlotte author and financial adviser who tracks such things, J&J is among fewer than 30 companies that have raised their dividends for at least the past 40 years.
Like many health care companies, J&J has a secret for its success: a serious emphasis on research and development. Last year's R&D spending was $4 billion, or 11 percent of revenue. In an age of vicious worldwide competition, smart firms make big money by bringing unique products -- in J&J's case, drugs and medical devices -- to market before other firms. When companies fight over price alone, profits get whittled away. J&J stays as far away from such battles as it can.
J&J generates about 60 percent of its earnings from prescription drugs, including Ortho-Novum, a contraceptive, and Ergamisol, for colon cancer. J&J's earnings, like those of other research pharmaceutical companies, are threatened by legislation and lawsuits that seek to weaken patent protections and by proposals that could lead to price controls. But, for this industry, political threats are hardly new, and they have the beneficial effect -- for investors -- of rendering the prices of drug stocks attractive. Despite its lofty and consistent increases in earnings, dividends and cash flow, J&J, for example, trades at a price-to-earnings (P/E) ratio of 26, based on the past 12 months' profits. That seems very modest to me.
Other drug companies, as I pointed out in a paean back in November, are even cheaper. Merck trades at a P/E of 18, and Pfizer, which has traditionally been the best performer among drug-only companies, has a P/E of 22. Merck's dividend yield is 2.6 percent and Pfizer's 1.9 percent -- at a time when five-year Treasury notes are paying just 2.8 percent interest. And, while all three of these stalwart drug companies have outperformed the market as a whole over the past year, J&J is down about 10 percent and Pfizer 15 percent. Only Merck has risen, by 10 percent.
As fetching as the drug companies are, the real health care excitement is found in the category Value Line calls medical supplies. The research service awards its top rating ("1") to only 100 of the more than 2,000 stocks it assesses. Right now, 15 of those are medical suppliers.
Typical of these top-ranked companies is Advanced Neuromodulation Systems (ANSI), which makes sophisticated devices that, when implanted, stimulate nerves and pump drugs to combat chronic pain. The company has no debt, and earnings have risen spectacularly, from 5 cents a share in 1999 to 56 cents last year and an expected 75 cents in 2003.
Or consider Biosite Diagnostics (BSTE), whose "Triage" line of rapid tests helps doctors in about half the nation's hospitals diagnose diseases. Its earnings have also risen by a factor of 10 in four years, and Value Line projects they'll rise at better than 30 percent annually through 2008, and yet the stock trades at a P/E of 28, based on expected profits this year.
Then there's Priority Healthcare (PHCC), which distributes drugs and medical supplies to clinics, doctors' offices and renal-care centers and to individuals with chronic diseases who treat themselves. This is a business that produces loads of cash, with minimal requirements for plowing it back into the company as capital investment. Priority has no debt, and earnings are rising at 20 percent annually. Its P/E, based on 2003 projections, is only 18.
Investors should understand that all three of these stocks are a good deal riskier than, say, Johnson & Johnson. They, too, face regulatory threats, and, with high profit margins, Advanced Neuromodulation and Biosite, especially, could attract much more competition.
Three more established companies (also with "1" ratings) to balance the speculative plays are Steris (STE), which makes infection-prevention systems for health care, industrial and research customers; Stryker (SYK), a leader in a range that includes hip replacements and maternity beds and a long-time favorite of one of the best analysts in the business, Elliott L. Schlang of Great Lakes Review; and Cooper Cos. (COO), which develops contact lenses and surgical instruments.
How good are these firms? Value Line last week used a series of tough screens to find stocks with high price and earnings momentum and above-average safety. Only 14 made the final cut, and among them were Cooper, Steris and Advanced Neuro.
Also on the list of 14 was American Healthways (AMHC), which provides management services for hospitals. At long last, the hospital and managed-care subsector is getting its act together. Aetna (AET), with 14 million clients, is increasing its earnings powerfully. WellPoint, First Health Group (FHCC), UnitedHealth Group and Oxford Health Plans (OHP) are thriving. But it is the niche players -- such as Renal Care Group (RCI), which provides kidney dialysis services and trades at a current P/E of just 17, despite earnings increases well into double digits -- that carry the most interest.
The hottest health niche of all is a small one: pharmacy services. AdvancePCS (ADVP), which manages drug benefits for 75 million people, has boosted its earnings in a Beautiful Line from 9 cents to $1.72 since its initial public offering in 1996, and yet it trades at a current P/E of just 17. Smaller, but just as impressive, are Caremark Rx (CMX) and Express Scripts (ESRX).
Sorting through such seductive stocks isn't easy, and, unfortunately, buying them in portfolios chosen by experts can present problems. For example, one of the best-performing health mutual funds in recent years, Fidelity Medical Equipment and Systems (FSMEX), is concentrated (its top five holdings, including Johnson & Johnson, Abbott and St. Jude, make up more than one-third of its assets) and costly (it charges a front load of 3 percent and annual expenses of 1.2 percent).
A lower-cost alternative, the health "folio" -- a computer- chosen group of 30 equally weighted stocks that you then manage on your own -- of the online financial firm Foliofn (www.foliofn.com), leans heavily toward drugs, though it also includes WellPoint; Stryker; Medtronic (MDT), another medical-device firm; and Anthem (ATH), a health insurer.
It's hard to find broader funds with moderate costs and decent performance. One of them, however, is T. Rowe Price Health Sciences (PRHSX), which is up 6 percent this year and carries an expense ratio of just 1 percent. It has lost money overall during the past three years but has returned an annual average of 5 percent since April 1998. The top five holdings of the fund are UnitedHealth, Anthem and three biotech drug companies: Cephalon (CEPH), Gilead Sciences (GILD) and MedImmune (MEDI).
While manager Kris Jenner has an obvious penchant for biotechs, the fund is far better diversified than most you'll find. It owns big drug companies, such as Pfizer; care-providing firms, such as Triad Hospitals (TRI), which operates in small cities; and suppliers, such as Advanced Neuromodulation.
The sector offers an embarrassment of riches, and it's a perfect fit for a sound financial strategy. After all, stock investing is a long-run affair, and there's no better business for the long run than making people healthy.
Of the stocks mentioned in this article, James K. Glassman owns First Health Group, Walgreen and Medtronic. He also owns Pharmaceutical HOLDRs, a portfolio of drug stocks, and Biotech HOLDRs, a portfolio of biotechs. His e-mail address is email@example.com.