Healthy Profits

Healthcare stocks went on a tear last year, posting a nearly 30 percent return and outperforming all other sectors in the S&P 500. The fuel for that growth—aging baby boomers, increased insurance coverage under the Affordable Care Act, profitable new drugs and technologies, and an active M&A market—will continue to propel healthcare stock prices this year.

But investors will have to be more selective in 2015. Once interest rates begin to rise, as seems inevitable, the resulting higher costs of borrowing may cause certain subsectors, such as small healthcare providers and biotechnology stocks, to stumble. What’s more, valuations have been driven up, making individual company analysis critical. Don’t bet on a rising tide lifting all boats.

Andy Acker
Portfolio Manager/Janus Global Life Sciences Fund
Best idea › Fertility/In Vitro Fertilization

Acker and many on his research team aren’t just stock savvy, they’re also scientists, which gives them a legitimate understanding of the viability of new therapies and their potential impact on the marketplace. “One of our key themes is to invest in companies that address high unmet medical needs,” Acker says.

Among the most pronounced of these areas: the $9 billion fertility sector. “There are 1.5 million in vitro fertilization cycles each year. The cost is over $10,000 per cycle on average and the success rate is only in the 25 percent to 35 percent range,” he says. “This is an unsatisfied market with a relatively low success rate, high out-of-pocket expenses and significant discomfort.”

Acker sees potential for major growth in, for example, new technology that uses egg stem cells, located inside the protective ovarian lining, to provide an existing egg the energy required to effect the process of fertilization, or to create an entirely new egg.

The technology was developed by OvaScience, a Cambridge, Mass.-based biotechnology company that went public in 2013. The company’s stock tripled in 2014, but it’s at the early stages of growth: So far, OvaScience technology is only being used in Canada, the United Kingdom, the United Arab Emirates and Turkey, and the first children born through the new procedures are due to arrive in the middle of this year.

Monica Dicenso
U.S. Head of Equity Strategy / J.P. Morgan Private Bank
Best idea › Healthcare Retailers

For basic healthcare services, consumers are increasingly bypassing their doctors’ offices and heading to their local CVS, Walmart, Rite Aid, Walgreens or other healthcare retailer. These and other large stores with pharmacies have been aggressively building out their businesses beyond prescriptions, toiletries and candy. They’re hiring clinicians, registered nurse practitioners and other healthcare workers in order to become quick stops for physicals, screenings, vaccinations and diagnosing and treating common ailments such as ear infections, strep throat, pink eye and the flu—all for a fraction of the cost of a traditional doctor’s visit.

In addition to price, consumers also like the convenience of retail clinics. While a growing shortage of family physicians can make it harder to get a prompt appointment at a doctor’s office, retail clinics are generally centrally located, have evening and weekend hours, and allow walk-in appointments.

DiCenso believes these businesses will get a boost from simple consumer economics. They’re relatively cheap, and price is increasingly important as more consumers take on high-deductible health insurance to offset rising premiums.

Brad Sorensen
Director of Market and Sector Analysis/Charles Schwab / Schwab Center for Financial Research
Best idea › Healthcare Providers and Medical Equipment

Throughout 2014, providers benefited from low interest rates and easy loans through private lenders. They refinanced debt and, with liquidity on hand, were active in mergers and acquisitions.

This year, smaller providers may take a hit when interest rates begin to rise, making it more costly for them to meet debt obligations. But larger providers—particularly large hospitals—can withstand small rate increases, and will continue to benefit as more people become insured under the Affordable Care Act and seek medical care. “The momentum is good and valuations aren’t a concern,” Sorensen says, adding that investors should expect steady growth in the next 12 to 16 months.

On the more speculative side, he believes medical equipment companies are poised for a boost this year. The Affordable Care Act imposed a new medical equipment tax, which Republicans in Congress are vowing to repeal, saying it is an undue burden on companies and will lead to lost jobs. “This is the year when things will get done in Washington, and this is a very unpopular tax,” Sorensen argues. “There could be a lot of upside due to a rollback.”

Owen Fitzpatrick
Head of U.S. Equity Strategy / Deutsche Bank
Best idea › Pharmaceutical Distribution Companies

Known as the middlemen of the healthcare industry, wholesale buyers and distributors of drugs may not be visible to the average consumer, but Fitzpatrick advises investors to take note. These companies, which buy drugs in bulk and sell them to hospitals, HMOs, pharmacies, physicians and clinics, are poised for a growth surge thanks to several trends.

Long-term growth will likely be fueled by an increase in demand for drugs as the baby boom generation ages and more Americans become insured. But there’s also good reason to be optimistic about near- and intermediate-term results. Profit margins on popular brand-name drugs are notoriously thin for these companies, but a wave of patent expirations on widely used designer drugs is creating a bigger business in the more profitable generic drug area.

“A good many drugs that were approved by the FDA in the 1990s and the early part of the last decade are hitting the point where their patents expire,” Fitzpatrick says, citing cholesterol-lowering Lipitor, the best-selling drug ever, and Nexium, a popular anti-reflux medication, as major examples. “These companies benefit because generics are more profitable.

As pharmaceutical companies try to make up for the loss of exclusivity on brand-name drugs, the push to develop so-called orphan drugs—medications for rare illnesses—has picked up. Orphan drugs are helping to fuel significant growth of specialty drugs, which are also highly profitable for wholesalers.

Those stocks aren’t cheap. “They’re trading at 17 times forward earnings,” Fitzpatrick says. “But the growth is there.”

Charlie Ryan
Evercore Wealth Management / Manager of Evercore Equity
Best idea › Cash Kings of Pharmaceuticals

Ryan is always on the lookout for companies with best-in-class management and innovative drugs. But given a more selective market for healthcare investors this year, he has added another criterion for sizing up prospects: the amount of cash they are generating.

Mergers and acquisitions will likely be a big driver of returns for investors this year, and big cash generators are the most likely candidates to seek expansion. Ryan notes there are a number of such firms in the healthcare space, particularly pharmaceuticals, where earnings have been far more predictable and steady than in other investment sectors.

Consider Gilead Sciences, whose cutting-edge new hepatitis C drug, combined with HIV and cardiovascular therapies, generated a 122 percent increase in revenues last year and one of the highest cash levels—$11.7 billion—in the industry. “The company is generating cash so quickly it’s likely to be opportunistic in mergers and acquisitions,” Ryan says.

Chris Adams
Senior Portfolio Manager / Delaware Investments
Best idea › Diabetes and Other Disease Management

With many chronic illnesses, it’s up to patients to manage regular medications and screening schedules. That’s a burden for patients, who often mismanage their treatment as a result.

Adams believes investors can get a big lift over the next one to five years from technologies designed to improve patients’ daily lives and disease management.

One highlight in this area is a growing ability to replace daily doses with a weekly or periodic injection that slowly releases the medication into the patient’s body. “This is especially applicable for mental health because keeping people on their medications is a big problem,” he says.

An Ireland-based firm called Alkermes is at the forefront of this technology. Until recently, Johnson & Johnson was distributing Alkermes’ technology, but the firm has gotten large enough to begin handling its own distribution. “It’s evolving from a royalty-based business to retaining full rights,” Adams says.

Another groundbreaking development is a tiny glucose sensor that sits under a patient’s skin and provides continuous feedback for diabetes patients. Medtronic has been a leader in glucose-monitoring technology, but it’s going to get some competition from Dexcom, which has developed a monitor for diabetics that provides continuous feedback via an app available on the Apple watch or iPhone. “This is a big long-term growth story,” Adams says.

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