The health-care sector is flashing mixed signals -- but the prognosis is good for investors who can navigate the risks.

A Thursday report from Morgan Stanley proclaimed health care the most attractive stock sector in the U.S. Among the reasons: Earnings estimates look achievable, cash flows are rich and valuations are modest by historical standards.

 

Deals on Health-Care Stocks

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The health-care sector is flashing mixed signals, but the prognosis is good for investors who can navigate the risks. Jack Hough reports on Markets Hub. Photo: Getty Images.

On Friday, meanwhile, the caretakers of the Dow Jones Industrial Average said they would add insurer UnitedHealth Group (UNH), which has a market value of $56 billion, citing the growing importance of health-care spending in the economy.

Overshadowing such positive signs, however, are reports like one earlier this month from the National Academies' Institute of Medicine. It found that unnecessary or overpriced treatments, excess paper-pushing and other vices are causing the U.S. to overpay for health care by some $750 billion a year.

That's more than $6,000 per household -- or enough money a year to turn future government deficits into surpluses. It's also a source of corporate income that is likely to be squeezed in coming years.

"You'd have to be living under a rock to think the current level of health-care spending is sustainable," says Kris Jenner, manager of the T. Rowe Price Health Sciences Fund .

So how should investors approach this combination of opportunity and worry?

First, by favoring companies whose goods and services can reduce overall health-care costs -- say, by speeding patient recovery times.

The key is to be mindful of valuations. Intuitive Surgical (ISRG), based in Sunnyvale, Calif., makes surgical robots that help doctors operate with smaller incisions. The costly machines are selling well, in part because faster healing can shorten hospital stays. But Intuitive, with a market value of $20 billion, trades at 34 times this year's forecast earnings, versus a median of 15 for companies in the Standard & Poor's 500.

That is too expensive for David Rolfe, manager of the $400 million RiverPark/Wedgewood Fund, which recently sold Intuitive on valuation concerns. A better bet, he says, is Varian Medical (VAR) of Palo Alto, Calif., a $7 billion medical-equipment maker that says its radiation machines can precisely target tumors to improve treatment times. Varian's shares sell at 16 times earnings.

Cerner (CERN), a $12 billion information-technology provider in North Kansas City, Mo., is also enjoying fast growth. Its systems can digitize patient records to reduce paperwork and help multiple doctors coordinate care. But its stock price of 31 times earnings should give investors pause.

Alexandra Lee, a doctor turned analyst at Sustainable Growth Advisors, a $4 billion Stamford, Conn., money manager, likes Cerner, but another of her favorites is cheaper: Perrigo (PRGO), of Allegan, Mich., is a maker of store brands of over-the-counter medicines, and has a market value of more than $10 billion. Store brands save customers money and provide retailers with larger profits than brand-name drugs, Ms. Lee says. Perrigo sells at 21 times earnings.

A second way to approach the tricky health-care sector is to look for companies whose shares are unlikely to be hurt by cost pressures in coming years, either because demand for their products is strong enough or because their shares already are cheap enough.

T. Rowe Price's Mr. Jenner likes Gilead Sciences (GILD) of Foster City, Calif. The drug maker, which is valued at about $46 billion, has an HIV treatment that can replace multiple pills with a single one. He expects a "substantial ramp in earnings" beginning late next year from a hepatitis C drug that has shown strong results in trials. Shares trade at 16 times earnings.

Mr. Jenner is bearish on most medical insurers in light of sweeping regulatory changes that make future profits uncertain. But he likes UnitedHealth, saying it has a knack for helping customers cut costs. Shares sell at 11 times earnings.

Russell Croft, co-manager of the $334 million Croft Value Fund, favors some household names with handsome dividend yields and valuations that he says already more than reflect looming cost pressures. One is Merck (MRK), which has a market value of $133 billion. It fetches 11 times earnings, and generates a 3.8% yield. Another is $178 billion Pfizer (PFE), which trades at 11 times earnings and has a 3.7% yield.

"These companies don't have to be gigantic winners over the next decade for their shares to provide solid returns," Mr. Croft says.

Mutual fund buyers might consider Mr. Jenner's fund, T. Rowe Price Health Sciences. It has led the competition with three-year returns averaging 22.4%, compared with 14.8% for the category average, and 15-year returns of 11.8%, versus an average of 8%, according to Morningstar. The fund has no upfront sales charge and costs 0.82% of assets a year, less than the peer average of 1.56%.