Here's to Your Health

What were most of us bellyaching about at this time last year? The price of a gallon of regular gasoline had crept 30 cents higher to $1.90 over the prior year. A single-family home in Las Vegas went for 60% more than in 2002. And an insured trip to an ear, nose and throat specialist cost patients their eye-teeth in health-care premiums.

Investors who bought shares in the sources of their malcontent have done nicely. The homebuilding, oil refining and managed health care components of the S&P 500 index gained 26%, 77% and 43%, respectively, in 2005. While gasoline and home prices have both demonstrated signs of moderating in recent weeks, we're taking this opportunity to screen for stock bargains within the managed health-care industry, where profits show promise of ballooning for years to come.

The long-term trend for health-care spending presents a clear picture. Americans lived just 47 years, on average, in 1900, according to the Centers for Disease Control. Today they live 77 years. People born in 2100 will live an estimated 90 years. Health-care spending as a percentage of gross domestic product has swelled to 12.1% today from 1.6% in 1943. Lehman Brothers expects health care's contribution to reach 18.7% by 2014. The firm points out that the overall economy hasn't grown more than 2% faster than health-care spending in any of the past 50 years; the converse has happened on 35 occasions.

Health insurers stand to benefit as much from cost cutting and increased efficiency as from swelling demand. In 2002 medical expenses increased 4.1 percentage points faster than overall costs, according to Lehman Brothers. That spread has narrowed in each of the past three years, and today stands at about eight-tenths of a percentage point. A recent Wall Street Journal story noted that 20% of tests under Medicare are repeated due to patients seeking care from multiple specialists who lack coordinated record-keeping.

In sum, managed-care companies stand poised to take in heaps of additional plan premiums in coming years, while paying out incrementally less in patient costs. And something tells us that these companies will make lucrative use of the bank model as that happens. Just as banks jack up credit-card interest right away when rates rise, but take their sweet time increasing savings account rates, expect health insurers to save money for their own bottom lines long before passing those savings on to plan members.

That's not mere complaining, mind you. It's complain-alysis. And it can lead to some profitable gripe-vesting.

We kept our screen methodology simple. We started with the 15 health-plan providers in our database, including giants like Aetna (AET), UnitedHealth Group (UNH) and WellPoint (WLP). Within this group we looked for two of our favorite attributes: strong share-price momentum and low price/earnings-to-growth, or PEG, ratios. (See our recent Price Momentum and Bargain Growth screens for more on the appeal of these criteria.) Stocks had to be up more than 20% over the past year; nearly all of them were. And PEG ratios had to be below the broad market's PEG of 1.5, suggesting that our survivors are, relative to their growth prospects, cheaper than the overall market. Ten stocks remained. The owner of the lowest PEG ratio — and today's Spotlight Stock — is Omnicare (OCR).

"We believe that the recent reaction to regulatory issues facing Omnicare is reminiscent of Henny Penny," wrote Alexander Draper, an analyst with San Francisco investment bank JMP securities. Some explanation might be needed. Henny Penny, also known as Chicken Little, comes from a classical fable of unknown origin wherein said chicken mistakes a falling acorn (or pebble from the roof in some versions) for a sign that the sky is falling. Covington, Ky.-based Omnicare is the nation's largest provider of pharmacy services to the elderly. It operates mainly through skilled nursing facilities and assisted living communities, and has trailing 12-month sales of $4.8 billion. Its "acorns" are a trio of investigations launched by federal and state agencies, one of which is looking into possible Medicaid fraud.

Those sound like big acorns, we know. Let's look at a few details. On Jan. 11 a state agency searched the company's Dublin, Ohio, facility for evidence of Medicare fraud in its durable goods unit. The unit contributes less than $10 million, or 0.2% of total sales, and the investigation is limited to one office within the unit. Another investigation in Massachusetts involves the pricing of three drugs prior to Omnicare's purchase of rival NeighborCare last fall. Analysts say sales for the three drugs in the year leading up to the NeighborCare purchase totaled about $65 million.

And finally, Michigan's attorney general launched a third investigation on Jan. 28, searching facilities in Detroit and other cities. It's not yet known if the matter in question involves Omnicare directly. Some on Wall Street think it may relate to an ongoing investigation of Johnson & Johnson (JNJ), from whom Omnicare buys certain medications.

For the "sky's falling" part of the story take a look at the stock's chart. Investors sold the stock off 14% in January, shaving a billion dollars worth of market value off of a company due to investigations that analysts say are highly unlikely to produce fines in excess of $10 million to $15 million. (In 2004 Omnicare paid a $1 million fine to settle a similar allegation over one drug in Maine.) The stock has recovered somewhat in February, but it's still down 7% since Jan. 11, when the investigations started.

Maybe the sky is, in fact, falling. But if it's not, then Omnicare is a bargain at 17 times forecasted 2006 earnings, vs. an average price/earnings ratio of 20 for health-plan providers. And its PEG of about 1.0 suggests it's cheaper than the overall market by a third relative to its growth prospects. Combine that with the case for managed-health-care stocks in general, and the outlook for Omnicare shares looks healthy indeed.