This Sector's Future Looks Healthy

05/30/2011 11:00 am EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Say what you will about the future of health care...it's hard to argue with 50 million Americans moving into the ranks of the insured. That enormous move is starting to pay benefits even now, says Paul Larson of Morningstar StockInvestor in this exclusive interview with MoneyShow.com.

Paul, health care stocks—which have been horrible laggards in this market recently—had a big move in April, where they really started to pick up steam a little bit.

Yeah. The healthcare stocks for a long period of time were the cheapest stocks as a group by our estimates. They’ve recently had a nice run.

I think what happened was the health-care reform legislation, which inserted a lot of fear, uncertainty, and doubt into that sector. The market hates fear, uncertainty, and doubt.

I think recently the market has started to be slightly less fearful of the effects of the health-care legislation, which we think at Morningstar is actually going to be a mild net positive for the sector.

There are certainly some negatives with the health-care legislation. Some of the companies are going to have to pay higher taxes associated with this and the device makers, and also the government is going to have more pricing pressure across the board in terms of reimbursements.

Then on the flip side, offsetting all this, we’re going to have somewhere in the neighborhood of 50 million more Americans who currently don’t have health insurance who are going to have health insurance. Surprise, surprise—people who have health insurance spend more money on healthcare than people that don’t have insurance.

So, whatever these companies are going to have to give up in terms of taxes and pricing, we think is going to be more than made up for in higher volumes.

What about the drug companies? We’ve seen some of them rallying, but don’t they have the same pipeline problems that they’ve had for the last few years?

There are some that have better pipelines than others, but this is a general problem for the industry, isn’t it?

Yeah. I’d say we’ve had declining R&D effectiveness for the greater part of a decade. What happened is that, back in the 1990s when we had the first-generation statins, it was a huge step up in terms of patient outcomes, of going from having high cholesterol to being able to control your cholesterol.

Like Lipitor, right?

Like Lipitor, or Zocor. But the second and third generation jump in effectiveness is very tiny, and so getting people to pay that same high premium for that second-, third-, and fourth-generation drug is a much harder sell, because they’re not that much more effective.

So these companies’ pipelines aren’t nearly as full as they once were. But I would say in aggregate, this is already priced in a lot of these stocks, and then some.

Can you name one that you like?

Sure. Abbott Labs (ABT) is one that I like, and I own it personally as well as professionally. It is a diversified health-care firm...relatively steady, stable, good financial health, and it’s trading at about 11 times earnings right now, despite the fact that it’s still growing at double-digit rates.

The big concern here is they have one drug, Humira, which is about 20% of its sales, and people are worried about what...

What does that do, that drug?

It’s a rheumatoid arthritis drug, an anti-inflammatory. People are worried about this one drug, when it goes off-patent, what’s going to happen.

But I think that Abbott is going to be okay, because:

  • One, this is a biologic drug, and there’s no meaningful pathway to generic competition with biologic drugs.
  • Also, some of the potential competing drugs are not approved yet, and they’re anything but certain to actually get approved.

So, anyway, with Abbott we can either pay ten or 11 times earnings with Humira, or maybe 13 to 14 times even if you totally took this drug away from its very steady, wide-moat firm. I think that’s a very attractive price.

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