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In Health Care, Cost-Cutting Pays Investors

Investors in health-care stocks have reason to feel ill: In 2010 the Standard & Poor's North American Health-Care Index had the smallest gain among the seven North American sector indexes. It rose by a mere 4.3 percent, vs. 26 percent apiece for the technology and cyclical-stock sector indexes. The industry is beset with challenges, from the uncertainties surrounding health-care reform to a wave of patent expirations that will arrive with manufacturers facing a dearth of blockbuster drugs in the pipeline. Still, leading health-care fund managers spy plenty of opportunities to profit in 2011.

Rather than count on new blockbuster products to power returns in 2011, managers such as Edward Yoon at Fidelity's Select Medical Equipment & Systems Portfolio (FSMEX) are looking for companies that offer strategies to help contain health-care costs. These can include insurance providers offering incentives for patients to shift their care from high-cost hospitals to lower-cost rehabilitation facilities and pharmacy benefit managers, or PBMs, that are increasingly in charge of prescription drug plans. Fidelity's medical equipment fund was among the top four health-care funds in a screen conducted by Bloomberg Rankings, scoring 83.2 out of 100 with a one-year return of 12.9 percent. The rankings gave equal weight to five criteria: total returns for one, three, and five years and Sharpe ratios—which show how well a fund's returns compensate investors for the risk taken—for three and five years.

Yoon and other leading health-care fund managers anticipate a national budget crisis by 2017 or 2018, as the U.S. government struggles to meet rising Medicare obligations. Total Medicare enrollment is projected to rise from the current 47.4 million to 80.4 million in 2030, when the youngest baby boomers will turn 65, according to the 2010 report of the Board of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds. Medicare spending is projected to climb from 3.5 percent of gross domestic product, to 3.9 percent by 2020, and to hit 5 percent of GDP before 2030.

Says Yoon: "We want to own companies that are going to solve these problems and will help bend the cost curve by not just slowing the rate of health-care costs but helping them decline." Worldwide revenues for drugs worth an estimated $200 billion will drop by up to 90 percent as branded patents expire over the next five years, says Yoon. Because profit margins on generics are much greater than on branded pills, Yoon expects makers of generic versions of these drugs to benefit, along with PBMs and drug distributors. Medco Health Solutions (MHS), a PBM, was the top holding in Yoon's portfolio as of Nov. 30.

Windfall for Dialysis Providers?

Most fund managers think that concerns about the costs and penalties of health-care reform are already priced into stocks. Some policy changes already slated for this year, however, may bring windfalls to certain companies. Fresenius Medical Care (FMS) and DaVita (DVA) will benefit from Medicare reimbursement for dialysis treatment, which became effective on Jan. 1, says Erin Xie, manager of the BlackRock Health Sciences Opportunity Portfolio (SHSAX), which was ranked fifth by Bloomberg, with a one-year return of 6.7 percent. The lift to these companies' earnings will probably have to wait until 2012, after they've logged a full year of higher revenues, says Xie.

In addition to companies that stand to benefit from generics, Fidelity's Yoon is positive on providers of health-care information technology because health care is one of the last industries to switch from paper files to digitized data. He believes that cost savings will be driven over time by companies that sell life science tools, as well as other movers in the personalized-medicine revolution. Spending in the latter area will initially favor outfits that perform genomic sequencing, he says—not only on the human genome, but on cattle and agriculture, too. That will help scientists identify relevant genetic markers leading to the best treatments for diseases among humans, animals, and plants. After that, companies that provide diagnostic tests and those that combine diagnostic tests with therapeutic treatments will benefit, Yoon says.

The managers of the Allianz RCM Wellness Fund (RAGHX) are also positioning themselves for an impending fiscal showdown. The fund, ranked 11th by Bloomberg, with a one-year return of 9.8 percent, is diversifying into non-health-care stocks in the belief that efforts to slash costs will have to extend to lifestyle choices such as diet. The portfolio, focused solely on health care in October 2008, now has 16 percent exposure to such companies as aquaculture manufacturers Marine Harvest (MHG:NO) and Nutreco (NUO:NA), a Dutch salmon-feed company that sees some of the strongest demand coming from Brazil, China, and India. As people in emerging markets become wealthier and more health-conscious, the long-term trend of protein substitution from beef and pork to salmon will increase, says Dan Hunt, a research analyst for the Allianz fund.

One Solution: Healthier Consumers

"Age and wealth are the biggest determinants for health-care spending now, driven by a preference for [a healthier] lifestyle," says Hunt. "Overall, you're going to see an increased blurring of the lines between consumer enterprises and health-care companies" as the solution to health-care spending turns increasingly to putting more pressure on individuals to change their behavior.

The T. Rowe Price Health Sciences Fund (PRHSX), ranked third by Bloomberg, with a one-year return of 16.6 percent, tends not to make abrupt allocation changes between health subsectors. One area that portfolio manager Kris Jenner says he has become more optimistic about this year is the provision of managed-care. Some of these companies will be able to provide solutions to the growing health-care spending morass, he says. Jenner singles out UnitedHealth Group (UNH), which has quietly been acquiring dozens of private companies with health-care IT capabilities that will be able to monitor treatment outcomes, as well as disease-prevention efforts. The market is slowing recognizing the company's growing resource base, but this will continue to play out over the next few years, says Jenner. One of United's pilot programs educates orthopedics patients on nonsurgical options and has resulted in a nearly 50 percent decline in hip and knee replacements among its members, says Rouven Wool-Lewis, T. Rowe Price's analyst for managed-health-care stocks. One of Jenner's most recent buys is Genzyme (GENZ), a biotech company focused on rare genetic diseases. Other fund managers are adding biotech names such as Zogenix (ZGNX) and Cephalon (CEPH) to their holdings.

Manning & Napier Life Sciences Fund (EXLSX) looks for midcap companies creating products that could transform their market and profit prospects. Its largest recent purchase is United Therapeutics (UTHR), which is developing an oral formulation of its pulmonary arterial hypertension (PAH) drug Remodulin, whose three current delivery methods are time-consuming and sometimes painful, says Jeff McCormack, one of the portfolio managers. He believes that the company, which now controls about 15 percent of the $2 billion global market for PAH treatment, could double its market share over the next five years if its oral Remodulin product succeeds. An oral treatment would initially cannibalize sales of existing Remodulin products but would eventually unlock a bigger market by being more suitable for patients in earlier stages of the disease, McCormack says.

Emerging Markets, Emerging Companies

The top health-care funds tend to favor U.S. companies, but many have substantial positions in non-U.S. companies. Two stocks that the Putnam Global Health Care Fund (PHSTX) recently bought—China Kanghui (KH) and Microport Scientific (853:HK)—are bets that China's demand for orthopedic implants and cardiovascular stents can grow more than 20 percent in the next three to five years. Emerging economies in which market penetration is relatively low offer companies higher growth opportunities than they'll find in the U.S. and Europe, says Kelsey Chen, manager of the Putnam fund, which came in 18th in Bloomberg's rankings, with a one-year return of 1.7 percent. Pharmaceutical companies such as Pfizer (PFE) are cutting costs as their products go generic, "but one area they're investing in is emerging markets," she says. "They're hiring sales reps to focus on tier-2 cities [in China] to offset the decline in more mature markets."

Indeed, foreign stocks account for about 30 percent of the holdings in Manning & Napier Life Sciences Fund. Half of the non-U.S. exposure is made up of company-specific bets "where we feel the company has products, either in development or recently launched, that are underappreciated by the investment community," says McCormack. He cites Brussels-based UCB (UCB:BB), which recently launched three products that are selling well and that he expects to offset the revenue loss from UCB's epilepsy drug, Keppra, whose patent in Europe expired in September. The fund's focuses its remaining 15 percent exposure outside the U.S. on emerging markets in which, McCormack says, "we [invest] prudently, realizing that the macroeconomic environment [GDP growth, currency fluctuations, and interest rates] in these markets bears a much greater influence over stock price performance than we see in the developed world."

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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