Five Health Care Stocks to keep on Your Radar Screen

Five Health-Care Stocks to Keep on Your Radar Screen Think innovation, diversification, and marketing. by Julie Stralow, CFA | 03-08-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints Health-care stocks haven't gotten a lot of love lately. This sector significantly lagged the market over the past three years, returning only 8% compounded annually (as measured by the Health Care Select Sector SPDR XLV) while the S&P 500 returned 16% on an annualized basis. This underperformance is no surprise given the intense scrutiny health-care companies have been under, especially since the Vioxx saga. Safety, legal, and regulatory risks abound in health care, and the Vioxx case continues to highlight those inherent risks. Combine those risk factors with drying pipelines and blockbuster patent expirations on the horizon for some industry titans, and many investors have run screaming for the exits when presented with these stocks. We think turning a blind eye to this highly profitable industry is a mistake. In fact, several of our favorite health-care companies are currently on sale. When performing a screen of health-care firms with wide moats, average or below-average risk ratings, and trading at or near our consider buying price, we are presented with a list of heavyweights. These companies may not be immune to the risks of this industry, but their abilities to generate economic value over the long term remain intact. Our favorite health-care companies exude the enviable advantages that often lead to long-term success in this industry. These include a record of innovation, a diversified product portfolio, and marketing prowess. 1. Record of Innovation Patents form the foundation of most health-care moats. Almost any company can get lucky once by introducing a product that generates substantial returns on invested capital for a patent's duration. However, the most successful health-care firms show an ability to introduce novel products again and again, allowing them to replenish revenue streams when old products face patent expiration. The ability to continually discover new products that treat unmet needs, usher those products through clinical trials, and receive regulatory approval in a timely fashion remains highly valuable in the health-care industry. 2. Diversified Product Portfolio The principles of portfolio diversification are not limited to stocks. Health-care companies that rely on diversified product streams often fare better and definitely exhibit lower risk profiles than counterparts that put all their eggs in one basket. We like companies that are able to excel in more than one discipline of the health-care industry, which includes pharmaceuticals, devices, and biotechnology, among other fields. Even if the company's prowess lies in only one area, its ability to draw on many products for revenue rather than only a few products increases our confidence in its long-term staying power. 3. Marketing Prowess While marketing is overlooked in many industries, salespeople bring enormous value to health-care companies. They can make or break a product, so health-care companies spend a lot of time and money to get the right message in the right physicians' ears. Many upstarts lack this vital link in the industry's value chain, which creates a barrier to entry. Until they can establish their own salesforce, newcomers often give away most of their products' profits in exchange for help from a larger partner to get treatments into patient hands. So even when an established health-care company doesn't discover a product, its sales and distribution capabilities often allow it to grab a large share of partnered profits. Five of our favorite health-care companies: Abbott Laboratories ABT Morningstar Rating: 4 Stars Economic Moat: Wide Risk Rating: Below Average From the Analyst Report: The backbone of Abbott's business model is its diversified revenue base. High-margin pharmaceutical products constitute 60% of sales, and the nutritional and diagnostics segments make up 22% and 18% of sales, respectively. The prescription drug business is one of the most profitable around, but it can be risky if patents expire and pipelines dry up. Abbott's diversified business segments provide a steady stream of cash that shields investors from bearing the full brunt of pharmaceutical product cycles. Amgen AMGN Morningstar Rating: 4 Stars Economic Moat: Wide Risk Rating: Average From the Analyst Report: Amgen's marketing strength and proven ability to commercialize biotechnology-based therapeutics make the company an ideal development partner for smaller biotech firms, potentially giving Amgen a leg up in negotiations for in-licensing new therapeutic candidates. Johnson & Johnson JNJ Morningstar Rating: 5 Stars Economic Moat: Wide Risk Rating: Below Average From the Analyst Report: We like J&J's global leadership positions in three attractive healthcare business lines: pharmaceuticals, medical products, and consumer products. Each line has excellent long-term growth prospects driven by favorable demographic trends or structural shifts in the U.S. economy toward quality-of-life services. The multiline platform provides valuable diversification in the event of an adverse development in any single business line. Medtronic MDT Morningstar Rating: 5 Stars Economic Moat: Wide Risk Rating: Average From the Analyst Report: Medtronic's vision is to establish a significant presence in chronic diseases, in addition to its historical stronghold in heart disease. Investments in neurological, diabetes, and spinal products from the mid- to late 1990s have started to pay off, offering new revenue streams and taking some pressure off heart products. Revenue from those three product areas inched up from 25% of total sales in fiscal 2000 to 39% in fiscal 2005. Compared with its peers, Medtronic relies less on any single type of product and is better able to weather glitches in the development or approval process for any particular new device. Novartis NVS Morningstar Rating: 5 Stars Economic Moat: Wide Risk Rating: Below Average From the Analyst Report: We think a relatively young branded-drug portfolio and the addition of the new fast-growing generic units will keep Novartis' sales growth at the top of the industry for the next several years.