Analysis: U.S. healthcare stocks face obstacles after 2011 run

NEW YORK Thu Feb 9, 2012 9:04am EST

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NEW YORK (Reuters) - After beating the market in 2011, healthcare stocks may struggle for a repeat performance this year as cash-strapped Americans keep putting off use of medical services and investors seek out faster growth stocks as the economy improves.

So far this year, healthcare has underperformed the broader market: The Standard and Poor's Healthcare index .GSPA is up about 4 percent compared to a 7 percent increase for the S&P 500 index .SPX.

Last year, the healthcare index rose 10 percent compared with little change for the broader market, as investors sought out shares of pharmaceutical companies and health insurers as a defensive play against the market's volatility.

"If the stock market is better, which we do believe it will be given the first five weeks, then healthcare will participate but will not be a leader," said David Katz, chief investment officer of Matrix Asset Advisors.

A rebounding U.S. economy could lead patients to resume doctor visits and elective procedures they had been putting off, which would benefit medical device makers, drug companies and healthcare providers such as hospitals. But that trend may take a while to materialize.

Meanwhile, a few companies that seem poised for particularly strong earnings growth are capturing interest, including Intuitive Surgical (ISRG.O) and Edwards LifeSciences (EW.N).

Investors expected a pick-up in the use of medical services at the start of 2012, but that trend did not emerge in financial reports by large healthcare companies over the past few weeks, Nuveen Asset Management analyst Tim Nelson said.

"Generally, we've seen no real tangible evidence in improvement in the propensity of the consumer to go see the doctor, or be admitted, or to have a procedure," Nelson said.

Les Funtleyder, portfolio manager for Miller Tabak & Co, said any sign of an uptick in medical services is the main factor he is watching for in the sector.

"That's generally good for almost everybody except for the HMOs," Funtleyder said, referring to health insurers. "If the economy stays weak HMOs will be alright."

The fewer medical services health plan members use, the lower the claim costs for health insurers, driving up profits.

"The areas we have favored most in healthcare have been the HMOs," said Jason Norris, senior vice president of research at investment advisor Ferguson Wellman, who likes Humana Inc (HUM.N) and Aetna Inc (AET.N). "We just think their business model is very attractive right now and don't see that changing."

RECOVERY MAY FAVOR RISK

The same weakness that has helped insurers has hurt medical device companies, such as Zimmer Holdings (ZMH.N) and St Jude Medical (STJ.N).

"If you're worried about losing your job you're not going to have your hip replaced," Katz said. "Our guess is the pendulum will swing back a little bit and they will be aided by a better economy."

Investors scooped up pharmaceutical stocks last year, due to relatively cheap valuations and hefty dividend payouts. Bristol-Myers Squibb (BMY.N) rose 33 percent in 2011, while Pfizer Inc (PFE.N) increased 24 percent.

But as sentiment about the economy improves, investors may leave the relative safety of big pharmaceutical stocks in search of higher reward propositions, such as technology and industrials. So far this year, the NYSE Arca Pharmaceutical index .DRG of large drug stocks is roughly flat.

"The market appears pretty focused on an economic recovery at this point," said Deutsche Bank analyst Barbara Ryan. "That would really favor much higher risk assets than pharma stocks."

That is true even within healthcare, as riskier biotechnology stocks are off to a fast start, spurred by a flurry of acquisitions. The Nasdaq Biotechnology index .NBI is up some 16 percent this year, while the NYSE Arca Biotechnology index .BTK has soared about 28 percent.

The very high prices being paid for biotech assets recently, such as a 163 percent premium Bristol paid in its $2.5 billion deal for hepatitis C-drug developer Inhibitex Inc INHX.O, may lure investors seeking to cash in on potential takeover targets.

ABBOTT, ZOLL, EXPRESS SCRIPTS IN FAVOR

Even if healthcare stocks remain sluggish overall this year, portfolio managers believe they can tally strong gains by holding some individual companies.

Oliver Pursche, president of Gary Goldberg Financial Services, focuses on large, dividend-paying companies and is particularly bullish on Abbott Laboratories Inc (ABT.N), so much so that even after Abbott splits off its pharmaceutical division later this year, he will continue to hold both stocks.

"Strong management. Strong dividends," Pursche said of Abbott. "The growth prospects of it continue to be double digits year over year."

Big dividend payouts are a reason Barry James, president of James Investment Research, favors Pfizer.

"Their earnings came in strong, and it's cheap and getting over 4 percent yield ... Maybe it's dull, but to us right now dull is beautiful," James said.

"Dividend paying stocks will do okay this year, but they're not going to dominate like they dominated last year," Katz said.

Though medical technology companies have generally struggled, some companies with enticing growth prospects are appealing to investors, such as Intuitive Surgical, which makes high-priced robotic surgical systems, and Edwards, which just won U.S. approval for a heart valve replacement system that helps avoid open-heart surgery.

Along these lines, Steven Demas of the Archer Funds likes Zoll Medical Corp ZOLL.O, which makes external defibrillators, including a wearable one called LifeVest.

"Zoll is another growth story," Demas said. "It could be a $2 billion business ... If I had to pick a healthcare stock, I would put that as the number one."

Other investors are seeking to capitalize on the wave of widely used brand-name medicines becoming available as low-cost generics over the next few years by investing in companies that will benefit from the trend, such as distributors and pharmacy benefit managers.

Matthew DiFilippo, chief portfolio strategist at Stewart Capital Advisors, is bullish on shares of Express Scripts (ESRX.O) regardless of whether it is able to complete its proposed $29 billion acquisition of rival pharmacy benefit manager Medco Health Solutions MHS.N, and pharmaceutical distributor AmerisourceBergen (ABC.N).

DiFilippo also has his eye on another wildcard hanging over the sector: the Supreme Court's decision on President Barack Obama's healthcare overhaul, due in late June. He said it was possible the court upholds the controversial provision requiring Americans to buy health insurance, or it rejects the entire law.

Drugmakers and health insurers have already accounted for the law as it was passed, so only a ruling that strikes down the law or significantly changes it would likely cause another big wave of investor uncertainty.

"If you're looking for direction for healthcare this year, you have to keep the Supreme Court in mind," DiFilippo said. "In terms of what that means, only time will tell."

(Editing by Michele Gershberg and Tim Dobbyn)

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