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Quarter-End Insights

Our Outlook for Health-Care Stocks

Health-care companies are relatively unscathed by the market meltdown.

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With recent market turbulence ratcheted up to hair-raising levels, the health-care sector has been buffeted on the margins. Fortunately, however, health-care companies remain relatively insulated from the ripples making their way through the economy. This is partially due to the low levels of financial leverage in many health-care firms. Many of our established drug, equipment, and services companies can generate enough cash to finance their business growth and do not need to rely on debt. This immediately lowers their exposure to some of the liquidity issues that have infected other industries. Additionally, most of the smaller biotechnology or development-stage companies typically tap equity financing because banks are unlikely to lend to such risky ventures in the first place. With the credit market seizing up, we see the low leverage of health-care companies as a silver lining in a dark cloud hanging over the markets currently. Finally, the larger factors that drive health care tend to be unrelated to macroeconomic market conditions--people still get sick whether assets are rising in value or falling.

Health-care companies can provide a relatively safe haven for investors in these times. However, the sector isn't without risk. There is plenty of risk that investors should keep in mind, such as political, regulatory, legal, clinical, and reimbursement risk. We simply note that exogenous risks in the health-care arena are less correlated with the factors that drive market risk, which allows health-care companies to offer a welcome change of pace. The Food and Drug Administration remains a major source of risk for health-care companies as the regulatory agency has continued to work toward minimizing the likelihood of another Vioxx or fen-phen incident. We have recently been surprised at a few high-profile drug candidates that the agency did not approve, including  Novartis(NVS) diabetes treatment Galvus,  Merck's (MRK) Tredaptive for high cholesterol, and  Schering-Plough's (SGP) innovative anesthesia drug sugammadex. Schering CEO Fred Hassan has gone on the record with his concern that the regulatory environment in the U.S. has put the country at risk of losing its leadership position in drug innovation. While this position remains a bit extreme, we do recognize that there's little stopping the FDA from clamping down further. The last time this risk-aversion trend reversed itself was in the 1980s when AIDS activists became very vocal and applied political pressure that pushed the FDA to focus on bringing new therapies to market.

We have also been taking a closer look at political risk now that we are in the home stretch of the presidential election. There are few issues where Senator McCain and Senator Obama differ more dramatically than on their health-care policies. Both candidates have focused their policy efforts on the issue of increasing access, which would decrease the number of uninsured people. McCain's more radical approach involves removing the tax benefit that comes with employer-provided health insurance and replacing it with an individual tax credit. This framework would likely cause some employers to stop offering group insurance, and more people would have to shop for policies on the individual market. Obama's strategy is focused on leveraging existing health-care infrastructure (leaving the tax benefit from employer-provided insurance intact) and broadening eligibility standards. Thus, more currently uninsured people could be covered by Medicare or Medicaid. A recently published analysis by health policy experts suggests that the McCain plan would in the long run result in fewer people insured, and Obama's plan would likely reduce the rolls of the uninsured. Unfortunately, neither candidate has provided a detailed plan on how to contain medical costs, which is truly the biggest health-care policy dilemma we need to wrestle with.

No matter which candidate is elected, there are a few things to keep in mind. Most health-care reform ends up being evolutionary rather than revolutionary, thanks to the nature of the political process and the inevitable compromises that must be made. Further, we are fairly confident that the idea of a single payer program is a non-starter. Coming off the last time health-care reform was front and center with the Clinton administration in the mid-1990s, we think the Democrats learned the lesson that any single-payer approach would alienate key parties who need to be at the negotiating table for any sort of change to take place. Lastly, the large budget deficit will likely prevent too much change from taking place in the next couple of years. We simply won't be able to afford to fiddle with the system too much.

Valuations by Industry
We have seen biotechnology and diagnostic companies move closer to being fairly valued over the past quarter. In both cases, this trend has been bolstered by acquisition activity that has made the remaining companies seem attractive to potential acquirers. Most recently shares of  Onyx (ONXX),  Imclone (IMCL), and  Amylin (AMLN) were bid up on speculation that they might be acquired. We expect this kind of strategic acquisition will continue as more large pharmaceutical companies look to add complementary products to their pipelines and seek suitable uses for the cash they generate.

On the other hand, managed-care valuations have become more attractive as various industry players have lowered their outlooks in the face of increased pricing pressure and rising medical costs. In the near term, it seems like managed care has been unable to raise premiums without losing members. We had already baked in more conservative projections on increased medical expenses and we think most managed care companies will try to pass on those costs to their customers going forward.

Health-Care Stocks for Your Radar
We've recently seen a number of high-quality companies with moats become very attractively priced. These are all companies that can demonstrate sustainable competitive advantages in their markets and are financially solid enough to weather the current market turmoil. Longer term, we think these companies have bright prospects.

 Stocks to Watch--Health Care
Company Star Rating Fair Value Estimate Economic
Fair Value Uncertainty

Current Price

Biogen Idec $69 Wide Medium $46
Waters $76 Wide Low $57
Novartis $73 Wide Low $53
Mylan $23 Narrow High $14
WellPoint $95 Narrow Medium $48
Data as of 9-18-08.

 Biogen Idec (BIIB) remains one of our favorite established biotech companies. Focused on oncology and autoimmune diseases, the firm pioneered the first monoclonal antibody for lymphoma--Rituxan is a huge blockbuster by any standard. Biogen's multiple sclerosis franchise is impressive. Even several new cases of a rare brain infection from the use of MS drug Tysabri hasn't hurt Biogen much. Not only is Tysabri's efficacy far superior to other treatments (which convinced the FDA to leave it on the market), but Biogen also has an older MS drug, Avonex, which some Tysabri patients would likely switch to.

 Waters (WAT) has carved out a leadership position in its equipment markets through an unwavering focus on innovation. While competitors continue to work on new products to match this generation of Waters' liquid chromatography instruments and mass spectrometers, we noted at an industry conference that Waters already had its next generation lineup nearing launch.

We are fans of  Novartis(NVS) diversified businesses. Not only does the firm have a major presence in branded pharmaceuticals, but it is also a major competitor in the generics, vaccine, and diagnostic areas. This allows Novartis to benefit from the synergies between the areas. With the move toward pairing diagnostics with specialized therapies that rely on the presence or absence of specific gene mutations, Novartis should benefit from being able to put the two pieces together. We also expect Novartis will have a leg up on traditional generic competitors once biosimilars for biologic therapies become more widely accepted. These cell-based therapies are difficult to manufacture and Novartis already has far more experience in this area thanks to its intellectual property across the branded drug and vaccine businesses.

 Mylan (MYL) had made good progress recently, beating our gross profit target by more than 10% thanks to strong volumes and favorable product mix. Mylan's purchase of Merck KGaA's generic division has created the third-largest manufacturer of generic drugs. Additionally the company announced an agreement with India-based Famy Care, the world's largest oral contraceptives manufacturer, to introduce a line of 22 generic oral contraceptives in 2010; this pact would shake up the longstanding generic oral contraceptives duopoly between  Barr (BRL) and  Watson (WPI).

 WellPoint (WLP) has also shown signs of improvement in the most recent quarter. While membership in the individual and small-group market declined, which we attribute to the weak economy, the company continued to steal market share among large national employers. Overall nonrisk membership increased 6.2% from the previous year, while risk-based membership fell 3.3%. Importantly, WellPoint is already the low-cost provider in most of its markets (where it has little competition from nonprofits). This means the firm is able to raise premiums to match any increased medical costs without losing membership in the long run.

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Debbie Wang has a position in the following securities mentioned above: BIIB. Find out about Morningstar’s editorial policies.