Why Health Care Stocks Are Looking Healthy

The sector has lagged during the long health care reform debate because the market hates uncertainty. But with a decision apparently near, these stocks look promising.

In 1994, "Forrest Gump" was the movie of the year, health care stocks were as cheap and unloved as they are today, and the reason was exactly the same: Washington was considering health care reform.

Final vote on Obama reforms near

This time around, it looks like President Barack Obama's health care reform ideas might actually become law, perhaps in the next few days. So betting on health care stocks now would be dumb, right?

Wrong. Pass or fail? To understand this picture, start with a little Forrest Gump logic. Because the details of health care reform remain unclear, the sector's future is like a box of chocolates: Investors don't know what they're going to get, so they are steering clear.

But there's limited risk that health stocks will fall when a bill passes because top money managers have already assumed legislation will be approved, according to a survey released last week by Deutsche Bank. This suggests passage is priced in -- already accounted for in stock prices.Msn.Video.createWidget('PlayerAd1Container', 'PlayerAd', 304, 314, {"configCsid": "MSNmoney", "configName": "player-money-4x3-articles-inline", "player.vcq": "videoByUuids.aspx?uuids= 6d25e84e-4563-427b-9704-a30014f0541e,1052c7f6-5589-4eb4-a324-51271ee0f627,54e4b603-9a8d-46d3-b260-dc804f9de91d,c3e7893b-adeb-43a5-9fb0-b190809da6bd,37817e1b-5359-40bd-b5ed-5fdea1664162,20fe584c-dd53-466b-b469-59d9e483a0e4", "player.fr": "iv2_en-us_money_article_Investing-MutualFunds-inline"}, 'PlayerAd1');Msn.Video.createWidget('Gallery4Container', 'Gallery', 304, 150, {"configCsid": "MSNmoney", "configName": "gallery-money-articles", "gallery.linkbackLocation": "bottom_left", "gallery.numColsGrid": "3", "gallery.categoryRequests": "videoByUuids.aspx?uuids=6d25e84e-4563-427b-9704-a30014f0541e,1052c7f6-5589-4eb4-a324-51271ee0f627,54e4b603-9a8d-46d3-b260-dc804f9de91d,c3e7893b-adeb-43a5-9fb0-b190809da6bd,37817e1b-5359-40bd-b5ed-5fdea1664162,20fe584c-dd53-466b-b469-59d9e483a0e4;videoByTag.aspx%3Ftag%3Dmoney_dispatch%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1;videoByTag.aspx%3Ftag%3Dbest%2520of%2520money%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1"}, 'Gallery4');Instead, simply clearing away the uncertainty could get them moving up. And if the reform push falters, well, the rally is on.

"The market hates uncertainty," says Robert Hodgson, the portfolio manager at BlackRock Healthcare Fund (MDHCX), which has beaten the market and its benchmarks by a healthy margin over the past five years.

If reform passes, Hodgson says, investors can begin "putting numbers on what is nebulous right now." They'll like what they see, he believes, particularly because many of the changes won't go into effect until 2014.

Meanwhile, company "fundamentals are still robust, and valuations are cheap. For at least several years in the future, fundamentals aren't going to change a whole lot," Hodgson says.

Simply settling the issue will draw investors to health care stocks, says Derek Taner, the manager of AIM Global Health Care Fund A (GGHCX), another outstanding fund in the sector based on five-year returns. Click graphic for interactive chartBlackRock Healthcare Fund"A lot of investors are thinking, 'It is too hard to figure out, so why don't I own Apple (AAPL, news, msgs) and Caterpillar (CAT, news, msgs), because they are blasting the numbers.' Once you get resolution, the sector is going to be much better off."

If reform fails, on the other hand, the gains could be really big as the stocks catch up to the rest of the market.Sector is 20% behind "Since the March low of last year, health care has severely lagged the broad market by 20%," says Scott Callahan, the portfolio manager at IconHealthcare Fund (ICHCX), making it the cheapest sector in the market. "We see tremendous value in a lot of these stocks."

He calculates that you get $1.18 in value for every $1 you put into health care stocks right now, compared with just $1.04 for every dollar that goes into the S&P 500 Index ($INX).

Here's another way to look at the potential. Before the Clinton health care reforms surfaced, stocks in the group typically traded for 1.2 to 1.4 times the price-earnings ratio of the S&P 500, says Ed Yardeni of Yardeni Research. That's a common comparison used to decide whether stocks are cheap compared with the market.

By the time the Clinton reforms were introduced in April 1993, the relative P/E had fallen to a record low of 0.84. But look what happened next:

By August 1994, with the plan losing support, the relative P/E for the group had recovered to 1.08.

By the spring 1995, the sector was back in the 1.2-to-1.4 range.

From the lows in 1993 through the next 10 years, health care stocks outperformed the S&P 500 by more than two times, Yardeni says.

Recently, the sector traded at a P/E that's 0.86 times the S&P 500's -- very similar to the low point of the Clinton years. This isn't to say history will repeat itself, but that's a sizable potential for gains compared with a very limited downside.

So how do you play this opportunity if you agree?

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"The market hates uncertainty," says Robert Hodgson, the portfolio manager at BlackRock Healthcare Fund (MDHCX), which has beaten the market and its benchmarks by a healthy margin over the past five years.

If reform passes, Hodgson says, investors can begin "putting numbers on what is nebulous right now." They'll like what they see, he believes, particularly because many of the changes won't go into effect until 2014.

Meanwhile, company "fundamentals are still robust, and valuations are cheap. For at least several years in the future, fundamentals aren't going to change a whole lot," Hodgson says.

Simply settling the issue will draw investors to health care stocks, says Derek Taner, the manager of AIM Global Health Care Fund A (GGHCX), another outstanding fund in the sector based on five-year returns. Click graphic for interactive chartBlackRock Healthcare Fund"A lot of investors are thinking, 'It is too hard to figure out, so why don't I own Apple (AAPL, news, msgs) and Caterpillar (CAT, news, msgs), because they are blasting the numbers.' Once you get resolution, the sector is going to be much better off."

If reform fails, on the other hand, the gains could be really big as the stocks catch up to the rest of the market.Sector is 20% behind "Since the March low of last year, health care has severely lagged the broad market by 20%," says Scott Callahan, the portfolio manager at IconHealthcare Fund (ICHCX), making it the cheapest sector in the market. "We see tremendous value in a lot of these stocks."

He calculates that you get $1.18 in value for every $1 you put into health care stocks right now, compared with just $1.04 for every dollar that goes into the S&P 500 Index ($INX).

Here's another way to look at the potential. Before the Clinton health care reforms surfaced, stocks in the group typically traded for 1.2 to 1.4 times the price-earnings ratio of the S&P 500, says Ed Yardeni of Yardeni Research. That's a common comparison used to decide whether stocks are cheap compared with the market.

By the time the Clinton reforms were introduced in April 1993, the relative P/E had fallen to a record low of 0.84. But look what happened next:

Recently, the sector traded at a P/E that's 0.86 times the S&P 500's -- very similar to the low point of the Clinton years. This isn't to say history will repeat itself, but that's a sizable potential for gains compared with a very limited downside.

So how do you play this opportunity if you agree?

Continued: The sector betsMore from MSN Money

 1 | 2 | 3 | next >

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