Two Favorite Health Care Companies
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I am a numbers person--especially when it comes to stock analysis. Every month, I fill up a spreadsheet with 1,000 stocks and 244 columns of data and formulas. I then turn my computer loose, and it goes wild performing two million calculations.
Why so many calculations?
I want the computer to tell me which companies have produced steady sales, earnings and dividend growth during the past 10 years. I also want to find companies that will continue to grow during the next year, two years, or even the next five years. In addition, I want to find companies that have strong balance sheets with little debt and lots of cash. And finally, I want my computer to tell me which stocks are undervalued and their appreciation potential.
Impossible? In a way, yes, but exploiting the capabilities of my computer is a good start to determine which companies deserve further study.
Lately, my computer is listing a lot of health care companies with very good potential. Several factors cause this phenomenon.
First, companies in the health care sector tend to be recession-resistant because people still need health care regardless of economic problems.
Second, there's a huge swell in the number of people reaching age 65. During the next 25 years, because of aging baby boomers, the over-65 population will increase by 80%, creating a dramatic rise in the demand for health care.
Third, a lot of health care companies seem to be undervalued, which would cause them to appear on my list. The low stock prices could be misleading, though, because health care reform could impact some of the companies in a very negative way.
Let's look at how the health care industry is divided, so we can concentrate on the sectors with the most promise and the fewest problems.
Health care companies generally fall into one of four categories: biotechnology, pharmaceutical, medical equipment and medical services.
The biotechnology sector is made up of a few large companies, such as Amgen and many small companies such as Human Genome and United Therapeutics. Biotech companies link biology and technology to produce biotechnology drugs using living micro-organisms, such as bacteria, yeast or cells, to enhance human life or the environment. A major component of biotech is the use of gene-splicing to produce new drugs. Many companies in the biotech sector are small and their success depends entirely on the outcomes of their research efforts. Investment in smaller biotech companies carries high risk, although rewards can be huge.
Pharmaceutical companies create pharmaceutical drugs from chemicals and compounds derived from synthetic ingredients and plant extracts. Typically, pharmaceutical companies are really big companies that produce a lot of different drugs aimed at treating an array of illnesses and diseases. The largest companies in the pharmaceutical sector are Johnson & Johnson, Pfizer and Novartis.
Patent expirations are especially troubling for pharmaceutical companies. Less expensive generic drugs can be introduced as soon as a drug's patent expires. In addition, the U.S. Food and Drug Administration usually issues exclusivity for shorter periods of time for pharmaceutical drugs than for biotechnology treatments. Companies with near-term patent expirations on major drugs include: Pfizer, Wyeth, Merck and Eli Lilly.
Pharmaceutical companies could be negatively impacted by proposed U.S. health care reform, as it will likely encourage less-costly generic drugs over brand-name drugs. The new plan could also lower reimbursements from Medicare, which would force lower drug prices--although lower reimbursements could be offset by the larger number of Americans with access to health insurance.
One bright spot for drug companies has emerged. The U.S. Congress approved additional funding for the Food and Drug Administration, which enabled the FDA to hire 800 new employees in 2008. Drug companies should now be able to get approvals for new drugs in a shorter period of time, which will allow companies to introduce drugs sooner and sell them for a longer period of time.
The third segment of the health care sector includes companies that make or distribute medical equipment. Equipment makers are experiencing increasing demand because of major technological advances such as less invasive surgery, robotics and computerized visual technology. The aging baby boom population will also increase the need for the use of medical equipment during the next 40 years!
Cutbacks in Medicare reimbursements should not become a problem for medical equipment makers. However, tighter controls by the FDA on products such as coronary artery stents will require companies to produce quality merchandise. Health care reform that includes coverage for more Americans will help more people to become eligible for medical procedures. The largest companies in the medical equipment sector include Alcon, Medtronic and Baxter.
The fourth segment of the health care sector is medical services, which encompasses companies in the managed care, hospital and clinical laboratory areas. Companies such as Aetna and Humana are vulnerable to government reimbursement cuts. Private insurers oppose plans that encourage healthcare cooperatives because they do not want to compete against other programs modeled after Medicare or Medicaid. Hospitals have been successful in cutting costs during the last few years, but rising uncollectible charges are a problem. Health care reform will probably help hospitals.
The future of companies in the health care sector will be more certain when health care reform is enacted. If and when passed, health care reform could impact segments of the industry positively while impacting other parts negatively. The main goals of the Obama administration are to expand coverage, contain costs and avoid creating problems for any of the involved industries. I generally favor medical equipment makers because they have the greatest potential with few problems.
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One of the important objectives of health care reform is to increase the efficiency of the current system from top to bottom. Cutting costs and waste could save billions and reduce everyone's health care costs considerably. My screening process has led me to a unique company that could play a big role in cutting health care costs.
HMS Holdings (HMSY) provides cost-reducing services to healthcare providers, Pharmacy Benefit Managers (PBMs) and government sponsored health care programs, such as Medicaid and the Veterans Health Administration.
HMS Holdings reduces costs for Medicaid by making sure claims are accurately paid, billing problems are minimized, and fraud has not occurred. According to reports, the Medicaid error rate of 10.5% costs $38 billion annually. Each year, HMS Holdings recovers more than $1 billion from fraudulent claims on behalf of government programs.
For the first half of 2009, HMS's revenues increased 25% and earnings per share soared 42% as a result of strong demand and new contracts. I forecast rapid 24% EPS growth during the next 12-month period and beyond.
I foresee great potential from a possible new national health plan that will stress a more efficient system with less waste. The company is small, with just $200 million in sales, but the balance sheet is strong. HMSY shares are high-priced at 32.3 times next 12-month EPS, but the potential is substantial.
I also like companies that produce generic drugs.
Health care reform will hopefully contain measures to reduce health care costs for all Americans. Drug costs are high, and one way to reduce the cost of prescription drugs is to promote the use of less expensive generic drugs. The largest generic drug company is Teva Pharmaceutical (TEVA), which is developing new generic drugs at an amazing rate.
Teva Pharmaceutical, based in Israel, develops, manufactures, and markets generic and proprietary branded (store-brand) drugs. The company is the largest generic drug producing company in the world and, in addition, sells active ingredients to other pharmaceutical companies.
Teva's largest selling generic drug, Copaxone, is used to treat multiple sclerosis. The company's aggressive acquisition and product development programs are driving strong sales growth. TEVA recently purchased U.S.-based Barr Pharmaceuticals for $7.5 billion. Barr is increasing Teva's generic drug sales significantly in the U.S. and in parts of Europe. The acquisition is already producing higher profits than expected.
Teva's product pipeline is very strong with 198 new drug applications waiting for FDA approval, several of which could become blockbusters. We forecast earnings growth of 28% during the next 12 months. Teva's generic drug business is growing more rapidly because consumers around the globe are opting for lower priced generic drugs.
TEVA shares are very reasonably priced at 12.5 times forward EPS with a dividend yield of 1.1%. The company's sales will increase 18% and EPS growth will likely be close to 28% during the next 12 months and 17% in future years. TEVA is an unbelievable bargain. Buy now.
J. Royden Ward
For Cabot Wealth Advisory
Editor's Note: You can read more about HMS Holdings and Teva Pharmaceutical and get continuing coverage of these stocks in Cabot Benjamin Graham Value Letter. There you'll not only find buy and sell advice for HMSY and TEVA, you'll get many other excellent value stock recommendations from J. Royden Ward each and every month. Roy applies the strategy of the father of value investing, Benjamin Graham, to find the market's best undervalued stocks. And he will tell you exactly when to sell, too. This year he's already recommended selling 10 stocks with average gains of more than 25%! Don't miss out on his next recommendations ... click here now to get started today!