Small- And Mid-Cap Stocks Offer Most Promise In Health Care Sector

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Cost of healthcare

The health care sector is expanding as more individuals obtain health insurance yet the investment opportunitiesare shrinking — in market cap.

Expected government cuts to Medicare and Medicaid, the uncertainty of health care reform and looming patent expirations are weighing heavily on the outlook of the biggest companies in the sector: large-cap pharmaceutical stocks.

“Despite how cheap they look, you want to avoid a sector close to a patent cliff,’’ says Derek Taner, manager of the Invesco Global Health Care Fund , who has been underweight large drug makers for the last eight years.

But big pharma isn’t reflective of the overall sector, says Taner, “The rest of health care really isn’t that expensive, there is lot of opportunity elsewhere.’’

Invesco Global Health Care is finding opportunities among mid-cap and small cap companies where one to three key products are driving performance. Their size makes them easier to follow and their above-average growth rates make them attractive acquisition targets in a consolidating industry.

Taner tends to buy these stocks at a discount following negative news. Being a value manager in a traditional growth sector enables the fund to buy promising stocks earlier than growth managers, who tend to buy after earnings have rebounded.

Teva Pharmaceuticals is one such value play. Shares are down 20 percent over the last 12 months but Taner says the generic drug maker is well positioned long-term. Teva also markets Copaxone for multiple sclerosis and is a savvy acquirer that is expected to generate mid single-digit EPS growth going forward.

Another opportunistic holding is CareFusion , part of a medical devices group that Taner considers inexpensive but susceptible to slowing growth rates. The company’s operating margins currently lag its competitors but Taner expects improvement over the next two to five years.

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You can gain focused exposure to the medical devices market via the Dow Jones U.S. Medical Devices ETF or the Fidelity Select Medical Equipment & Systems Portfolio.

Managed care is the Invesco fund’s biggest overweight group. These stocks, which include fund holdings Wellpoint, Aetna, and Unitedhealth Group , have responded well to health care reform, are fairly priced and generate strong free cash flow.

Direct plays on the managed care segment include the Dow Jones U.S. Healthcare Providers ETF and theFidelity Select Medical Delivery Portfolio.

The Manning & Napier Life Sciences Fund searches for health care stocks that improve convenience for patients, payors and service providers.

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Health care information technologyproviders are one of the prime beneficiaries of the need to streamline recordkeeping, cut costs and meet new government standards. Manning & Napier fund manager Jeff McCormack says we’re only in the first phase of a multi-year escalation in demand.

Cerner is well positioned to benefit from existing demand for healthcare IT in the U.S. and future demand in overseas markets. The firm currently generates 20 percent of its revenue outside the U.S., a figure that could rise to 30 percent to 40 percent over the next several years.

Minimally invasive procedures are another convenience that can lower costs and speed recovery times. Here, McCormack likesInsulet , a maker of implanted insulin pumps that is taking share from larger rival Medtronic.

Diagnostics firms such as Alere also improve convenience and comprise more than 25 percent of the Fund’s portfolio. Alere is helping consumers take control of their care through self testing products and managed services.

Another quarter of the Manning & Napier fund is devoted to international stocks serving a growing demand for health care in developing markets.

“The wealth effect will drive consumption,” says McCormack. “All countries want a domestic [health care] solution.’’ In South Korea, pharmaceutical maker Green Cross Corp. is meeting the need and building the infrastructure to expand regionally.

Large-cap drug makers could become attractive again once they develop profitable replacements to expiring products and the controversy around implementation of the Obama’s administration health care programs clears up.

In the meantime, fund managers recommend favoring smaller, more nimble stocks that can help curb rising health care costs.

“The health care sector will continue to face cost and reimbursement pressure, but I believe there will be opportunities to capitalize on this trend through investments in companies that innovate and help the system save money,’’ Edward Yoon, manager of the Fidelity Select Health Care Portfolio , said in a recent shareholder report.