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Health care still has potential, analysts say

Supporters of the Affordable Care Act celebrate as the opinion for health care is reported outside of the Supreme Court in Washington, D.C., on June 25, 2015.
Al Drago | CQ Roll Call | Getty Images

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Wall Street likes health care despite its vulnerability to political headwinds and underperformance this year.

The sector is down more than 2 percent this week after a new assault on drug pricing by Hillary Clinton and others, who criticized Mylan for dramatic price increases for its EpiPen allergy treatment.

The company's stock was slammed and biotech and drug stocks slumped. Mylan closed 0.7 percent lower Thursday, down nearly 12 percent for the week, while the iShares Nasdaq Biotechnology ETF (IBB) ended almost 1.2 percent lower on the day for a roughly 2.5 percent decline for the week.

The overall S&P 500 health care sector extended losses Thursday and was the second-worst performer in the index this year.

"To me this sector is becoming attractive because it consistently delivers solid earnings and revenue growth. At the same time it's one of the only sectors that's inexpensive," said Kelly Bogdanov, vice president and portfolio analyst at RBC Wealth Management.

The sector is well diversified with high growth biotech names but it's also used as a defensive play, especially as many analysts expect the health industry to expand with the aging population.

In the second-quarter earnings season, the S&P health-care sector had the second-highest percentage growth in earnings per share of 7.5 percent and had the second-largest proportion of companies beating earnings estimates, according to Thomson Reuters. Health care overall is expected to post 6 percent earnings-per-share growth in the third quarter.

"First we have to get past the election and once we get past that I think some of the political headwinds could lift," Bogdanov said. Her firm has been market weight on health care for much of the year because of political risks, but said it could become more positive if those risks fade.

Much of Wall Street is already bullish on the sector. In a quick survey this summer of eight major investment analysts' calls on S&P 500 sectors, CNBC found six of those firms were overweight health care.

While the is up more than 6 percent for the year, the health-care sector is up less than 1 percent and vying with financials for the worst performance over that time.

There "could be some of the sentiment risk from potential drug price cuts," said Mike Bailey, director of research and chair of FBB Capital Partners. But he said the chance of such a cut is "slim to none."

Bailey said many of those firms "continue to produce good drugs and grow margins." He said he would be more concerned about actual harm to those businesses if, in an unlikely scenario, the Food and Drug Administration took a different view on drug approval, or if pharmacy benefit managers such as CVS or UnitedHealth moved to pressure prices.

From a technical perspective, analysts also see longer-term potential, especially for biotech.

"I think short-term underperformance is to be expected from biotech stocks, and other high-beta areas of the market, as the major indices pull back. However, I expect them to exhibit leadership in Q4," BTIG Chief Technical Strategist Katie Stockton said in an email.

However, the political headwinds could linger longer than many analysts expect.

"Obamacare is in trouble, and the announcement of huge premium increases will be embarrassing for the Democrats, who will urge adoption of a public option. Clinton will seek to change the subject — she targeted Mylan's allergy drug pricing yesterday. She will be a headline risk for drug companies for months (or years) to come," Horizon Investments Chief Global Strategist Greg Valliere said in a note Thursday.

A Republican presidential win also brings political risks to health stocks. Republican presidential candidate Donald Trump plans to repeal the Affordable Care Act, and his health-care platform highlights the need to negotiate pharmaceutical drug prices.

"What's happening this year is you have both sides of the aisle … showing more headline risk," said John Canally, chief economic strategist at LPL Financial. But he also saw "relatively low" chance of major price changes for a majority of drugs given likely opposition from Republicans in Congress.

Health insurers such as UnitedHealth have also come under pressure recently as federal health regulators are investigating whether some care providers are gaming Obamacare to get higher insurance reimbursements, while major insurers said they will significantly cut their offering of Obamacare plans next year.

In the near term, the "drug pricing aurora surrounds all," said Evercore ISI specialty pharmaceuticals analyst Umer Raffat, who noted that money managers were indiscriminately looking more negatively at the drug-related stocks right now. He has buy ratings on Allergan, Medicines Cos., Alkermes and Teva Pharmaceutical, and hold ratings on Valeant Pharamceuticals and Mylan.