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How to cash in on the Trump effect on health-care stocks

Electronic medical records
Reza Estakhrian | Getty Images

Repeal of the Affordable Care Act has placed health-care investors at risk. But there are parts of the U.S. health-care system that President Donald J. Trump plans to shake up, which may present buying opportunities. Currently, health stocks are underpriced compared to other sectors of the market.

"We're investing in a time of substantial uncertainty," said Marshall Gordon, director and senior research analyst at ClearBridge Investments. "Everybody is searching around for what might happen."

Thanks to the uncertainty, the broad health-care stock index has fallen by nearly 6.3 percent since last August, but it is up more than 3 percent since the election. The sector, which has tended to trade at a premium to the S&P 500, is about 10 percent cheaper than the benchmark, noted Brad Sorensen, managing director of market and sector analysis at Charles Schwab.

"It's not major, but when you look at the rest of the sectors, that does make it pretty attractive in a market where it's tough to find good value," he said.

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The biotech sector, in particular, has seen its P/E come down from its 2015 peak. The S&P 500 health-care sector forward PE is 14.9 compared to its historical average of 19.3 over the last 20 years. The NASDAQ Biotech Index is trading at 34 times forward PE compared to 49.8 since 2009.

This is not due to a lack of growth — it's been one of the better stories over the past decade in terms of earnings growth — but concerns about sector valuation amid regulatory scrutiny, said Joe Abbott of Yardeni Research. He thinks the sector remains a good opportunity.

This week's meeting between Trump and drug company CEOs is a good example of the volatility that will move stocks — up and down — as the government begins to make changes.

The health-care ETFs starting the year strong

ETF
Year-to-date return (%)
1-year return (%)
YTD flows ($)
Ticker
SPDR S&P Biotech 9.7 27.7 (-100M) XBI
BioShares Biotechnology Clinical Trials Fund 7.8 2.5 1M BBC
BioShares Biotechnology Products Fund 7.7 46 2M BBP
iShares Medical Devices 7 23 153M IHI
VanEck Vectors Biotech 6 11.7 34M BBH

(Source: XTF.com)

On Tuesday, in the meeting with drug makers, Trump called on them to produce their pharmaceuticals in the United States and said, "We have to get the prices down. We have to get the prices way down."

But Trump also promised in the Tuesday meeting to make it easier for pharmaceutical companies to win regulatory approval for their products. What the president was not as forceful on was drug prices. Trump had recently said drug makers were "getting away with murder" and indicated he might even recommend the government drive a hard bargain through Medicare. But on Tuesday, even as Trump reiterated that prices are too high, the market interpreted his view as now backing away from an earlier, less industry-friendly threat to allow the government to drive a hard bargain over drug prices.

Biotech-focused stocks and ETFs had the largest gains on Tuesday, with the iShares Nasdaq Biotechnology Index ETF up 3.5 percent and the S&P Biotechnology Index up 4.5 percent since Tuesday.

There is a long-term reason to buy in: Americans are aging and will need more medicines and care. According to the U.S. Department of Health and Human Services, 14.5 percent of the U.S. population was 65 or older in 2014. That number is expected to climb to 21.7 percent by 2040.

In interviews conducted before Trump's meeting with drug companies this week, analysts who cover the sector said there are reasons to believe it could do better under Trump. Pharmaceuticals and biotechnology are less impacted by ACA changes than other parts of the market.

Several big drug companies have seen their prices fall modestly this year, including Gilead Sciences and Celgene, which are down about 1.8 percent and 1.3 percent, respectively, potentially presenting buying opportunities.

Like with health-care reform, it's still unclear as to how Trump will approach drug pricing, and the government could negotiate some prices with companies for Medicare, but it's unlikely we'll see any major changes to the way things operate now, said Ashtyn Evans, an equity analyst with Edward Jones, in an interview before the Tuesday meeting. If anything, it will be the private insurers that do more of the negotiating, but with the outcry over drug pricing, from the public and from Trump, many companies have already taken a more modest approach to price increases, Evans said.

Longer-term, more Americans will need more medicines, and a number of innovative drugs for Alzheimer's, cancer and other diseases are being developed now. That won't change under Trump. In fact, more drugs could get approved — Sorensen thinks the U.S. Food and Drug Administration may be less stringent on approvals under the new president.

"He has talked about easing regulations of all sorts, and those could include the drug industry," Sorensen said, referring to comments that predated Tuesday's meeting. "That should help profitability."

Popular 2017 health care trades

ETF
YTD flows ($)
1-year flows ($)
Assets ($)
Ticker
iShares US Medical Devices 147M 189M 1.1B IHI
Fidelity MSCI Healthcare 35.7M (-52M) 620M FHLC
VanEck Vectors Biotech 35M 60M 633M BBH
iShares US Pharmaceuticals 15.6M (-29M) 684M IHE
First Trust AMEX Biotechnology Index 8M 28M (-1.5B) FBT

(Source: XTF.com)

Despite the uncertainty, with many stocks now trading below where they have in the past, Evans suggests looking at the more innovative names and at companies that are diversified by product type, geography and payer.

She has a buy rating on pharma company Merck, which has several product lines, including drugs for animals, which isn't impacted by the ACA, and it's been developing a promising cancer drug, Keytruda, that use the body's immune system to fight the disease.

"It's not reliant on government reimbursements or private payers," she said.

Year-to-date, Merck is up 3.1 percent. In earnings reported on Thursday morning, Merck presented earnings that were mostly in line with estimates but did say it thinks worldwide sales will be flat in 2017 compared to last year. Shares rose by close to 3 percent after the report.

No matter what one buys, though, it's going to be a rocky ride for a while. Investors need to have the strength to hang on to their stocks, but eventually things will calm down and prices will rise. It's not unlike what the industry saw after the now former president Obama took office in 2008.

"Remember, there was terrible uncertainty in 2008, but these stocks have done phenomenally well," said ClearBridge Investments' Gordon. "When the fear is high, that's when you can make a lot of money."

— By Bryan Borzykowski, special to CNBC.com