(FORTUNE Magazine) – The health-care crisis is all around us. Every day brings new revelations about the burden that the rising cost of medical care is placing on society. From a new Medicare prescription-drug bill that could cost taxpayers as much as $600 billion, to small businesses struggling to provide health insurance to their employees, we're all affected by it. The federal government's number crunchers peg last year's health-care tab at some $1.7 trillion. That's equal to about 15% of the entire economy--a percentage that's rising every year.

All that spending, though, should be telling you something else: Those trillion-plus bucks are going into somebody's pockets. It seems almost too obvious to point out, but many companies are riding this health-care boom to riches. And that means that the cost of medical care presents as big an opportunity as it does a burden. After all, if you're going to pay for it, why not profit from it?

To say that health care is the Next New Thing in investing, of course, is like saying that someday the web might have a real effect on our daily lives: It happened a long time ago and it just keeps getting truer every day. Consider that over the past ten years the return of the S&P 500 Health Care index has been double that of the broader S&P 500. Betting on the sector has long been a way for the savviest investors, like Sam Isaly or Ed Owens, to outperform the market. Isaly's Eaton Vance Worldwide Health Sciences fund has a ten-year annualized return of 18%, almost seven percentage points better than the S&P. And the venerable Owens has averaged a market-stomping 20% return for the past two decades in his Vanguard Health Care fund.

Is there potential for this kind of performance in the future? You bet. "There's probably no area in the market where growth is so assured," says Steve Leuthold, head of the Leuthold Group, a respected research and money management firm in Minneapolis. "The growth is a given as far as I'm concerned." Leuthold, for one, thinks health care will be the best-performing sector over the next decade. It's also his favorite area for the year ahead, accounting for 34% of the core portfolio he has guided to a 14% average annual return over the past five years.

Robert Gold, who oversees health-care equity research for Standard & Poor's, likewise predicts the sector's market impact will increase greatly in the coming years. He expects health care's weighting in the S&P 500 stock index, now at 13%, to rise to almost 20% over the next ten years, mirroring the industry's growth in the economy. (Indeed, one way for investors to play the boom is to buy the Health Care Select SPDR (XLV, $31) exchange-traded fund, which offers broad exposure to the sector.)

Experts such as Gold and Leuthold draw their confidence in the long-term power of the health-care boom in large part from that all-too-obvious demographic trend: the coming wave of baby-boom retirees. As heavily discussed, overly hyped, and incessantly studied as this phenomenon may be, however, there's no denying the sheer market power of 75 million trick-kneed, Prevacid-popping, ointment-loving consumers. Fact is, aging boomers are going to spend and spend on everything from Band-Aids to Botox to body parts.

You can almost hear the cash registers ring.

Put this powerful demand picture together, and what you get is an industry of suppliers with phenomenal pricing power. Over the past five years prices for medical goods and services have risen an average of 4.8%, roughly double the inflation rate. "The supply side is essentially dictating the prices," says Princeton health economist Uwe Reinhardt.

The macro trends are compelling enough, but the real smart-money types--the Owenses and Isalys, for instance--go beyond that level of analysis. In any large industry certain sectors are going to grow faster at any one time. It's the ability to read the trends correctly that makes it possible to really profit.

For instance, opportunity exists not just because the nation is turning grayer but also because so many of us are working longer and are eager to maintain our physical vitality. We're talking about a generation that remembers Steve Austin as the $6 million man and feels that medical science can--and should--make them stronger, faster, and better looking. They're demanding a level of care previously unheard-of. A decade ago, who would have imagined that we'd be hot to have our vision surgically corrected by shooting lasers into our eyes? Or to inject botulism into our foreheads to get rid of wrinkles? Somehow, even if those therapies were available 50 years ago, it's hard to picture our grandparents using them.

But the demand is not limited to vanity medicine. For every new baldness medication or other lifestyle enhancer, there are still enormous gaps in care that health-care companies are eagerly trying to close. "Does anyone believe that we have good therapies for metastatic cancer, Alzheimer's, multiple sclerosis, Parkinson's disease, or diabetes?" asks Kris Jenner, manager of the T. Rowe Price Health Sciences fund. "The need is tremendous."

Aided by increasingly sophisticated research coming out of academic and government institutions, medical companies are, in fact, bringing innovative therapies to market. Minimally invasive surgery techniques for implanting heart valves and bypass grafts, for example, may soon make open-heart surgery a thing of the past.

Ironically, another factor that will help some companies is the very notion of runaway health-care costs itself. A whole subsector of businesses has sprung up during the past decade that specialize in reducing the expense for society as a whole. "In every cloud of problems there's a lining of opportunity," says Leuthold. "Companies involved in retarding health-care costs or making health-care delivery more efficient are going to prosper."

After talking to many of the best investors in the business, plowing through government studies and analyst reports, and screening dozens of companies based on their financials, we identified ten sure-footed firms that stand to benefit big-time from five major trends driving the health-care boom. Now you can give with one hand and take with the other.

JOINT MAKERS Ready to earn an arm and a leg

Students of urban legends will be forgiven for believing that the body-parts trade is limited to airport bars in Mexico. In fact, nowadays fixing a bum wheel has become almost a routine part of medical care. A growing number of substitute parts can be had with a little more than a nip and tuck from your doctor. And it's not just for patients in desperate discomfort. Baby-boomers who refuse to let their creaky bodies keep them off the ski slopes and tennis courts are increasingly having their joints replaced. They're taking out their eroded elbows, ankles, knees, and hips, and replacing them with artificial ones, usually made of ceramic or titanium. Fully 40% of the nearly 600,000 joint replacements in the U.S. are now performed on the under-65 crowd, says Morgan Stanley analyst Jason Wittes. That's up from 20% only 15 years ago. "The needle has definitely moved," Wittes says.

Stryker (SYK, $95) is a veritable body shop for weekend warriors. The sixth-largest medical-equipment maker, with $3.6 billion in annual sales, the company makes products ranging from surgical drills to spinal rods to bone cement. Fixing up broken bodies is in Stryker's DNA. The company got its start back during World War II and derived much of its business from the military. It has expanded over the years--it now has three broad business segments, including orthopedic implants, medical and surgical equipment, and rehabilitative services--but it has never lost focus on what's most important for investors: growth. Net earnings have increased 25% a year, on average, for nearly 30 years. And the stock has risen at a compound annual rate of 29%.

Chief executive John Brown shook up the medical-device industry last year when he enlisted golf great Jack Nicklaus to plug Stryker's artificial hip in a high-profile ad campaign. (Critics complain that such direct-to-consumer ads, popular with drugmakers, are wasteful and potentially misleading.) More recently the company has been getting glowing reviews for what some have called the "global-positioning system" for knee-replacement surgery. Stryker's new high-tech tool, which consists of a "smart camera" and special software, alerts doctors to any unwanted shifts in the patient's leg during surgery. As a result, surgeons are able to align the knee implant much more accurately, leading to fewer complications.

Among the many attractions of the orthopedics market, says Bob Millen, co-manager of the top-ranked Jensen fund, which counts Stryker as its largest holding, are the big barriers to entry. Products have long clinical histories and are often protected by patents. Also, surgeons are reluctant to switch because the cost of retraining can be high and they develop loyalty to their sales reps. The upshot is that these companies are consistently able to push through 3% to 5% price increases each year.

Zimmer Holdings (ZMH, $79), which can trace its roots back to 1927, has been getting a body makeover of its own lately. For years the company had been cooped up as a division inside Bristol-Myers Squibb, where it competed for funding with Bristol's drug business. But Zimmer CEO Ray Elliott pushed Bristol to cut his unit loose, which it did in 2001. Free to flex his muscles, Elliott bought Swiss rival Centerpulse for $3.4 billion last year. The deal catapulted Zimmer into the No. 1 spot in the orthopedic-device field and got it into the fast-growing spinal-implant market.

Elliott intends to keep Zimmer growing by making a big push into minimally invasive surgery. The company recently won a patent for a new artificial hip and surgical procedure that can be performed on an outpatient basis, with no hospital stay. With the new technique, the surgeon makes two incisions, as small as 1.5 inches each, and generally navigates around the muscles, ligaments, and tendons without cutting them to access the hip joint. It's a vast improvement over traditional hip-replacement surgery, which requires a ten-to 12-inch incision and a three-to five-day hospital stay. More than 500 surgeons have already been trained to perform the procedure. Analysts on Wall Street expect Zimmer to increase annual profits by 18% for the next several years.

KNOWLEDGE IS POWER It's finally time to plug in to medical IT

The mountain of file cabinets at your local hospital offers telling testimony to the medical industry's need to join the Information Age. Now the cry to turn those files into more reliable bits and bytes is becoming deafening. The push is coming largely from big employers, insurers, and health-care advocacy groups, which point to a landmark 1999 federal report that found that medical mistakes kill as many as 98,000 people each year; subsequent reports have found they also cost as much as $9 billion a year. Even President Bush has joined the crusade. In his State of the Union address, he asked Congress for $100 million in next year's budget to finance demonstration projects promoting the use of information technology to improve health-care quality. The systems are intended to better coordinate care and overcome problems as common as illegible handwriting on doctor's prescriptions that cause patients to receive the wrong drugs or doses. In short, the heat is on the nation's 5,000 hospitals. And only a few dozen of them are making full use of the latest computerized patient safety techniques, such as an online system to order prescriptions.

The market is well aware of the growing opportunity in this field. In fact, over the past year shares of the two companies we like best have shot past our ideal buying prices. Nevertheless, their prospects for growth are strong.

Cerner (CERN, $45) should benefit as hospitals upgrade their technology. CEO Neal Patterson, an Oklahoma farmboy and onetime tech consultant for Arthur Andersen, transformed the field in the mid-1990s by offering hospitals software to link their business and clinical sides, from emergency room to billing office. Though it's still relatively little, with $840 million in sales, Cerner now boasts more than 1,500 clients, primarily small local hospitals. Already Cerner has attracted legions of fans, including Vanguard Health Care skipper Ed Owens, the largest shareholder, with nearly 8% of the company's shares.

Patterson is a drill sergeant of sorts, always ready to pounce on an opening. He once made headlines for berating the rank and file in a nasty e-mail after noticing that the parking lot was empty after 6 P.M. (He later apologized.) Patterson now sees the threat of bioterrorism as a growth opportunity.

Meanwhile, business at Cerner's bread-and-butter operations couldn't be better. The company recently reported record revenues from new business bookings of $255 million and record total revenue backlog of $1.25 billion in last year's fourth quarter. Wall Street analysts expect Cerner to boost annual earnings 25% for the next several years, according to Zacks Investment Research.

Drug companies also depend on timely information to hawk their goods. Sure, they have scientists with fancy degrees working to develop the next wonder drug. But at the end of the day, you're not going to move any product if your sales force is sleeping on the job. Given the $800 million or so it costs to bring a new drug to market these days, drugmakers need to stay on top of sales and market trends more than ever.

IMS Health (RX, $27) has the goods to do just that. It's the dominant provider of sales and marketing information to the drug industry, with an unrivaled database that tracks 75% of all drugs consumed in the world--more than a million different products. With $1.4 billion in sales, IMS provides drug companies with reports to help them keep tabs on everything from which pills doctors are doling out to how well their sales reps are performing.

The firm was started 50 years ago by one of the fathers of the drug-marketing business, Ludwig Wilhelm "Bill" Frohlich. At first IMS published rinky-dink syndicated studies showing how drugs were selling in particular regions. But as the pharmaceutical industry exploded into the $470 billion colossus it is today, drugmakers demanded increasingly detailed studies.

To spur growth, CEO David Thomas, a former IBM manager, is pushing IMS into higher-margin services businesses. Change has come slowly, as IMS has always operated as a data vendor. But he's brought in several top pharma executives to serve as consultants, and their efforts are bearing fruit. Consulting and services business grew 23% last year, topping the $100 million mark for the first time.

IMS offers everything Henry Berghoef, co-manager of the top-notch Oakmark Select fund, looks for in an investment: commanding market share, high barriers to entry, and fat margins. In addition, it lets investors ride the 8% to 9% annual growth projected for the global pharmaceutical business--without associated headaches such as patent expirations. "For all the well-publicized challenges the industry has, you still have a lot of emerging companies that require IMS's services," Berghoef says.

COST CONTROLLERS Turning dollars saved into dollars earned

Want an easy way to clamp down on medical inflation? Stop people from getting sick. Obvious as that may sound, the health-care community is only now fully waking up to the idea. In the past few years a new breed of firms, known as disease managers, has emerged to help patients with costly chronic diseases such as asthma, diabetes, and heart disease manage their illnesses better so they don't progress and become costlier to treat. According to the Centers for Disease Control, these patients, a group of some 90 million people, account for an astounding 75% of the nation's health bill. Clearly, the savings opportunity here is huge.

American Healthways (AMHC, $24), a small Nashville company with around $200 million in sales, is widely considered the leader in this promising new field. Founder and current chairman Thomas Cigarran recognized the potential of disease management back in 1996, when he signed his first contract with the Principal Financial Group's insurance arm. But it wasn't until recently that business began to heat up. In just over two years, the number of patients enrolled in the firm's programs has quadrupled to more than a million. The firm currently has 49 health-insurance customers including Cigna, Oxford, and Anthem.

Think of disease managers as professional naggers. The firm has 1,200 nurses, stationed at eight call centers across the country who check in regularly with patients by phone to encourage them to get all the necessary tests and treatments for their diseases. (Enrollment is voluntary.) Diabetics, for example, are urged to have their cholesterol checked each year, since they're at greater risk of having heart attacks. Asthma sufferers are pushed to keep regular tabs on their lung capacity to prevent the onset of a full-fledged attack.

Early results have been impressive. American Healthways saved Blue Cross and Blue Shield of Minnesota $40 million last year. That shaved three percentage points off its overall cost increase. With numbers like that, it's not surprising that Wall Street believes disease management could soon become a $20 billion business. Considering that such firms had combined sales of less than $600 million in 2002, there's huge growth opportunity. "We're still very much in the early innings," says Mike Balkin, who holds the stock in his top-ranked William Blair Small-Cap Growth fund.

To be sure, competition is heating up. The biggest threat is from health plans such as Kaiser Permanente that have built, or are starting to build, their own internal disease-management programs. But given the large startup costs to offer these services and the quick payback that many health insurers require to make an investment on that scale, analysts believe standalone firms such as American Healthways can capture as much as half the market.

Exploding prescription-drug costs are whacking everyone, particularly seniors, who are by far the biggest purchasers. Sure, some can hop on a bus to a pharmacy in Canada. But what about retirees who can no longer look after themselves and require around-the-clock care?

That's where Omnicare (OCR, $42) comes in. The Kentucky company purchases drugs in bulk from manufacturers and then doles them out to residents in nursing homes and assisted-living facilities. Serving nearly 40% of all people in those settings, Omnicare has a commanding share of the long-term-care market.

What really sets Omnicare apart, says shareholder Kris Jenner of T. Rowe Price, is the science behind its system. With the help of outside geriatric-care experts, the company created the industry's first database that ranks more than 1,000 medications based on how effective they are for seniors. Company pharmacists then recommend medications to the institution's doctors that, the company insists, are most appropriate for their patients. Omnicare contends the database helps reduce the costly adverse drug reactions that seniors often experience. The upshot is that the company may be able to save long-term-care facilities and private-pay patients up to 30% on their drug bills.

Spun off from W.R. Grace in the early 1980s, Omnicare set its sights on the long-term-care market from the start. In 1994 the company signed a contract with Health Care & Retirement Corp., one of the largest nursing-home operators in the U.S. To gain leverage, CEO Joel Gemunder snapped up dozens of small pharmacy-benefit managers in the 1990s. Today Omnicare distributes medications to more than a million residents in 47 states.

KNOCKOFF PILL PUSHERS Fast, cheap, and in control.

We've been hearing for some time about how generic-drug makers are poised to cash in because some $35 billion in branded drugs are going off patent in the next few years. But what you may not know is how much they'll reap because of the new Medicare law, the initial stages of which go into effect next month, when beneficiaries start using the new drug-discount cards. The new law, which gives them a federally sponsored drug benefit and takes effect fully in 2006, not only gives them better access to meds but also will get them cheaper generics more quickly by limiting Big Pharma's ability to keep generics off the market. Among the key changes, the law limits brand firms to a single 30-month stay when they sue a generic firm for patent infringment; previous law allowed brand firms to issue multiple stays by asserting more than one patent. Alan Sager, a health economist at Boston University School of Public Health, has calculated that generic-drug companies stand to rake in at least $14 billion in increased profits over the next eight years.

Investors need to tread carefully, however. Competition is vicious in this market. The first company to get its filing for a generic version of a drug accepted by the FDA receives 180 days of marketing exclusivity. But when that runs out, competitors usually jump in, and margins plummet.

The best way to invest in the generic-drug sector is to pick the dominant companies or find ones with unique niches, where pricing isn't so cutthroat. Mylan Laboratories (MYL, $23) qualifies as both. The company sells more than 125 generics used for hypertension, depression, and other conditions. These aren't your garden-variety copycats, however.

What really sets the company apart in this brutal, commoditized business is that Mylan focuses on products that are hard to make and require special manufacturing capabilities, such as extended-release oral tablets and skin patches. This limits competition and keeps gross margins at about 50%, compared with the industry average of 40%. More than half of Mylan's products rank first in market share in their categories. Over 70% rank first or second.

Mylan's approach is largely a reflection of the against-the-grain style of Chairman Milan Puskar, who co-founded the company in 1961. In the mid-1980s, Puskar helped uncover corruption at the FDA's generic division in which federal officials were accepting bribes to approve products. Following a federal investigation, several officials went to jail.

Puskar and CEO Robert Coury are now making a big push into branded drugs. They plan to leverage the company's current relationships with doctors to move new medicines launched by their Bertek Pharmaceuticals unit. Branded drugs currently account for 20% of Mylan's revenues. They have said that they intend to increase that to 50%.

If Mylan is a major player in the generic-drug world, the knockoff king is Teva Pharmaceuticals (TEVA, $64). You may never have heard of the Israeli company. But you could very well be taking one of its drugs. One in every 15 prescriptions in the U.S. is a Teva product, making the company this country's largest drug supplier. With $3.3 billion in revenues, it sells more than 450 drugs in North America, Europe, and Israel--everything from antibiotics to heart medicines. "They have by far the richest generic portfolio in the industry," says Standard & Poor's analyst Phillip Seligman.

Teva started out in 1901 as a mere drug distributor. A turning point for the company came in the 1930s, when many Jewish scientists, fleeing from Nazi Germany, joined Teva's operations in Jerusalem. The drugmaker went public in 1951.

These days Teva is making its own big push into branded drugs. Its first was Copaxone, a multiple sclerosis drug introduced in 1996. Today it's Teva's biggest seller, generating more than 20% of sales. Last year Teva filed an application for its second proprietary drug, Parkinson's disease remedy Rasagiline, which could generate hundreds of millions in yearly sales. The company hopes to receive FDA approval for the medication this year.

Chief executive Israel Makov doesn't have any illusions about turning Teva into a brand-name producer, however. His goal is to double sales every four years by remaining largely a maker of me-too medications. That seems achievable, given Teva's well-stocked portfolio. As of February, the company had 112 generic drugs awaiting final Food and Drug Administration approval, representing $68 billion in branded sales.

THE IMAGE MAKERS Harnessing the power of vanity

Narcissism is as old as, well, Narcissus. But you don't need a history degree to see that we've become more obsessed with our looks over the years. Thanks partly to the ever-increasing skill of plastic surgeons, the number of people who had cosmetic surgery nearly quadrupled between 1992 and 2002, to just over two million. And now the popularity of hit TV shows like Extreme Makeover is making surgical self-improvement more and more socially acceptable.

We're not sure if that's a trend that's going to (or, frankly, ought to) last. But we do have a hunch that people will always want to avoid acne, psoriasis, and other nasty skin conditions. And it turns out that the dermatology market is a great place to be if you sell medicine or anti-aging products. (Those baby-boomers are increasingly concerned about the age spots they're starting to notice in the bathroom mirror.) In contrast to many internal medicines, skin products are easy to produce and have strong patent positions.

Jonah Shacknai, a lawyer who advised giant drug companies such as Pfizer, realized all this back in 1988 when he started Medicis Pharmaceutical (MRX, $44). First, he contracted out manufacturing and much of the lab work, which freed up capital. Then Shacknai built his product line with a combination of acquisitions, licensing, and internal research. Soon Medicis was selling a number of national over-the-counter and prescription brands, including acne antibiotic Dynacin.

Shacknai had a lofty goal--$100 million in sales by 2000--which he achieved somewhat easily. Medicis sales last year were $248 million; profits, $64 million. Yet he still has plenty of room to grow in the $5 billion dermatology market.

His plan is to roll out at least one new product every year, and he has $500 million in cash to make sure he meets that goal. Thanks to the company's stellar sales force, which is amply rewarded with uncapped commissions and paid above industry standards, new offerings get a big push. "Their sales force is one of their best assets," says Kent Gasaway, manager of the top-performing Buffalo Small-Cap fund and a Medicis shareholder. And dermatology is one subspecialty in which a relative handful of sales reps--Medicis employs about 100 to market its skin medicines--can cover the nation's 14,000 doctors practicing in the field.

Medicis also offers something for those investors looking to capitalize on one of the more frivolous offshoots of the makeover craze. In December the FDA approved the company's wrinkle eraser Restylane to compete with Botox. Unlike Botox, which freezes the muscles underneath the wrinkles, Restylane, a synthetic gel made from a hyaluronic acid, is used to fill in creases. The product is manufactured by Sweden's Q-Med, which has been selling it in Europe since 1996, giving it a lengthy safety record. Medicis paid $160 million to be the sole American distributor, and analysts on Wall Street believe it could eventually become a $100-million-a-year seller. Overall, they expect Medicis to boost annual profits by more than 20% for years.

One look that isn't in danger of going out of style is a pretty smile. And as the success of products like Crest Whitestrips (with $300 million in annual sales) makes clear, there's a big market for cosmetic dental products. That's why we like Patterson Dental (PDCO, $78). Name a dental device and Patterson moves it--from picks to needles to drills. The Minneapolis company is the nation's largest distributor of dental supplies, with $1.9 billion in sales. The beauty, if you will, is that Patterson is smack in the middle of three powerful trends: increased per-person dental spending as boomers age; growing popularity of new cosmetic dental work; and increased insurance coverage for dental services. Together, they have helped Patterson lift per-share earnings better than 20% a year over the past decade.

Another plus is that the $4.8 billion dental-supply industry remains enormously fragmented, which means takeover targets abound. CEO Peter Frechette has made a number of acquisitions over the past 15 years, including the December 2001 purchase of Modern Practice Technologies, a maker of computer-networking equipment for the front office. He's made most of those acquisitions with cash on hand and company stock, so debt isn't a problem.

Indeed, the Jensen fund's Bob Millen, who recently purchased shares, points out that Frechette has been a particularly effective steward of investors' money. Patterson's return on equity (net income divided by shareholders' equity) has averaged close to 20% over the past ten years, significantly better than the 14% average for companies in the S&P 500.

Now Frechette is looking to digital X-ray machines, which produce images faster than current machines and sometimes lead to higher insurance reimbursements. Fewer than a quarter of the nation's 150,000 dentists now own these systems, which cost upwards of $60,000. He has nearly 1,000 tech reps trained and ready to install them on-site and network entire offices. All told, Frechette thinks Patterson's sales growth will outpace the estimated 7% to 9% annual growth of the market.

And with Patterson's stock selling at a 34% discount to our estimate of the company's fair value, we think that's something to smile about.

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