Strong Medicine: Best bets in Big Pharma

(Money Magazine) -- For a while, it seemed that 2006 would be the Year of the Health-Care Stock. After years of middling returns, the shares of drug companies, biotechs, medical equipment makers and managed-care firms had matched the gains of the S&P 500 through the fall, and many big drug stocks were outperforming the market.

But then came a virtual epidemic of bad news. There were options-backdating scandals involving several insurers, including industry leader United Health Group (Charts); concerns about the safety of drug-coated stents, which caused a pullback in the shares of several big medical equipment makers; and the November elections, which depressed Big Pharma and managed-care stocks.

Investors dumped the shares on fears that the new Democratic Congress would push for the government to negotiate lower drug prices for Medicare beneficiaries and seek cuts in the premiums paid to insurers that run managed-care programs for the elderly and disabled.

In December, Pfizer's (Charts) stock dropped 11 percent when it suspended trials on torcetrapib, the cholesterol drug that many expected to be the company's new blockbuster.

Other large drug stocks took a hit as well, as the news stoked long-time concerns about the inability of drugmakers to replace older drugs that are going off patent protection.

But look closer, and you'll find that most of the issues behind the recent pullback are short-term problems. Meanwhile, long-term health-care spending is going nowhere but up, up, up.

Here are the reasons some of the smartest investors today believe that the recent price dip in these stocks has created a long-term buying opportunity.

The Dems won't do that much damage Kris Jenner, manager of the T. Rowe Price Health Sciences fund, says that investors over-reacted to the changes in Washington. He expects the new Congress to create Capitol gridlock, not substantive changes to health-care policy.

Phil Dow, director of equity strategy with RBC Dain Rauscher, adds that even if there is reform, it might not have a drastic effect since the feds won't want to cripple drugmakers. "Democrats get cancer and diabetes too," he says.

Big Pharma isn't out of ideas True, Pfizer's torcetrapib woes highlighted the sector's biggest risk: a scarcity of new drugs to replace off-patent ones that face fierce competition from generic drugmakers. But "the big drug companies have the financial wherewithal to refill their pipelines," says Walter McCormick, a fund manager with Evergreen Investments.

Some firms are doing that by buying small biotech firms, which often trade at prices only slightly higher than the cash value of their assets. These biotechs aren't likely to create large-scale blockbusters, but they often specialize in medications for so-called orphan diseases, which affect small numbers of people. Making drugs for these illnesses can be lucrative, since governments typically offer tax credits and extra-long patent protections to companies that develop treatments for them.

Health Care is a safe haven in a slowing economy Many on Wall Street expect the economy to slow in 2007. And sectors like health care typically hold up well when times get tough because people still need to buy medication even when they're paring back on overall spending.

That's what happened during the 2000-2001 recession, when drug stocks outperformed the broader market by a wide margin. This year the S&P Healthcare index is expected to post an earnings increase of 11 percent, compared with 5 percent profit growth for the S&P 500.

Demand for health-care products is rising One thing is for sure: Baby boomers aren't getting any younger, and that bodes particularly well for pharmaceutical makers and biotechs.

According to research from T.Rowe Price, spending on drugs by people between the ages of 55 and 74 is expected to triple between 2005 and 2015. And people between the ages of 35 and 54 are expected to spend twice as much on medication over the next decade.

Moreover, political concerns and such short-term issues as options backdating are now fully priced into health-care stocks, says Legg Mason Value Trust manager Bill Miller. Insurers like Aetna and Health Net, both of which Miller owns, trade for about 13 times next year's estimated earnings, compared with 16 for the S&P 500.

Large, diversified healthcare companies like Johnson & Johnson (Charts), Abbott Laboratories (Charts) and Novartis (Charts) are priced well below their historical average yet are expected to report stronger profit growth than the broader market.

"I've never seen these stocks trade this cheap," says strategist Dow.

Despite all the promise, there's no doubt that health-care stocks carry risk. For most people, it's best to take a broad approach to the sector rather than place bets on any given stock.

The simplest way to go: an ETF like the Health Care Select SPDR (XLV (Charts), which mirrors the S&P Healthcare index, or Vanguard Health Care (VHT (Charts), which owns 278 health-care stocks.

The day Pfizer pulled the plug on torcetrapib, both ETFs fell less than 1 percent. If you prefer trying to outperform the index (at the risk of coming up short), consider the T. Rowe Price Health Sciences fund (PRHSX (Charts), which has a good history of finding biotech winners, according to Morningstar analyst Christopher Davis, and an expense ratio under 1 percent.

Finally, if you are willing to gamble on one or two stocks, Wyeth (Charts), which trades for just 15 times 2007 earnings estimates, may be the best bargain among large drug companies. Evergreen's McCormick likes the company because it has a diverse portfolio of best-selling drugs, most of which are not due to go off patent for many more years.

An even riskier but potentially more lucrative play is biotech Gilead Sciences (Charts), which holds patents for drugs that treat the hepatitis B virus and HIV. It's a top holding of Money 70 fund T. Rowe Price Blue Chip Growth (TRBCX (Charts). Earnings are expected to increase an average of 19% for the next few years.

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Best investments...Funds: Money 70 and Stocks: Sivy 70

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