Field Guide to Health Care Stocks

By Daniel Price and Angela Topoian
Analysts, mPower

In This Story Aging Populations Spur Growth A Diverse Sector Pharmaceutical Firms Biotechnology Products, HMOs and Hospitals Health Stocks and Your Portfolio

Health stocks posted some of last year's most impressive returns in an otherwise poor climate for U.S. stock exchanges. How did they do it?

To a certain extent, they did it by dint of circumstance. Health care companies provide people with medical care, produce drugs to treat and cure ailments, and study the human genome in the hope of scientific breakthroughs. These areas flourished in 2000 independent of general market conditions.

minute: read this article at a glance.

Technical Terms Index Large-cap stock Sector Small-cap stock

Many mutual fund managers recently increased their health care stock holdings, as general market instability increased the sector's appeal. Several managers shifted money from technology stocks to health stocks toward the end of 2000 to decrease volatility in their portfolios. In interviews with mPower, some managers have said they have a positive short-term outlook for medical product and device stocks, and that over the long term, they are bullish on biotechnology stocks.

Changes in the market represent a boost in the industry's contribution to the total large- and small-cap stock markets as their weighting in major stock indexes increases steadily. For instance, over the past year, the weighting of health stocks in the S&P 500, the most common Index tracked by index funds, have grown 2.75 percent.

A broader snapshot of the markets shows the Russell 3000 Health Care Index gaining 34.4 percent in 2000, while the overall Russell 3000 Index lost 7.5 percent during the same period. As a result of health stocks' strong performance, the health component of the Russell 1000 and Russell 2000 Indexes also grew.

Source: Russell/Mellon Analytical Services. S&P 500 data from BARRA’s Web site.

Aging Populations Spur Growth

Stock analysts have long forecasted enormous growth for the health industry as advances in the study of genetics and related technologies promise a slew of new products for consumers and the population continues to age.

According to the Pharmaceutical Research and Manufacturers of America (PhRMA), people over 65 years old currently make up 12.5 percent of the U.S. population but account for 34 percent of the country's health care expenditures. PhRMA projects that more than 20 percent of the U.S. population will be older than 65 by 2010.

In addition to favorable population shifts, current economic forecasts for slowing growth and declining interest rates are advantageous for the health care industry in the short term. Past performance is no guarantee of future results, but history does suggest that health stocks perform relatively well during economic slowdowns. Their noncyclical behavior (an ability to buck the general declining trend of a slowdown) is characteristic of defensive stocks. When cash is tight, consumers may put off buying new cars and computers but they will, nevertheless, continue to pay for medicines and health services.

A Diverse Sector

The health care sector is quite diverse and includes pharmaceutical companies, biotechnology firms, HMOs, hospitals, and medical equipment manufacturers. Each of these subsectors is affected by different issues but all share a common goal — to profit while preserving or restoring the health of their clients. Understanding the issues affecting each sector can help investors better analyze their portfolios in an effort to minimize risk and increase long-term returns.

Pharmaceutical Firms

Pharmaceutical companies are among the largest and best-known firms operating within the health sector. They include giants like Eli Lilly, Pfizer and GlaxoSmithKline, which make drugs such as Prozac, Viagra, and Zantac. These companies generally work with chemical compounds to develop new drugs and diagnostics to aid the ill. However, many pharmaceutical companies are exploring new biotechnology arenas to expand their existing product lineup.

One of the major challenges facing pharmaceutical firms is increased competition from generic drug manufacturers. The Food and Drug Administration (FDA) has estimated that over the next five years, 858 drugs will lose patent protection, opening the doors to generic competition. Pharmaceutical companies' profits are highly dependent on exclusive rights to market the products of their costly research efforts. When patents that protect these rights expire, generic drug manufacturers erode pharmaceutical companies' profits by selling comparable drugs at discounts of 80 percent to 90 percent.

The Food and Drug Administration has estimated that over the next five years, 858 drugs will lose patent protection, opening the doors to generic competition.

So, why do most brand-name drugs cost more? Generic drug manufacturers don't have to invest massive capital for research and development (R&D) and advertising — a core expense for pharmaceutical companies. According to its annual report, Bristol-Myers Squibb spent 13 percent of its budget on R&D and a whopping 49 percent on the marketing and advertising of its drugs in 1999.

Bristol-Myers Squibb's top selling anti-anxiety medication, BuSpar, is one example of a drug that may face competition from generics this year. According to Bristol-Myers Squibb, in 2001, the company will lose an estimated $550 million of revenue to generic competitors if the firm's BuSpar patent expires. Bristol-Myers Squibb is currently working to develop a new BuSpar patent that will allow the company to hang on to its market share.

However, the FDA may impede pharmaceutical companies' profits by delaying or rejecting the approval of new drugs. Only 20 percent of drug compounds in the first phase of FDA testing will eventually make it to market, and FDA approval generally takes five to nine years.

Drug companies have been working with the FDA to shorten the drug approval process while still maintaining high safety standards. In 1992, Congress passed the Prescription Drug User Fee Act, a law designed to speed up the process, which made pharmaceutical companies pay the FDA $327 million to hire 600 more drug reviewers.

Biotechnology

The line between pharmaceutical companies and biotechnology firms has recently blurred after dozens of interindustry acquisitions and partnerships.

Biotechnology firms are typically younger than pharmaceutical companies and may have few or no products on the market. Uncertainty about biotechnology firms’ potential products and revenues tends to make their stocks volatile.

Biotech companies have historically distinguished themselves from pharmaceutical firms by working primarily with biological materials. They frequently specialize in using a specific biological material and attempt to develop that material into marketable products. For instance, "proteomic" companies work with proteins and "genomic" companies work with genes.

These companies also face many of the growth barriers that trouble pharmaceutical companies. They, too, are heavily regulated by the FDA and frequently bombarded by ethical questions. Cloning and genetic manipulation are two ethical issues that have sprung into the limelight in the past few years. Congress may draft legislation to ensure that these and other technological advances are used in a socially responsible way.

The line between pharmaceutical companies and biotechnology firms has recently blurred after dozens of interindustry acquisitions and partnerships.

Congressional moves on prescription drug legislation may further hamper biotech firms' success. A congressional price cap on prescription drugs would limit the revenue that a pharmaceutical company could earn from a single product, which might leave these companies with less cash to spend on R&D, joint ventures with biotech firms, and biotech company acquisitions. Price caps might also make it unprofitable for pharmaceutical companies to make products designed for small markets (e.g., rare illnesses).

Products, HMOs and Hospitals

Demand for medical products and devices is, in part, driven by the growth of pharmaceutical and biotechnology companies. These companies may need the latest in medical product technology in order to facilitate R&D.

Medical diagnostics is another area facing rapid change. Many firms are creating diagnostic tools that will bring tests out of the lab and into doctors' offices, which may provide patients with more timely results and better care.

HMOs and hospitals are fighting their own battles with Congress; Medicare reform and a Patient's Bill of Rights are current topics of debate. The Patient's Bill of Rights would be detrimental to HMOs because it could give consumers greater power to sue them.

Further, HMOs and hospitals are expected to face additional battles with cost-conscious employers; as medical costs continue to increase, those companies will look at cutting health benefits.

Health Stocks and Your Portfolio

Related Reading What's Going On with Tech Stocks? Will a Bush Victory Help the Health Care Sector? Who Let the Bears Out?

If you own mutual funds, health stocks are likely a part of your portfolio. As an investor, you might want to take a look at your mutual fund holdings to see exactly how many health stocks you own. It is also important to see whether these stocks are diversified among the different categories in the health care sector discussed above.

In general, holding too much of one type of stock can add to a portfolio’s volatility. How much volatility you can accept in your investments depends on your individual goals, situation and risk tolerance. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Field Guide to Health Care Stocks

By Daniel Price and Angela Topoian
Analysts, mPower

In This Story Aging Populations Spur Growth A Diverse Sector Pharmaceutical Firms Biotechnology Products, HMOs and Hospitals Health Stocks and Your Portfolio

Health stocks posted some of last year's most impressive returns in an otherwise poor climate for U.S. stock exchanges. How did they do it?

To a certain extent, they did it by dint of circumstance. Health care companies provide people with medical care, produce drugs to treat and cure ailments, and study the human genome in the hope of scientific breakthroughs. These areas flourished in 2000 independent of general market conditions.

minute: read this article at a glance.

Technical Terms Index Large-cap stock Sector Small-cap stock

Many mutual fund managers recently increased their health care stock holdings, as general market instability increased the sector's appeal. Several managers shifted money from technology stocks to health stocks toward the end of 2000 to decrease volatility in their portfolios. In interviews with mPower, some managers have said they have a positive short-term outlook for medical product and device stocks, and that over the long term, they are bullish on biotechnology stocks.

Changes in the market represent a boost in the industry's contribution to the total large- and small-cap stock markets as their weighting in major stock indexes increases steadily. For instance, over the past year, the weighting of health stocks in the S&P 500, the most common Index tracked by index funds, have grown 2.75 percent.

A broader snapshot of the markets shows the Russell 3000 Health Care Index gaining 34.4 percent in 2000, while the overall Russell 3000 Index lost 7.5 percent during the same period. As a result of health stocks' strong performance, the health component of the Russell 1000 and Russell 2000 Indexes also grew.

Source: Russell/Mellon Analytical Services. S&P 500 data from BARRA’s Web site.

Aging Populations Spur Growth

Stock analysts have long forecasted enormous growth for the health industry as advances in the study of genetics and related technologies promise a slew of new products for consumers and the population continues to age.

According to the Pharmaceutical Research and Manufacturers of America (PhRMA), people over 65 years old currently make up 12.5 percent of the U.S. population but account for 34 percent of the country's health care expenditures. PhRMA projects that more than 20 percent of the U.S. population will be older than 65 by 2010.

In addition to favorable population shifts, current economic forecasts for slowing growth and declining interest rates are advantageous for the health care industry in the short term. Past performance is no guarantee of future results, but history does suggest that health stocks perform relatively well during economic slowdowns. Their noncyclical behavior (an ability to buck the general declining trend of a slowdown) is characteristic of defensive stocks. When cash is tight, consumers may put off buying new cars and computers but they will, nevertheless, continue to pay for medicines and health services.

A Diverse Sector

The health care sector is quite diverse and includes pharmaceutical companies, biotechnology firms, HMOs, hospitals, and medical equipment manufacturers. Each of these subsectors is affected by different issues but all share a common goal — to profit while preserving or restoring the health of their clients. Understanding the issues affecting each sector can help investors better analyze their portfolios in an effort to minimize risk and increase long-term returns.

Pharmaceutical Firms

Pharmaceutical companies are among the largest and best-known firms operating within the health sector. They include giants like Eli Lilly, Pfizer and GlaxoSmithKline, which make drugs such as Prozac, Viagra, and Zantac. These companies generally work with chemical compounds to develop new drugs and diagnostics to aid the ill. However, many pharmaceutical companies are exploring new biotechnology arenas to expand their existing product lineup.

One of the major challenges facing pharmaceutical firms is increased competition from generic drug manufacturers. The Food and Drug Administration (FDA) has estimated that over the next five years, 858 drugs will lose patent protection, opening the doors to generic competition. Pharmaceutical companies' profits are highly dependent on exclusive rights to market the products of their costly research efforts. When patents that protect these rights expire, generic drug manufacturers erode pharmaceutical companies' profits by selling comparable drugs at discounts of 80 percent to 90 percent.

The Food and Drug Administration has estimated that over the next five years, 858 drugs will lose patent protection, opening the doors to generic competition.

So, why do most brand-name drugs cost more? Generic drug manufacturers don't have to invest massive capital for research and development (R&D) and advertising — a core expense for pharmaceutical companies. According to its annual report, Bristol-Myers Squibb spent 13 percent of its budget on R&D and a whopping 49 percent on the marketing and advertising of its drugs in 1999.

Bristol-Myers Squibb's top selling anti-anxiety medication, BuSpar, is one example of a drug that may face competition from generics this year. According to Bristol-Myers Squibb, in 2001, the company will lose an estimated $550 million of revenue to generic competitors if the firm's BuSpar patent expires. Bristol-Myers Squibb is currently working to develop a new BuSpar patent that will allow the company to hang on to its market share.

However, the FDA may impede pharmaceutical companies' profits by delaying or rejecting the approval of new drugs. Only 20 percent of drug compounds in the first phase of FDA testing will eventually make it to market, and FDA approval generally takes five to nine years.

Drug companies have been working with the FDA to shorten the drug approval process while still maintaining high safety standards. In 1992, Congress passed the Prescription Drug User Fee Act, a law designed to speed up the process, which made pharmaceutical companies pay the FDA $327 million to hire 600 more drug reviewers.

Biotechnology

The line between pharmaceutical companies and biotechnology firms has recently blurred after dozens of interindustry acquisitions and partnerships.

Biotechnology firms are typically younger than pharmaceutical companies and may have few or no products on the market. Uncertainty about biotechnology firms’ potential products and revenues tends to make their stocks volatile.

Biotech companies have historically distinguished themselves from pharmaceutical firms by working primarily with biological materials. They frequently specialize in using a specific biological material and attempt to develop that material into marketable products. For instance, "proteomic" companies work with proteins and "genomic" companies work with genes.

These companies also face many of the growth barriers that trouble pharmaceutical companies. They, too, are heavily regulated by the FDA and frequently bombarded by ethical questions. Cloning and genetic manipulation are two ethical issues that have sprung into the limelight in the past few years. Congress may draft legislation to ensure that these and other technological advances are used in a socially responsible way.

The line between pharmaceutical companies and biotechnology firms has recently blurred after dozens of interindustry acquisitions and partnerships.

Congressional moves on prescription drug legislation may further hamper biotech firms' success. A congressional price cap on prescription drugs would limit the revenue that a pharmaceutical company could earn from a single product, which might leave these companies with less cash to spend on R&D, joint ventures with biotech firms, and biotech company acquisitions. Price caps might also make it unprofitable for pharmaceutical companies to make products designed for small markets (e.g., rare illnesses).

Products, HMOs and Hospitals

Demand for medical products and devices is, in part, driven by the growth of pharmaceutical and biotechnology companies. These companies may need the latest in medical product technology in order to facilitate R&D.

Medical diagnostics is another area facing rapid change. Many firms are creating diagnostic tools that will bring tests out of the lab and into doctors' offices, which may provide patients with more timely results and better care.

HMOs and hospitals are fighting their own battles with Congress; Medicare reform and a Patient's Bill of Rights are current topics of debate. The Patient's Bill of Rights would be detrimental to HMOs because it could give consumers greater power to sue them.

Further, HMOs and hospitals are expected to face additional battles with cost-conscious employers; as medical costs continue to increase, those companies will look at cutting health benefits.

Health Stocks and Your Portfolio

Related Reading What's Going On with Tech Stocks? Will a Bush Victory Help the Health Care Sector? Who Let the Bears Out?

If you own mutual funds, health stocks are likely a part of your portfolio. As an investor, you might want to take a look at your mutual fund holdings to see exactly how many health stocks you own. It is also important to see whether these stocks are diversified among the different categories in the health care sector discussed above.

In general, holding too much of one type of stock can add to a portfolio’s volatility. How much volatility you can accept in your investments depends on your individual goals, situation and risk tolerance. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.