Health care stocks worth considering

You’ve got the shivers and the shakes. Your ears are ringing, your head aches, and your left leg thumps when you rub your belly.

Hey, the stock market is making everyone sick these days, and Wall Street doesn’t seem to have a cure. But a dose of health care stocks might help ease your pains.

The Standard & Poor’s 500-stock index has fallen 13 percent this year, and 23 percent since its Oct. 9 peak. S&P’s health care index suffered right along with the S&P 500 until the end of June.

“In March, health care stocks were neck-and-neck with financial stocks for worst performance,” says Paul Davis, manager of Schwab Health Care fund.

Since June 30, though, the health care index has recovered nicely, gaining 7.6 percent, versus virtually no change in the S&P 500.

Why the rally in health care? As a starting point, health care stocks are a traditional defensive play: No matter how sick the economy is, people still need lumbago treatments. Furthermore, many big pharmaceutical companies pay decent dividends, which have a palliative effect on stock-price pains. Merck, for example, has a 4.35 percent dividend yield; Pfizer pays 6.64 percent.

But drug companies had also been so beaten up on Wall Street that they started to look too cheap to pass up.

“Investors just couldn’t ignore them,” says Samuel Isaly, manager of Eaton Vance Worldwide Health Sciences. For example, analysts expect Pfizer to earn $2.51 a share in 2009. At Thursday’s closing price of $19.37 per share, Pfizer’s price to future earnings ratio is a bit under 8.

Investors weren’t the only ones snapping up health care stocks. Health care companies were, too. In July, Roche offered almost $44 billion for Genentech, a giant biotechnology company. And Bristol-Myers Squibb offered $4.5 billion for ImClone, another big biotech firm, last month.

Big biotechs have one thing that big pharmaceutical companies want: new drugs. Many of the biggest pharmaceutical companies are also facing patent expirations on their biggest sellers. Proprietary blockbuster drugs often have 95 percent gross profit margins, says Derek Taner, portfolio manager of AIM Global Healthcare Fund. The total sales of Lipitor, Pfizer’s cholesterol-fighting drug, are roughly equal to the revenue from Starbucks, Taner says.

Furthermore, the supply of new drugs at the big pharmaceutical companies is dwindling.

“The pipelines don’t look good,” says Paul Davis, portfolio manager at Schwab Health Care fund.

Because the big drug companies may not have replacements for their big blockbuster drugs, they are shopping for companies that might – hence the bidding for Genentech and ImClone.

Thanks to the credit crunch, relatively few new biotech companies have appeared recently.

“It’s hard to get financing,” says Eaton Vance’s Isaly.

So the sweet spot in the health care industry is the larger biotech firms with decent new products in the pipeline.

Unless you have a fairly good understanding of the testing process for new drugs – as well as for the market for those drugs – you’re probably better off investing in health and biotechnology through a mutual fund.

Be aware, however, that the fund industry has unleashed many new, highly specialized health care funds. Consider the HealthShares funds, which offer portfolios specializing in infectious diseases, eye problems and tummy troubles, too.

As a general rule, you should treat them with the same caution you’d treat a petri dish full of Ebola virus. After all, your average diversified health care fund is more volatile than the S&P 500. Your average biotechnology fund is more volatile than the average health care fund. Funds that specialize in various ailments are even more volatile still.

For example, the HealthShares Emerging Cancer fund gained 17 percent in July, but list 15.6 percent in June. That kind of volatility could make anyone sick. Stick with a broadly diversified health care fund and apply it to your portfolio with care. You’ll feel better in a few years.