Why Health Reforms Won't Kill Health Stocks

Fidelity manager: Undervalued healthcare sector could hold bargains, and still has potential for growth.

Male nurse smiling holding clipboard with medical team discussing in the background
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Investors have been wary of health-related stocks since Congress passed the health reform bill in 2010 that pushes providers to deliver more service for the money they are paid. But Eddie Yoon, who manages the Fidelity Select Health Care Fund, says the undervalued sector could hold bargains, and still has potential to grow faster than the overall economy.

"Relative to its history, healthcare stocks are undervalued on an absolute and relative basis," Yoon says. "Given the long-term track record of the sector exceeding market returns at lower relative risk, this should be an excellent time for healthcare equities. "

After a slack period during which investors assessed the healthcare bill, the sector has been rising sharply as fears begin to recede. Yoon's fund has managed a solid gain of more than 20 percent over the past year, and started strong with a 6.5 percent gain in January.

To be sure, there will be tough medicine for some companies to swallow as more of the provisions in the health bill take effect, particularly insurers facing new coverage mandates and increased competition from low-priced government-sponsored insurance plans.

"There is uncertainty surrounding the policy for insurers, and I don't like to invest in uncertainty," says Yoon. "So I am underweight insurers. But they are a relatively small part of the overall investment picture in healthcare."

Reforms will also hit hospitals, nursing homes, and other providers of services who have operating costs that will rise faster than healthcare payouts, he adds, though many are owned privately or have a nonprofit status.

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The provisions cover 1,900 pages of requirements for companies and healthcare providers that will largely take effect this year and next. Broadly speaking, it will expand insurance coverage to 30 million more people and push healthcare providers to become more cost-effective in the services and products they provide.

"The market impact from healthcare reform should be fairly limited given how much time the market has had to digest the news," says Yoon. He expects growth in the sector to be "incremental positive" in the year ahead.

What's next for healthcare stocks. More important for investors is the long-term impact of cost-cutting that new reforms will impose, and which companies emerge as winners and losers in that new environment.

"It will put increasing pressure on companies to innovate in ways that address the upward pressure on growth and cost," says Yoon. "This should put a premium valuation on companies that are truly driving deflationary forces into the market. "

Already, companies that provide cost-cutting solutions are among the hottest stocks in the market. These include simple mail-order houses that provide cheaper prescriptions and large-scale enterprise computer systems to help hospitals and corporations manage costs. Yoon's fund was an early buyer of one of the fastest-growing pharmacy benefit management companies, Catamaran, which has grown fivefold in value since 2009. Other stocks in this sector include Express Scripts, which recently acquired Medco, and HMS Holdings. (Fidelity fund managers do not comment on individual stock holdings.) The PBMs, as they are known, are part of a growing number of cost-containment companies aimed at reducing costs for healthcare consumers large and small.

"Hospitals often don't even know what they are paying for," says Yoon. "There is a huge amount of work to be done on IT systems creating more transparency for them."

Healthcare growing with aging boomers, emerging markets. Investors can still make money by focusing on growth dynamics in the health sector that remain favorable despite healthcare "headwinds" holding growth in check, Yoon says. Aging baby boomers are pushing up healthcare demand and the industry is expanding globally on new spending from a fast-growing, health-conscious middle class in emerging economies.

[Read: Emerging Markets to Consider in 2013.]