Where to find healthy profits

published 26 April 2007

As the population ages and demands more treatments for its ailments, the healthcare sector will reap the benefits, says John Stepek. Here's how you can, too.

Two things in life are certain, so the saying goes: death and taxes. And in both cases, most of us would rather put off paying the bill for as long as possible. That's why investing in the health sector has always been viewed as a good long-term defensive bet. The logic is straightforward as people get older, they have more medical problems, so they need more drugs, operations and complicated procedures to keep them healthy. And the demographic make-up of the world is on the drug companies' side: according to a recent Euromonitor report on the sector, between 2000 and 2005 the percentage of the global population aged 65 or over rose from 7.1% to 7.5%, while the total number of people in this age group rose by 12%.

Another bonus for health companies is that despite the classic image of the frail pensioner in the council flat, the reality is that old people are getting wealthier. Certainly in the West, as more and more members of the baby-boomer' generation start to enter their 60s, the elderly once viewed as a frugal, thrifty bunch are being replaced by a new breed of "yuppy elderly", as Euromonitor puts it. These people have grown up pursuing the good things in life, feel comfortable with spending money, and have no intention of surrendering meekly to old age. They may need more healthcare, but they've also got the wherewithal and the desire to pay for better-quality, more-effective treatments. According to research from investment group T Rowe Price, says CNN Money, spending on drugs by people aged 55 to 74 should triple between 2005 and 2015.

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But it's not just about the grey pound. As with everything these days, another huge source of demand lies to the East. More and more Asians join the ranks of the middle classes every day and just like their peers in the West, they want a better, healthier standard of living. The other good reason to get into healthcare is that it is generally one of the better places to be in an economic downturn even if hard times arrive for the global economy, people still need to spend money on drugs. So the future looks rosy for healthcare demand. The question is, what are the best ways to take advantage?

The main firms that spring to mind when thinking about healthcare stocks are, of course, the big pharmaceutical firms. The likes of Pfizer and GlaxoSmithKline supply us with countless pills and potions, doing everything from keeping our cholesterol levels low to improving our love lives. Meanwhile, their research and development (R&D) departments are constantly working on new experimental treatments that every drug company hopes will be their next big blockbuster product.

The other big problem is with patents. Pharmaceutical companies only have exclusive rights to sell their drugs for a limited period of time hence the need to keep finding new ones. After a certain period, generic drug makers can release copycat versions of the pills, at much reduced prices. Goldman Sachs reckons big drug firms face what broker Charles Stanley describes as an "unprecedented" patent expiry in 2012 up to 17% of pan-EU, drug-sector revenues are at risk from generic competition that year, compared with $7bn to $12bn a year between 2007 and 2011.

This problem is being exacerbated by rapid growth in demand from emerging markets. According to Jim Jubak on MSNmoney.com, research group IMS Health reckons that emerging market countries will be behind 30% of the growth in drug sales this year, almost as much as the US (36%). This is helping the cheaper generics to steal more market share from patented drugs the generic market is expected to grow by 13-14% this year, and more drugs will lose their patents, with too few replacements in the pipeline.These issues are one reason why the leading treatment field to be involved in over recent years cholesterol treatments is giving way to a new market leader. According to IMS, the anti-cholesterol market will remain broadly static this year, with growth of just 1% or 2%. There is still plenty of demand for such drugs "the need for anti-cholesterol drugs goes up as your income goes up, and you adopt more and more elements of a US-style diet", points out Jubak, meaning that emerging-market patients are more than compensating for "massive penetration in developed markets".But the problem is that they are opting for cheaper generic versions as the more popular anti-cholesterols lose patent protection.

So what is replacing cholesterol as the target of choice? Well, as Dan Burrows says in SmartMoney, "sometimes the most tremendous industry fundamentals can be found in the most morbid of places" and they dont come much more morbid than cancer. One major side effect of people living longer and staying healthier is that it means more and more of us live long enough to die from diseases that are largely associated with old age.

In terms of big drug groups with exposure to cancer sales, says Jubak, Genentech (US:DNA) is well positioned. It has two established cancer drugs, Rituxan and Herceptin, bringing in more than $2.5bn a year, compared with 2006 total sales of $6.6bn. But reaction to its first-quarter results was lukewarm, with analysts concerned about slowing growth. A better bet might be Jubak's favourite stock in the sector, Novartis (US:NVS). The group has a solid portfolio of oncology drugs, few of its patents are close to expiry, and its generic drugs unit, Sandoz, is the biggest in the world, with total sales of $5bn. This means it is able to benefit from the patent-expiry problems that dog its rivals. Jubak has a December 2007 price target of $71 a share on the stock.

A purer play on the increase in cancer is Radiation Therapy Services (US: RTSX). The group is the largest listed independent provider of radiation therapy services. The group is snapping up smaller rivals in what is a very fragmented market and now has 77 treatment centres. Wall Street analysts reckon the shares should hit $38 in the next 12 months from less than $30 just now. SmartMoney magazine likes the stock the costs and new technologies involved "erect a significant barrier to entry for would-be competitors". It trades on a p/e of 23, with forecast earnings growth of nearly 20% a year.

In the UK, both AstraZeneca (AZN) and GlaxoSmithKline (GSK) look good value, trading on forward p/es of 14.6 and 13.5 respectively, compared with the FTSE 100 average of nearly 17. Our preference would be GlaxoSmithKline, which has two new potential blockbuster cancer treatments, Tykerb (for breast cancer) and Cervarix (for cervical cancer) progressing down the development pipeline. The stock also has a yield of just over 3%. Otherwise, the brave might look to the smaller drug developers looking for cures for nasty diseases the smaller the company,the riskier the stock, but we've had a look at what's on offer and how youcan cut the risks of investing see the box on page 24.

Another sector set to benefit from the rise in the numbers of older people is the medical devices sector. These supply us with things like hip replacements and artificial joints. The global market for orthopaedics was worth $29bn last year, which could grow to $36bn by next year, says Wachovia Capital Markets. As one fund manager tells MarketWatch.com, "a lot of baby-boomers are starting to reach the point where they need new knees".

Barron's reckons that the stocks best placed to benefit are the UK's Smith & Nephew (SN) and US group Wright International (WMGI). Smith & Nephew is now the world's fourth-largest hip and knee implant company, while Wright is a small player, but its profits are among the fastest-growing in the sector. Both look rather expensive on respective p/es of 24 and a whopping 61, so they may not necessarily be a good way in right now stocks to watch rather than to buy perhaps.

Investors who would rather get broader exposure to the sector not a bad idea given the aforementioned problems with news flow can invest in a number of exchange-traded funds (ETFs). CNN Money suggests the Health Care Select SPDR (US: XLV) this mirrors the S&P Healthcare Index, giving you exposure to US giants such as Johnson & Johnson and Abbot Labs. Or you could get worldwide exposure by going for iShares S&P Global Healthcare Sector Index Fund (US:IXJ), says SmartMoney.

But there's more to health care than disease. As Euromonitor points out, as people get older they become more "aware that to avoid illness they will need to look after their health". On the one hand, increased urbanisation has led to more sedentary lifestyles and increased consumption of unhealthy foods hence the much-reported obesity epidemic'. But at the same time, there's been a corresponding rise in interest in living more healthy lifestyles.

One of the most visible signs is the seemingly unstoppable growth in the organic food industry. Many players are too small to invest in directly but in the US, organic retailer Whole Foods Market (US: WFMI), which plans to open a massive store in London in June, has delivered extremely impressive returns over the past ten years. The trouble is that this sort of growth rapidly draws the attention of bigger competitors. In fact, Whole Foods recently merged with former rival Wild Oats Market, partly to offset rising competition from the likes of Wal-Mart. And in the retail business, when you're going head to head with the US equivalent of Tesco, it's a brave investor who'll bet on the small guy. So a better bet for investing in organic foods, says SmartMoney, would be the company that supplies both Whole Foods and Wal-Mart with produce United Natural Foods (US: UNFI). The group is the largest such distributor in the US and faces "no significant competition", which means it looks a decent bet, even on a p/e of 26.

Another trend is that as people have become wealthier, they are more willing to pay for treatments that would once have been regarded as cosmetic. Take dentistry, for example. In the US, the market for dental implants is growing at more than 10% a year and the market for cosmetic dentistry as a whole is growing at 13% annually. In this sector, SmartMoney likes the look of Sirona Dental Systems (SIRO). The group makes and designs chairs, dental equipment and lasers. Sales are growing at 25% to 30% a year, justifying the high p/e of 27.

As we've mentioned, one problem with living longer is that it leaves you exposed to all sorts of horrendous diseases. Many were very uncommon when most people were dying in what we would now see as middle age. The good news is that there's lots of exciting work being done by smaller drug-discovery firms to try to find cures for the most common killers, such as strokes, heart attacks and cancer. And it's among these smaller firms that some of the most lucrative investments can be found. For example, at the end of last month, Oxford BioMedica signed the biggest licensing deal ever for a UK biotech. Sanofi-Aventis agreed to pay up to £350m, plus royalties, for rights to its TroVax cancer drug, which could be used to treat kidney, lung and prostate cancer. The company's shares have nearly doubled in the past six months alone.

Another bullish factor for small drug-discovery firms is that big drug developers are very keen to replenish their ailing pipelines. AstraZeneca has acquired several companies in the past year, including Cambridge Antibody Technology (CAT), which was bought out for £13.20 a share last May, a 67% premium. Garry White of Outstanding Investments reckons there's much more to come "Pfizer alone looks set to spend about $17bn to fill its structural needs".

The trouble is that for every Oxford BioMedica there are plenty more firms that don't make it. It's no surprise drug development is a costly business. According to Investors Chronicle, "it takes up to $1.2bn to take a new drug from test tube to the market, and only one in ten products will be a success". So how can you maximise your chances of picking a multi-bagger, rather than winding up with a lemon?

The drugs pipeline is obviously important. The more a firm relies on the fortunes of a single drug, the bigger the risk. Ideally, some products should be in the later development stages Phase II or III trials. A drug in Phase III has a 50% to 70% chance of success, says Ed Bowsher on Motley Fool. Research costs a lot, so the cash burn' rate is also key (a good rule of thumb is for firms to have enough cash to last at least two years).

Management is widely seen as particularly important in this sector. Experience of guiding previous products through the development maze is a good sign, while "a good balance of commercial experience" and science knowledge helps, says Investors Chronicle. Among the more interesting stocks tipped by the magazine are SR Pharma (SPA), a gene therapy company working on products ranging from lung cancer treatments to age-related blindness, and Medical Marketing International (MMG), which is working on chemotherapy products based on precious metal ruthenium, which it believes are more effective than traditional platinum-based treatments. But even if a stock ticks all these boxes it can still come a cropper. And that's why the most important piece of advice is to buy enough stocks to make sure your occasional winners make up for the large numbers of losers. Unfortunately, for most investors, this is too time-consuming, not to mention costly. So those interested in the sector might be better to invest in a fund that can deliver diversity without the hassle of stock picking.

In the UK, a good bet is The International Biotechnology Trust (IBT), which has risen 17.2% over the past year and currently trades at a near-two percent discount. The trust also holds unlisted biotech companies, offering one of the only ways into these companies available to retail investors. Bowsher prefers it to the Finsbury Emerging Biotechnology Trust (FEB), which is 90% invested in the US and has fallen 9.4% over the past year. There are no UK exchange-traded funds (ETFs) covering the sector, but in the US, HealthShares has launched a range of ETFs investing in specific healthcare sectors, with names like HealthShares Emerging Cancer (US:HHJ) and HealthShares Cardiology (US:HRD). Meanwhile, James B Stewart of Smart Money suggests the iShares Nasdaq Biotechnology Index Fund (US: IBB).

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