How to profit from US healthcare reform
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Associate Editor
David Stevenson Mar 26, 2010
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While we've been putting up with one of the most boring Budgets ever, real history has just been made over in the States.
The Patient Protection and Affordable Care Act has been signed into law by President Obama. This is the biggest reform of US health policy in four decades. It will widen healthcare coverage to more than 30m Americans who so far haven't been able to get it. We cover the implications here: Healthcare: Obama's big reform goes through.
But what does it mean for investors? Well, there's one group of healthcare-related shares that's long been shunned by fearful investors. Yet the new deal could be the turning point that sends these neglected stocks soaring...
Buy big pharma
Since well before reaching the Oval office, President Obama has been talking US healthcare reform. And that has kept investors away from one particular group of healthcare shares – big pharmaceutical firms.
Indeed, the shares of major drug makers round the world have been in the doldrums for years as analysts have fretted about their prospects.
But here's the irony. US healthcare reform is actually likely to prove very good news for the country's drug companies.
Indeed there are now three major reasons why these 'big pharma' shares are set to return to fashion. And why they look ripe to buy.
First, 'off-patent' worries are overdone. To fill you in, when the patents on 'blockbuster' drugs expire, these high-margin products can then be cloned by other manufacturers and sold much more cheaply. At that point, sales collapse, meaning the drug maker has to find a new golden goose.
Big pharma is facing a 'patent cliff' over the next three years. Clearly, that's not great news. But it's hardly new news either. The world and his dog have been talking about it for ages.
And investors have long been factoring any potential damage into the sector's share prices. The S&P Pharma index is actually 10% lower than it was 12 years ago. So we can fairly assume the risks are now more than fully 'priced in'.
US drug stocks are cheap
That leads onto the second reason. US drug stocks are now very cheap. Look at the chart below.
Source: Bloomberg
We'll go through it line by line. The blue line is the stock market valuation of the US pharma sector. As you can see from the left-hand scale, the p/e has dropped from over 40 in 1999 to around 11.5 today.
That's some de-rating! Investors have gone from expecting great things from the pharma sector to expecting nothing but boredom, punctuated with disappointment. This is the sort of thing you'd normally only expect to see if a sector's profits have collapsed.
So has this happened with drug stocks? Nope. Just take a look at the red line. That shows the earnings per share generated by the S&P Pharma index over the past 12 years (rebased to 100). As you can see, the sector's net profits have gone up by some 175% over this time.
Even better, it's a nice straight line, too. That means returns have grown consistently year-on year.
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Compare this to the light green line. This is the earnings of the overall S&P 500 index. It's much more variable, and the end result is just a 60% profit increase over the period. Yet the S&P 500 index itself is up by almost 10% over this time.
What's more, the 'normalised' p/e on the S&P index – which measures the average of ten years' earnings – is now 21.3. That compares with the long-term average of 16.4.
To sum up, investors are pricing the wider market much higher than average, and vastly higher than the pharma sector. In fact, big pharma is nearly 50% cheaper than the S&P 500 at its current level. That's despite the fact that the wider market has delivered far weaker growth, and far more volatility than pharma stocks.
That's about as raw a deal as you can get. We've been of the view for six months that the stock market was taking far too dim a view about healthcare stocks (Snap up drug stocks while they're still cheap).
The US healthcare reform should see pharma stocks re-rated
And now that looks set to change. The third reason to buy big pharma now is because America's healthcare reform looks likely to prove the catalyst for a major re-rating of big pharma stocks.
Any fears that a US NHS was imminent have gone. The legislation allows the drug industry to "avoid any of the issues that were particularly of concern - price control or more regulation by the federal government," says Barbara Ryan at Deutsche Bank.
"The big winners are some of the branded pharmaceutical companies", says Federal Trade Commission chairman Jon Leibowitz. "The big loser is the American consumer, who is going to have to pay an extra $3.5bn a year in much-needed drugs".
This big US blue chip could double
So what are the stocks to buy? We like several, and we'll be covering them in MoneyWeek magazine in the coming weeks (if you're not already a subscriber, you can claim your first three issues free here). But one we've mentioned before – and the largest of the US drug makers in terms of market cap – is Pfizer (NYSE: PFE). At $17.54 a share, it's on a 2010 p/e of 8, and has a prospective dividend yield of 4%. That yield is pretty juicy when you consider that the S&P 500 average is closer to 2%.
So how much money could you make? Of course, there's a currency risk in buying non-UK shares – you lose out if the pound climbs. But as a very rough-and-ready guide, take a look at Pfizer's p/e of 8. If that were to rise only as high as the wider market's long-run valuation level of 16 – which is hardly an unreasonable ask – even on unchanged earnings you could be looking at potential dollar profits of near enough 100%.
Our recommended article for today
'Recovery' stocks are companies that have fought back from financial disaster to deliver healthy returns for investors. Tom Bulford explains how to spot them, and picks four companies for adventurous investors.
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