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Of Mutual Interest

Horizon brightens for health care funds

By Mark Jewell
Associated Press / March 28, 2010

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If your money is in a mutual fund that specializes in health care stocks, now might be a good time to congratulate yourself for sticking with it while others gave up.

The fog that’s kept these funds in the dumps has mostly lifted, and their managers see clear opportunities ahead.

As debate slogged on over President Obama’s overhaul, health sector funds posted a 41 percent average return over the past 12 months. As strong as that might seem, the sector trailed the pack in the bull market that started last March. Health funds rank next-to-last among 21 domestic fund categories, according to Morningstar.

Meanwhile, investors pulled $3.5 billion out of health funds, paring the category’s total assets to $38 billion.

Blame uncertainty, the mortal enemy of investors. The highly partisan back-and-forth over whether to pass a bill and what to include became a drag on health care stocks.

With the finishing touches in place, the key unanswered questions are how quickly the changes will affect corporate bottom lines, and which companies can best adapt to expanding regulatory reach.

“There’s going to be volatility along the way — without question,’’ says Rosanne Ott, comanager of the $291 million Alger Health Sciences Fund. “But I think you’re going to see more people want to come back and look at the fundamentals of these businesses.’’

But no one is saying gains will come easy for health care stocks and the funds that specialize in them. After the House passed the reform bill, four fund managers with health care expertise shared their thoughts about potential investment risks and opportunities:

■ Temper expectations: Until now, health care companies have been reluctant to adjust earnings expectations in response to the law. That will probably end as early as next month, when companies begin reporting first-quarter earnings. Investors will closely watch for any changes, and perhaps sell shares of companies that don’t appear to be forthcoming about the impacts on their bottom lines.

David Farhadi, comanager of Alger Health Sciences with Ott, says the initial earnings impact will be so negligible that few companies will adjust 2010 expectations. But that will change as more pieces of the law are phased in. He expects many companies will trim 2011 earnings expectations 2 to 3 percent overall. The big shift will come in 2014, when more states set up exchanges offering new low-cost coverage options for those without access to employer-based plans.

■ Keep optimism in check: Historically speaking, health care stocks are extremely cheap now, because of the overhang from the debate, says Eddie Yoon, manager of the $1.6 billion Fidelity Select Health Care Fund.

But he cautions investors to remember that the market’s expectations have already been priced in — stocks typically anticipate shifts in the economy and corporate profits six months in advance. And while there’s been no shortage of surprises in the legislative tussle, the key health care battles were resolved months ago.

“The market has had a lot of time to digest the information that’s been out there,’’ Yoon says.

For example, take the lackluster response of health care stocks since the legislation cleared the House on Sunday night.

Through the week’s first three trading days, health care stocks within the Russell 3000 index rose an average 0.31 percent, trailing the 0.83 percent gain for the index as a whole.

While the law’s passage removed any doubt that stricter regulation of the industry is coming, investors may also have been relieved to get certainty that some of the more sweeping proposals abandoned earlier won’t be revived.

■ Think cost controls: Some proposed government price controls on the drug industry were dropped from the final legislation, but the overhaul will still rein in costs. Expect rising sales of generic versions of pricier brand-name drugs, which are now seeing a surge in patent expirations.

That’s a key reason why Kelsey Chen, manager of the $1.3 billion Putnam Global Health Care Fund, counts Teva Pharmaceutical among her fund’s top 10 holdings. Israel-based Teva is the world’s biggest generic drug maker. Much of its business is overseas, including emerging markets where growth is expected to be faster than in the United States.

Chen says her current investing sweet spot is in companies like Teva that have good fundamental growth prospects, and also will benefit from the health care law.

■ Don’t rule out big pharma: While makers of brand name drugs will take a hit, the news isn’t all bad. Pharmaceutical companies will pay an estimated $90 billion in new taxes and fees. But they’ll also offset much of that by expanding their market. Some 32 million more Americans are expected to be covered under Obama’s plan, either through buying private policies or an expansion of Medicaid.

The law also will gradually close what’s known as the “doughnut hole’’ coverage gap in the Medicare drug benefit. The gap means many retirees have been reluctant to buy higher-priced prescription drugs because of their substantial out-of-pocket expenses.

The gap’s closure, to be phased in gradually and be completed in 2020, means some high-price drugs could get a sales boost, Farhadi says.

■ Remember bigger picture: With all the changes the law will bring, it’s easy to lose sight of other key forces affecting the industry. Any successful investing strategy, Fidelity’s Yoon says, must play off the aging of the US population and surging demand for health care in overseas markets.

“The world,’’ Yoon says, “is getting older and sicker. Those are the factors that will affect the sector for the long run.’’

Mark Jewell writes about personal finance for the Associated Press.