Morningstar Advisor - October/November 2012 - (Page 32)

Sector Rap Morozov: I think it is the biggest question right now surrounding health care. Is this the new normal? Will people be more conservative with their health-care spending? What we saw in this past cycle was that people pulled back in their use of health care, and not just for elective procedures, but procedures that we didn’t think patients would delay or defer. Employers are raising premiums for insurance plans and making deductibles higher. Higher deductibles mean higher out-of-pocket costs. Patients will have to ask the question, do I really need to go to a doctor now, or can I just postpone it again? If this is the new norm, then the growth of health-care expenditures will probably get closer to the GDP growth. Health-care-cost inflation has been a couple percentage points ahead of real GDP, which has caused health care to grow to 18% of the total GDP. That cost curve could change. Guziec: We’ve mentioned a few stocks, but what else do we like? Morozov: Express Scripts ESRX is clearly one of membership. As a result, it has great scale. Scale is going to be the name of the game going forward, since managed-care companies’ ability to underwrite is going to be very limited in Obamacare. Scale allows companies to spread administrative costs over a large membership base, and WellPoint has the second-largest membership base. WellPoint is trading at somewhere around seven times forward earnings, which is a 15% to 20% discount to most of its peers. It’s trading at about a 35% discount to our fair value estimate. We also like the medical-technology sector. A company I mentioned earlier, Covidien, is our top pick in the med-tech space. This is a company that emerged from underneath the Tyco roof a few years ago. Since then, management has done a stellar job of shedding some noncore businesses that the company carried when it was part of Tyco. This reversed a trend that many firms back in the day took of bringing non-related products under one roof and turning into huge conglomerates. Covidien went the other way and focused on the device area and invested a lot of research and development into its device space. Its R and D went from around 1% to 1.5% of total sales to 4.5% percent of sales, in a short four years—which has yielded a great number of new products. The company is going to be more or less a pure play device firm, once it completes a spinoff of its pharma unit, which is scheduled for early 2013. It’s trading at about 30% discount to our fair value estimate, and the market clearly underappreciates the earnings growth there. Guziec: What about some pharma names? Conover: In pharma, one industry that we As pharmaceutical firms lose patent protection on high-margin products, they need to cut costs. One way that they’re doing that is outsourcing their research and development. Contract research organizations do this much more cheaply than the pharmaceutical firms, so they’re getting a tremendous amount of business. We think Icon’s one of the better positioned CRO firms out there. Roche is a biotech name that we like. The firm has a high exposure to biologic products that have long duration of patents. These are the products that are not facing pricing pressure as much as other products in the pharmaceutical and biotechnology landscapes. It’s a wellpositioned firm that the market is undervaluing. Pfizer PFE is a firm that we think is underappreciated for its ability to cut costs. Not only is it outsourcing some of its research and development projects to CROs, but it’s also cutting its sales force and streamlining manufacturing and adapting to its patent cliff, well ahead of what we think investors are anticipating. On top of that, Pfizer has one of the best positioned pipelines that it’s had in the past five years. Guziec: There are some attractive yields in big pharma, especially in a low-rate environment. Conover: That’s a really good point. In a current environment where yields are very difficult to find, the average yield of big pharmaceutical firms is close to 4%. And those are very stable dividends. It’s very unlikely that you’ll see a dividend cut from the big pharmaceutical firms. The payout ratio for the industry is approximately 40%; it’ll probably maintain that 40% payout ratio, while earnings will probably grow close to 2% to 3% over the next five years on a compound annual growth rate. You’re not going to see increases to the dividend that robustly but, nevertheless, there is very secure cash-flow generation. K Philip Guziec, CFA, is a derivatives strategist with Morningstar. the strongest companies right now in the health-care space. After its merger with Medco, it is the largest pharmacy benefit manager in the United States. The PBM space is very consolidated. There are only two major players now left, with CVS Caremark CVS being the other one. Because of its size, Express Scripts has very strong bargaining power, both over big pharma and other customers. So it’s one of our top picks in the space, trading at a fairly attractive price, about 20% to our fair value estimate. WellPoint WLP is a 5-star stock in the managed-care space. This is a value story, as execution has been subpar for the company. It underperformed the entire managed-care space primarily because of the mishaps with execution. That said, WellPoint is one of two managed-care companies that has an economic moat, which stems from its massive haven’t talked about is contract research organizations, or CROs. One name we like in the space is Icon ICLR. This is an industry that’s benefiting from big pharmaceuticals’ patent cliff, which has caused firms to cut costs. Finding secondary ways to play major themes in health care is a great way to position investments. This is one of those types of plays. 32 Morningstar Advisor October/November 2012

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Contents
Contributors
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012

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