Finding Alpha in the Healthcare Space

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I'm a big fan of healthcare stocks.  Everyone spends money on healthcare at some point in his or her life.  Sometimes circumstances are unfortunate, but there is good money to be made in the healthcare business.  This industry features healthcare insurers, drug manufacturers, retirement home operators, medical equipment manufacturers and more.  You can choose from low-beta insurers like UnitedHealth Group (NYSE: UNH), or you can get into some higher beta biotech stocks like Onyx Pharmaceuticals (NASDAQ: ONXX).  There's a stock in this industry that will satiate every investor’s risk appetite. 

In this article we're going to check out what hedge fund managers are doing with these stocks among others in the healthcare sector to help get an idea of how we might increase our chances to find alpha moving forward in 2013 (here’s another way to do so).

Let's start with UnitedHealth, my favorite health benefits provider.  I personally am a big fan of holding low-beta insurers like UnitedHealth in my long-term portfolio.  Revenue is up 8.6% in 2012, slightly above the 8% average revenue growth rate for the past five years.  Net income is up 7.6% in 2012 and has a 5-year average growth rate of 16.7%.  The company’s stock has a beta of .50, a 1.5% dividend yield, and generates an 18% return on equity (industry average is 16.3%).  Eagle Capital Management, managed by Boykin Curry, holds over 9 million shares of UnitedHealth in its 13F portfolio (check out the fund’s top stock picks). The fund has a track record of crushing the S&P and Russell 1000 returns in the long run by a significant margin.

WellPoint (NYSE: WLP), meanwhile, is another health benefits provider.  Revenue for WellPoint has remained pretty much flat since 2008, while net income has grown at a rate of about 1.6% per year.  The company’s stock price is down about 4% since the start of 2012, and has lost close to 25% since the start of 2008. WellPoint offers a 1.8% dividend yield, which is slightly above UnitedHealth's payout. 

William B. Gray's Orbis Investment holds the largest known quantity of WellPoint shares of the 400+ hedge funds we track (see the full list of hedgies invested in WLP), and the stock is the fund’s third largest holding. Jean-Marie Eveillard's 200-year old fund, First Eagle Investment Management, holds about $355 million worth of WellPoint in their $27 billion portfolio, making it their 28th largest holding.

Let's cover Onyx Pharmaceuticals, a biotech company, next.  Palo Alto Investors has a $1 billion portfolio, and Onyx is their number one holding, comprising 17% according to their most recent 13F filing.  Palo Alto's investment team consists of mostly experienced medical doctors who have transitioned into the investment field. This is a large bet from a highly specialized team, so we should definitely take a closer look at why this fund holds the conviction it does. 

Onyx’s stock is up about 80% since the beginning of 2012 and up over 120% since the beginning of 2008.  This biotech develops and markets Nexavar, an inhibitor of liver cancer and advanced kidney cancer.  They are also conducting clinical trials on a number of other drugs, most of which are used in the treatment of cancers and autoimmune disorders.  Biotech stocks are typically more volatile than other healthcare stocks because a lot of their revenue depends on drugs they invest in passing clinical trials so they can go to market.  Any threat to a biotech's main drug(s) can potentially eliminate their bottom line completely, so it’s crucial to perform due diligence before investing in this type of healthcare stock.

Pfizer (NYSE: PFE) is a company that must be in the discussion; some of Pfizer’s blockbuster drugs include Lipitor, Viagra, and Celebrex. Shares are currently priced 24% higher than the start of 2012, and are near their pre-recessionary trading range.  Revenue is down 13% from 2011-2012, and EBITDA shrank almost 16%, but both figures have still grown positively at a compounded rate of 5% and 2.7%, respectively. Like UnitedHealth, this is another investment with a low beta. 

Most importantly, Pfizer also offers a 3.5% dividend yield, well above both United Health and WellPoint.  This stock is the No. 1 holding in both the Kahn Brothers and Orbimed Advisors’ funds. Irving Kahn, who practices the same value-based approach as Benjamin Graham and Warren Buffett, manages Kahn Brothers. At a forward P/E below 12.0x and a discounted book valuation of about 16% to its industry’s average, it’s easy to see why Kahn is bullish.

Merck (NYSE: MRK) is yet another major drug manufacturer held by both Kahn and Orbimed.  The stock ranks third in Kahn's portfolio and second in Orbimed's.  With a beta of 0.35 and a dividend yield of 4.10%, this stock is a stable cash cow and would fit nicely in any portfolio.  Shares are only up 7.8% since the beginning of 2011, but if you bought the 2008 lows you would have made approximately 14% per year before any dividend payments. If you had bought the highs in 2008 you would be down about 32% right now, although after dividends you would only be down about 22%. 

No one can know for sure if any of these healthcare stocks will generate healthy returns for your portfolio, but they represent some of the best plays in this space at the moment. My personal favorites mentioned here include UnitedHealth, Pfizer, and Merck.  I'm a big fan of Benjamin Graham's approach to investing because it has worked considerably well for me, so noticing the two aforementioned stocks as top holdings in Kahn Brothers’ portfolio, I naturally want to follow suit. 


This article is written by Mark Jones and edited by Jake Mann. Insider Monkey's Editor-in-Chief is Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article.  The Motley Fool recommends UnitedHealth Group and WellPoint. The Motley Fool owns shares of WellPoint. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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