The healthcare sector is made up of many different industries – from pharmaceuticals and devices to health insurers and hospitals – and each has different dynamics. Investments in this sector are affected by many variables, including positive trends related to demographics and negative trends related to reimbursement.

Healthcare investing requires a multifaceted approach to understand the underlying drivers. Investors can profit from investments in both the overall sector and/or its industries. This article will detail the differences among the various healthcare industries and which metrics investors should follow before making an investment.

Trends in the Healthcare Sector
When deciding on a healthcare company in which to invest, keep the following prevalent trends in mind. Changes to or continuations of these trends can have implications for a variety of areas within the healthcare sector.

Positive trends include:

  • the aging population and the baby boomers
  • people living longer with chronic disease
  • obesity and diabetes epidemics
  • technological advances
  • the global reach of disease
  • personalized medicine

Negative trends include:

  • a single-payer system (Medicare/U.S. government)
  • expenditure as an increasing share of gross domestic product (GDP)
  • the uninsured
  • cost controls
  • consumerism

Take One Pill and ...
Pharmaceutical and biotech companies both manufacture "drugs", but differ in how those drugs are created. Pharmaceuticals are generally considered small chemical compounds that easily pass through barriers or membranes in the body, while biotechs are considered large protein compounds that have trouble passing through membranes. (To learn more, read Using DCF In Biotech Valuation, Chasing Down Biotech Zombie Stocks and Measuring The Medicine Makers.)

These companies often spend a significant percentage of revenue on research and development (R&D) to discover new compounds. The "hit ratio" is very low as discovery of new compounds is very difficult and tedious. When investing in the drug companies, there are several things to keep in mind. You need to have some understanding of:

  • the underlying disease or condition that a specific drug treats
  • the number of people affected
  • the number of compounds currently available
  • the process of discovery and coming to market, specifically the rigorous clinical trials required by the Food and Drug Administration (FDA)
  • the availability of substitutes, including generic versions of drugs
  • patents
  • the overall marketing framework, which may include revenue or profit-sharing agreements with other companies

This is an industry that is greatly affected by clinical-trial data, and surprises about the outcomes of the data can affect the stock price tremendously. Positive surprises - better-than-expected clinical data, faster time to market, etc. - can cause stocks to appreciate significantly in a short time period, while negative surprises can have the opposite effect. In addition, aftermarket data, such as the number of prescriptions written, market share, FDA warnings or the loss of a patent will affect investments. This is an industry that requires active monitoring on the part of the investor. (For more on the risks and rewards of investing in pharmaceuticals and biotechnology, read The Ups And Downs Of Biotechnology.)

Who Pays the Bills?
Health insurers are the companies that pay the bills - sort of. Companies purchase health insurance in one of two general ways:

  1. The purchasing company assumes the risk of paying all the bills.
  2. The health insurer assumes the risk.

A company's choice can affect its risk and profitability.

Underwriting skills drive health insurers' profitability. The better the underwriting, the lower the medical costs relative to the premium (or payment) received from the purchasing company. The key ratio that health insurers report is the medical cost ratio. This ratio is akin to the operating-profit ratio and should be looked at as a trend analysis. The medical loss ratio is also an important ratio and is similar to the gross margin, only in reverse (lower ratios are better). In addition, you want to invest in a company that has a conservative, trustworthy management because there are often timing mismatches between when medical services are consumed and when the bills are paid. (To learn more about the role of insurance underwriters, see Is Insurance Underwriting Right For You?)

Proper liability reserves is also an important measure to review. These stocks are generally more stable and less susceptible to surprises as compared to drug stocks. However, following government regulation, particularly bills related to Medicare and Medicaid funding, is important as the U.S. government is the single largest purchaser of healthcare services. The

House Ways

and Means Committee is the part of the government that affects Medicare legislation. In addition, it is often perceived that the Democratic Party is less friendly to healthcare companies than the Republican Party, and stocks in the industry will often react to changes in party control of the government. (To read more about how the party in power affects the stock market, read For Higher Stock Returns, Vote Republican Or Democrat?)

The providers of medical services - the hospitals and clinics - are the cornerstone of healthcare in the U.S.U.S. laws mandate that all facilities with an emergency room treat anyone that walks through the doors, regardless of whether that person has health insurance or money to pay for the services. This legislation has created strong competition to hospitals in the form of free-standing clinics and specialty hospitals, which do not have emergency rooms and, as such, are not required to provide services to everyone. (Read What Does Medicare Cover? to find out more about government healthcare coverage.)

These clinics are able to pick and choose which patients to treat and benefit from higher payments from insurance companies. Meanwhile, hospitals are faced with bad debts impacting their profitability. The bad-debt ratio is an area of focus for investors. In addition, cost controls are key for hospitals' profitability. Many hospital systems have yet to make technological advances like electronic medical records, proper purchasing and operating systems a part of their standard operations, although this seems to be changing.

Controlling costs among numerous cost centers is very difficult for hospitals. The ones that do this well and incorporate computer systems tend to be considered the best managed. In addition, hospitals that are able to recruit specialist physicians, such as neonatologists, are able to increase EBITDA per bed as specialty medical practice generally garners higher payments for services. Other than bad-debt ratios, EBITDA per bed and overall utilization or capacity rates are other important metrics. (Read more about the uses and pitfalls of EBITDA in A Clear Look At EBITDA.)

Other Industries
Pharmacy benefit managers (PBMs) are companies that administer drug benefits on behalf of insurers. They work in tandem with the health insurer and can be considered an outsourced segment of health insurance. Generally, when you go to the pharmacy to have a prescription filled, the pharmacy will contact (via computer) your PBM to see if you are covered for the particular drug. Additionally, if you receive your drugs via mail, they usually come from the PBM's distribution center. (Read The Bottom Line On Margins for more insight into how a company makes money.)

PBMs tend to benefit from more email transactions and generic prescriptions filled because they generally receive a higher margin for that type of service. In addition, PBMs receive higher margins on specialty drugs, drugs that are injected (such as biotech drugs) or drugs that need to be refrigerated and are typically not sold at a local pharmacy (because these types of drugs require more attention). Therefore, PBMs that have a large specialty pharmacy component tend to have higher margins.

Distributors are intermediaries between the drug manufacturers and the pharmacies, and receive a service fee for controlling the logistics for the pharmaceutical companies. Many distributors also have other lines of business that improve margins, such as packaging some of the drugs, but the service-fee margin is the primary driver of profits.

Medical technology and device companies manufacture a host of medical products, from bandages all the way to artificial joints and heart stents. These companies, similar to the drug manufacturers, spend a large percentage of revenues on R&D, and some need to follow the same clinical-trial path. Investing in these companies requires knowledge and analysis of the new technology as well as the competitors and known substitutes. Adoption rates and gross margins are important indicators of a company's success, which is similar to other technology companies.

Investing in healthcare stocks can provide generous returns, but it is also tedious due to the many factors affecting stock prices. The healthcare sector is vast, and there are many large and small companies to choose from in various industries. To help ease the burden, there are investment vehicles like ETFs and healthcare mutual funds in which you can invest; they can reduce the volatility of investing in individual stocks by diversifying holdings. (Read more about diversification and investing in our Risk And Diversification tutorial.)

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