Health care mutual funds could help cure what ails you

You've got the shivers and the shakes. Your ears are ringing, your head aches, and your left leg thumps when you rub your belly.

Hey, the stock market is making everyone sick these days, and Wall Street doesn't seem to have a cure. But a dose of health care stocks might help ease your pains.

The Standard & Poor's 500-stock index has fallen 13% this year and 23% since its Oct. 9 peak. S&P's health care index suffered right along with the S&P 500 until the end of June. "In March, health care stocks were neck-and-neck with financial stocks for worst performance," says Paul Davis, manager of Schwab Health Care fund swhfx.

Since June 30, though, the health care index has recovered nicely, gaining 7.6%, vs. virtually no change in the S&P 500.

Why the rally in health care? As a starting point, health care stocks are a traditional defensive play: No matter how sick the economy is, people still need lumbago treatments. Furthermore, many big pharmaceutical companies pay decent dividends, which have a palliative effect on stock-price pains. Merck, for example, has a 4.35% dividend yield; Pfizer pays 6.64%.

But drug companies had also been so beaten up on Wall Street that they started to look too cheap to pass up, "Investors just couldn't ignore them," says Samuel Isaly, manager of Eaton Vance Worldwide Health Sciences. For example, analysts expect Pfizer to earn $2.51 a share in 2009. At Thursday's closing price of $19.37 per share, Pfizer's price-to-future-earnings ratio is a bit under 8.

(The P-E ratio — a stock's price divided by its earnings per share — is a measure of how cheap or expensive a stock is, relative to its earnings. Lower is better: The S&P 500's P-E, based on 2009 operating earnings, is about 12.)

Investors weren't the only ones snapping up health care stocks. Health care companies were, too. In July, Roche offered $44 billion for Genentech, a giant biotechnology company. And Bristol-Myers Squibb offered $4.5 billion for ImClone, another big biotech firm, last month.

Big biotechs have one thing that big pharmaceutical companies want: new drugs. Many of the biggest pharmaceutical companies are also facing patent expirations on their biggest sellers. Proprietary blockbuster drugs often have 95% gross profit margins, says Derek Taner, portfolio manager of AIM Global Healthcare fund. The total sales of Lipitor, Pfizer's cholesterol-fighting drug, are roughly equal to the revenue from Starbucks, Taner says.

Furthermore, the supply of new drugs at the big pharmaceutical companies is dwindling. "The pipelines don't look good," says Davis.

Because the big drug companies may not have replacements for their big blockbuster drugs, they are shopping for companies that might — hence the bidding for Genentech and ImClone.

Thanks to the credit crunch, relatively few new biotech companies have appeared recently. "It's hard to get financing," says Eaton Vance's Isaly. So the sweet spot in the health care industry is the larger biotech firms with decent new products in the pipeline.

Unless you have a fairly good understanding of the testing process for new drugs — as well as for the market for those drugs — you're probably better off investing in health and biotechnology through a mutual fund. The five health care funds with the best five-year records are in the chart.

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