When can investors expect health care stocks to recover?

You're driving along in your '89 Buick, and you hear a horrible rattling noise. Unfortunately, it's not your transmission: It's your abdomen. The doctors screen every inch of you, find nothing and bill you for $10,000. And you wonder: Is there any way I can make money off this?

Why, of course there is. Health care stocks are cheap and offer a long-term play on the increasingly aged Baby Boom. But, thanks to the uncertainty about U.S. health care policy, you have some time to ponder your moves before buying a health care fund.

The stock market hit bottom on March 9, when the Standard & Poor's 500-stock index swooned to 676.53. Since, it has rallied 34.5%, including dividends, putting it in bull market territory. But S&P's health care sector index has rebounded just 17%.

What ails health care?

David Farhadi, co-manager of the Alger Health Sciences fund, points to health care reform being a top priority for the Obama administration. Look at health care stocks the week of Feb. 23, when the president delivered a speech on health care reform, Farhadi says, and you see that "it delivered a massive hit to most of the players."

The unknown makes Wall Street sick, and at the moment, the details of Obama's plan are unclear. And that's why investors are steering clear of the sector. You can operate in many other sectors that don't have as much uncertainty.

Worries about the U.S. dollar also weighed on many of the big pharmaceutical stocks, says Samuel Isaly, manager of the Eaton Vance Worldwide Health fund. The Federal Reserve's trade-weighted dollar index soared for much of last year, which hurts U.S. companies' earnings from abroad.

This bears some explanation. Suppose your company earns 1 million euros in profit from German sales each quarter. Suppose it takes $1.50 to buy a euro, so your profit is $1.5 million. Now let's say that the dollar rises in value, enabling investors to buy a euro for just $1.30. Your profit gets cut to $1.3 million.

Nevertheless, health care stocks have certain charms. Unlike a CAT scan, health care stocks are cheap. A standard way to look at a sector's relative value is through its price-earnings ratio — a stock's price divided by its earnings per share. The lower the P-E, the cheaper the stock, relative to earnings.

Standard & Poor's says that the health care sector trades at 11 times 2009 earnings, vs. 16.4 times earnings for the broad market as a whole. Compared with 2009 earnings, then, health care stocks are reasonably cheap.

Scott Callahan, co-manager of Icon Healthcare fund, likes to look at a sector's fair value price, which is the fund's estimate of all of the sector's companies' intrinsic values, given their future earnings prowess. He thinks health care stocks are worth about $1.13 for every dollar invested — which is to say, they're cheap. Stocks in the managed health care subsector are particularly cheap at $1.37 for every dollar invested. "Of all the sectors, it's at the top in terms of value," Callahan says.

Apparently, some health care companies feel that the stocks are cheap, too: The industry has had several large acquisitions recently, including Merck's recent purchase of Schering-Plough and Roche's purchase of Genentech. Eaton Vance's Isaly thinks there could be as many as 15 more acquisitions of smaller biotech firms in the offing.

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