Our outlook for health-care stocks

Health-care utilization has not been immune to weak aggregate demand in the United States, but we're finally starting to see slow recovery in the pace of health-care spending in that country. Granted, the overall economy's slow pace of improvement and the looming sequestration cuts guarantee some road bumps in 2013, but we anticipate the overall demand to recover as the U.S. economy strengthens and unemployment levels continue to decline. We believe the pace of health-care expenditure growth should exceed that of the overall economy, with pent-up demand for health-care services, lower unemployment levels and rising commercial insurance membership bolstering the sector, aided by the waning generic wave.

The magnitude and duration of negative impact from sequestration on health-care spending remains unknown, as Medicare spending cuts are likely to be spread over a period of years. There are still a few question marks surrounding the sustainability of certain Medicare-related revenue streams, particularly Medicare reimbursement of dual eligibles. There are also still unresolved issues with the sustainable growth rate, unrelated to sequestration issue, but arguably more important for the long-term trajectory of health-care spending in the U.S.

Offsetting some greenshoots from the U.S., the European demand situation remains bleak. Austerity measures and an even slower pace of recovery (assuming there is one) made Europe a difficult market in 2013, and there are few indications that the situation could improve down the road. For now, health-care companies continue to view this marketplace as challenging, particularly in light of ongoing pricing cuts on both branded and generic drugs.

The good news is that health-care companies are relying less and less on the developed world for growth, as emerging markets are featured prominently in the strategic positioning going forward. Pharmaceutical and to a lesser degree device companies have made significant inroads into emerging markets over the past few years, and with revenue from these geographies becoming meaningful (in some cases emerging markets contribute nearly a quarter of total sales), the pace of the health-care spending growth there will become an equally important indicator.

Valuations in the sector are no longer very appealing

Health-care stocks continue to defy expectations, and, year to date, health care is the top-performing sector, gaining 23%. Despite the worse-than-expected performance throughout the recession, the sector's five-year growth now stands at 13%. Outside the medical instruments and supplies industry, other areas of health care all delivered north of 20% gains so far in 2013, with biotech (40%) and medical care (49%) in particular outperforming the overall market by a significant margin. With two years of stellar returns behind us, our expectations for 2013 are more muted. We think the investment community has recognized the many sector headwinds but has settled on a positive long-term outlook. Our coverage universe is now considered largely fairly valued, with a few exceptions, most notably in medical devices and managed care.

Even with major headwinds swirling through the managed-care industry, we believe players with economic moats will churn out strong long-term profits. Narrow-moat firms UnitedHealth Group UNH and WellPoint WLP are our top picks in the space. We think a large and diverse membership base is the key driver in economic moat creation, as it allows managed-care organizations (MCOs) to more effectively leverage fixed costs, gain population management expertise, diversify risk and gain negotiating power over providers. With the bulk of the PPACA set to come on line in 2014, the operating environment will be pressured, but there are a few opportunities on which, in our opinion, top MCOs will capitalize.

Buybacks and acquisitions, not deleveraging, are part of key cash deployment strategy

Reducing debt hasn't been the greatest point of emphasis for most health-care firms, considering their strong cash flows and manageable leverage. Buybacks remain the preferable cash deployment strategy outside of acquisitions and reinvestments, although their pace has decelerated as of late. With growth prospects still uncertain given the macro environment in the U.S. and Europe, cheap debt remains the key source of capital to fund growth strategies, particularly acquisitions. We believe Big Pharma firms will probably continue to rummage around biotechnology for their next targets, and our top five biotech takeout targets all offer the combination of highly sought factors: pipeline potential, therapeutic area attractiveness, collaborative fit and digestible size. Our top biotech picks are Onyx ONXX, Regeneron REGN, Incyte INCY, Biomarin BMRN and Seattle Genetics SGEN.

Valeant VRX made the biggest acquisition splash over the past few months, acquiring Bausch & Lomb for about US$9 billion. In our view, significant reinvestment opportunities make Valeant's moat extremely valuable. The firm's ability to continually reinvest all of its cash flows has been the key driver of the performance. Valeant's aggregator strategy is a risky one, but the company has been successful not just effectively integrating and extracting synergies from companies it acquires, but also continually identifying right targets.

	Top Health-Care Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
	Convidien		$76.00	Narrow	Medium	$53.20
	Teva Pharmaceuticals		$50.00	Narrow	Medium	$35.00
	Gilead		$71.00	Narrow	Medium	$49.70
	UnitedHealth		$76.00	Narrow	Medium	$53.20
	Data as of 6-24-13

Covidien  COV
The spin-off of the pharmaceutical business will complete Covidien's transformation from a health-care conglomerate into a pure-play device firm and should allow investors to appropriately judge the company and its core device business. We consider the shares undervalued, and Covidien remains our top pick in devices. Covidien's device growth prospects are compelling, as the latest product launches have been well received by the marketplace. Moreover, while many device firms struggle to adapt to a changing regulatory and reimbursement environment in the U.S., Covidien's products address the growing emphasis on total value and thus shouldn't face the same level of scrutiny as those of some of its peers. We anticipate its growth prospects to be among the best in the industry, and with emerging markets also fueling growth, we expect strong revenue and earnings momentum despite ongoing investments in R&D and sales.

Teva Pharmaceutical  TEVA
Teva faces a difficult transition phase over the next few years, but we think the company's narrow economic moat can sustain its leadership in the specialty pharma industry. In the generics segment, management will focus on improving operating costs in the company's sprawling manufacturing empire, while also retaining a focus on emerging markets to reduce risks from the U.S. patent cliff and pricing concerns in Europe. The risk of branded and generic competition on Copaxone creates a more severe headwind in Teva's branded segment. Copaxone's patent protection through 2015 and a reasonably healthy pipeline, including biosimilar and respiratory products, leave us optimistic that management can successfully transition the company beyond its near-term challenges. Although these hurdles will subdue Teva's growth, healthy free cash flow leaves opportunities for acquisitions, dividend growth and share repurchases.

Gilead  GILD
Strong sales surrounding Gilead's core tenofovir molecule--in the forms of Viread, Truvada and Atripla--have made the firm the dominant player in the market for HIV therapies and have produced stellar operating margins. Gilead's Complera and Stribild are seeing rapid uptake and strong reimbursement, and they should help Gilead both retain market share beyond the first HIV patent expirations (starting in 2018) and improve its profitability (particularly Stribild, an all-in-house product carrying the firm's highest HIV product price tag). While Gilead paid a steep premium to bring Pharmasset's hepatitis C pipeline under its wing, it puts the firm in prime position to introduce the first all-oral drug regimen in 2014. We think Gilead could see hepatitis C sales in 2022 of $10 billion, or half of our global market estimate that year, and this franchise should allow it to counter maturing HIV sales beyond 2022.

UnitedHealth Group  UNH
We believe UnitedHealth possesses a narrow moat and will continue to be one of the best-performing MCOs. The firm continuously generates outsize returns on invested capital, or ROICs, through the leveraging of its large and diverse membership base to scale its costs. The firm has a solid line-up of products and participates in most major MCO markets (individual, group, government). This diversification shields the firm from adverse developments within one specific market.