How stock-market investors can play health care’s latest merger mania

Start with Aetna, Allergan, the SPDR S&P Biotech ETF and the SPDR S&P Health Care Equipment ETF.

  • By Jeff Reeves,
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  • Investing in Stocks
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If you’re looking for a single piece of the stock market to hang your hat on, tech has been a popular choice. But there’s a fresh reason to now turn to the health-care sector, another big winner over the past decade.

Some big-picture trends are well known. Health care is recession-proof: Emergency room visits and heart attacks aren’t tied to overall economic growth rates, and that provides a strong baseline of revenue for health-care companies. There’s also a long history of above-average growth in the sector thanks to aging Baby Boomers. That’s on top of persistently high rates of inflation for medical spending across the board in the U.S., as our objectively overpriced health-care system squeezes more cash out of patients’ pockets.

These trends have long been driving strong performance for health-care stocks. Consider the Vanguard Health Care ETF (VHT) has surged 195% in the last 10 years while the broader S&P 500 (.SPX) is up only about 110% in the same period. Other more aggressive pieces of health care like biotechnology have done even better; the SPDR S&P Biotech ETF (XBI) has leapt about 460% in the last decade.

But this year’s wave of big mergers gives investors another reason to step into this sector.

That’s because an increasingly consolidated sector sets the stage for better pricing power thanks to reduced competition and bigger cost savings as operations are mashed up. On top of the longstanding appeal of health-care stocks as stable and growth-oriented businesses, this makes the sector a slam dunk in 2018.

Fewer players to share in bigger opportunities

The biggest recent example of health-care consolidation is Thursday’s $67 billion bid from insurer Cigna (CI) to purchase pharmacy-benefits manager Express Scripts (ESRX).

In years past there was an odd dance between insurance companies negotiating with pharmacy-benefit managers, or PBMs, that administer the drug coverage portion of their plans. The PBMs then would negotiate with Big Pharma on drug prices.

The idea of this merger is simple: Cut out the middle man.

In truth, this deal is a boon for Express Scripts shareholders — and not just because of a roughly 8% pop in shares on Thursday. Bitter negotiations with insurer Anthem Inc. (ANTM) fell apart last year, and the company warned that the insurer, its biggest partner, representing about 18% of the PBM’s revenue, would be walking away at the end of 2019.

The move also is representative of a broader sector trend. In December, pharmacy giant CVS Health Corp. (CVS) announced it would shell out $69 billion for health insurance company Aetna (AET). Though at the very end of the year, it was 2017’s biggest deal and was widely expected to reshape how health-care companies function — across insurers, dwindling PBMs, drugmakers and even health-care providers.

Anyone who has followed health care for even a short time has seen the impact of big shake-ups on other parts of the sector.

Look at the big drugmakers. From 1995 through 2015, 60 pharmaceutical companies got mashed up into just 10 leaders.

And then there are the hospital operators. Consulting firm Kaufman Hall reported at the end of last year that 115 hospital and health-system mergers had been booked — up from 102 the prior year more than double the 60 mergers in 2008, before the Great Recession. The firm reported that a third of all those transactions involved just three players — Community Health Systems (CYH), Quorum Health (QHC) and Tenet Healthcare (THC). That’s outside the megamerger last year of Advocate Health Care and Aurora Health Care, which would have combined revenue of nearly $11 billion and create the 10th largest not-for-profit hospital system in the country.

Amazon tackles health-care costs

Three employers are creating a company to rein in health-care costs.

Every time we see evidence of this trend, we hear promises for better health outcomes and the potential for decreased costs for customers — I mean, patients.

I’ll leave it up to others to parse whether any of this will change the quality of American health care for better or worse. But one thing is clear: The companies that remain after these megamergers emerge even more powerful than before, with fewer competitors.

What’s the trade?

Given the big-picture potential of health care to hang tough in a time of trouble coupled with this continued consolidation of power, you can understand why the sector is in favor right now.

In fact, hedge funds are heavily weighted toward the sector, with allocations to health-care stocks at a five-year high. Top recommendations from investment banks, according to Goldman Sachs, include insurer Aetna and drugmaker Allergan (AGN) (the target of a $150 billion megamerger with Pfizer (PFE), a few years ago that was scrapped but has since been rumored to once again be in the works under the pro-business environment of the Trump administration). Both Aetna and Allergan have obvious appeal if those respective mergers come to pass, and in this environment of consolidation that seems very likely.

Of course, if you really want the pop of a buyout premium, dabbling in smaller players could give you more bang for your buck. Just look at the $9 billion acquisition of Juno Therapeutics by Celgene (CELG) back in January that resulted in an instant 90% profit for shareholders. It’s admittedly a riskier strategy, but I listed a few potential buyout targets after that deal, including Bluebird Bio (BLUE) which still might be worth a look if you don’t mind a more aggressive play on the space.

There’s also broad play to be made on smaller companies in health care via ETFs. These include the SPDR S&P Biotech ETF and the SPDR S&P Health Care Equipment ETF (XHE) that have promising acquisition targets among their holdings. And unlike iShares sector funds that purport to cover biotech or medical device stocks broadly but are very top-heavy thanks to market-cap weighting, the SPDR funds are mostly equal weight with no single stock representing more than 2% or 3% of the portfolio. This means you can benefit much more when a tiny stock gets bought out for a huge premium.

Of course, you could do worse than simply piling into the big boys that are doing all the buying. Growth may not burn down the house since they are already so large, but the entrenched giants are going nowhere regardless of any short-term market volatility.

The poster child for Big Medicine is Johnson & Johnson (JNJ), which booked $76 billion in revenue last year across everything from over-the-counter Tylenol to prescription blot-clot treatment Xarelto to biosurgery equipment. Its sprawling health-care business became even larger last year after a $30 billion buyout bid for Swiss biotech firm Actelion. On top of that, J&J has increased its dividend annually for the last 55 years, and, alongside tech king Microsoft (MSFT), is one of just two AAA-rated U.S. corporations. You don’t get much more stable than that.

As you can see, there are plenty of different flavors of health-care stocks. But the one theme they all share is the stability of a reliable industry and big profit potential amid continued consolidation.

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