On March 22, the U.S. House of Representatives passed a landmark bill that gives roughly 32 million uninsured Americans health-care coverage for the first time. It was a historic moment for our southern neighbours, but here in Canada keen investors were watching something other than the explosion of punditry on CNN — they were watching stock prices in the volatile American health-care sector. The new legislation will have a profound impact on every player in the field, from big pharma to private drug plans to health maintenance organizations — and for savvy investors, the resulting uncertainty could offer some big opportunities.

The main changes ushered in by the bill are new controls on health-insurance premium costs and new rules that prevent insurance companies from using pre-existing medical conditions to refuse coverage. Most Americans will now be forced by law to get health insurance — there’s a penalty if they don’t — and new government subsidies will help families pay for it. This reform will have both positive and negative consequences for companies in the health-care sector. More drugs and more services will now be used, which should translate into higher profits. But while there are no price controls governing how much medicine can be sold for, pharmaceutical companies will have to pay higher Medicaid rebates and provide a 50% price discount on drugs provided through Medicare. Pharmaceutical company Eli Lilly estimates that the rebates alone will cost it about $400 million in 2010.

Many Canadian investors haven’t been following the changes closely, as at first glance, the U.S. health-care sector may not seem like a must-have for northern portfolios. However, Bob Gorman, a portfolio strategist and vice-president at TD Waterhouse, says that view could be a mistake. He points out that health care is vastly underrepresented in the Canadian equity market, which is overweight on commodities and financials. To ensure a properly diversified portfolio, it’s wise for Canadians to focus their foreign equity holdings on sectors that are underweight at home. Stephan Patten, portfolio manager in charge of health-care strategy for Montreal-based Sectoral Asset Management, says Canadians should have a market-weight exposure to the global health-care industry of about 10%.

According to Jerome Pfund, Sectoral’s CEO, now may be a good time to buy. He says U.S. health-care stocks are currently undervalued due to the new rebate and price discount rules. But over the long run, the sector will likely benefit from 32 million additional Americans gaining access to care. “These two things — negative effect on pricing and positive volumes — are not happening at the same time,” he says. “That presents great opportunities.”

One of the big winners may turn out to be the biotech sector, which Derek Taner, lead manager of the Invesco Global Health Care Fund, finds very cheap right now. Many companies in the field have demonstrated consistent growth, he says, and it’s a sector ripe for consolidation. Patten also likes biotech because it’s one of the more innovative, faster-growing areas in health care.

The picture for the big pharmaceutical companies isn’t as clear. They could also benefit over the long term, as more insured Americans means more sales, with the generic drug makers benefiting the most as insurance companies try to control their costs. But John Power, senior vice-president of U.S. equities and portfolio manager for Fidelity Investments, is worried that big pharma may not see the boost some are suggesting. That’s because Medicaid rebates on prescription drugs — money pharmaceutical companies must pay back to states to keep Medicaid-related drug costs low — are set to jump from 15% to 23%. Due to that increase, Power is downgrading expectations on pharma companies in general.

HMOs may also be at risk. These insurance companies work with doctors, hospitals and employers to get patients low-cost care, and some say they may eventually lose control over their rate increases. The current situation in Massachusetts, where state approval has been the norm for years, is an example of what can go wrong. In April, when non-profit HMOs asked the state government to increase premium rates to cover rising health-care costs, it refused, approving only 10% of the increase insurance companies wanted. The HMOs responded by saying they would be forced to deny certain treatments. That’s a major concern for Power, since people are now mandated to have health-care insurance. “The highly politicized nature of health-care rate increases in Massachusetts is likely to be replicated at the national level,” he says, “which bodes poorly for private health insurance.”

Other sectors will undoubtedly benefit from the new legislation. There is wide agreement among Taner, Gorman and Power that the pharmacy benefit managers (PBMs) — such as Express Scripts and Medco Health Solutions — will be big winners. PBMs administer prescription drug programs and act as the middlemen between employers, drug companies and the American people. They also negotiate rebates with drug companies and keep track of what medicines employer health plans cover. With more people accessing drugs, expenses will rise; it’s the PBMs’ job to keep those costs down, which will likely mean guiding people to generic drugs. Power says any service that helps people keep costs low will do well post-reform.

There are many ways for investors to tap into the U.S. health-care sector. Canadians can buy stocks on the American exchanges, as well as health-care-themed mutual funds and exchange-traded funds (ETFs), such as the Health Care Select Sector SPDR (NYSE: XLV), which follows the S&P 500 Health Care Sub-Index, the main benchmark for the industry. There’s also the iShares Dow Jones U.S. Healthcare Sector Index Fund (NYSE: IYH), which tracks the Dow Jones health-care index.

It will likely take years for all the effects of the recent health-care reform to become evident. The S&P health-care index saw a strong rebound from the market crash in 2008, posting a 19.7% return in 2009, but thanks to the uncertainty imposed by the health-care reforms, the sector has dropped a little bit in 2010. That could be good news for investors who missed out on the great rebound of last year, as long as they can handle a bit of volatility. “The market is underperforming,” says Taner. “People need to own more.”

Best bets

These health-care companies were selected by fund managers who follow the sector as likely to benefit from the recent reform:

Johnson & Johnson (NYSE: JNJ) Most of us know this New Jersey–based company as the makers of Tylenol and Band-Aids — but it also produces a number of prescription drugs and medical devices, and thus stands to gain from the changes imposed by the health-care bill, says Bob Gorman, portfolio strategist and vice-president at TD Waterhouse. At the same time, the consumer products operation, which isn’t directly affected by the bill, could provide a stabilizing effect. According to Gorman, the price-earnings ratio for J&J is currently below its long-term average, the stock has a dividend yield of 3.32%, and it has increased that dividend every year for the past 40 years.

Bristol-Myers Squibb (NYSE: BMY) New York City–based Bristol-Myers Squibb is another favourite of Gorman’s. While its fortunes vary depending on how many drugs it’s working on, he says Bristol-Myers is a well-managed operation with a “decent drug pipeline.” It’s also a global company, so while it stands to benefit from the increased health-care demands in the U.S., it will also capitalize on growth from places like China and Mexico. In the past year, the company has focused on building its biotech and specialty drug operations — it purchased cancer drug maker Medarex last September — while divesting its non-pharmaceutical assets.

Gilead Sciences Inc. (Nasdaq: GILD) Derek Taner, lead manager of the Invesco Global Heathcare Fund, likes many biotech companies, but his favourite is Gilead Sciences. The Forest City, Calif., company develops a number of specialty drugs for AIDS, liver disease and respiratory illnesses, among other things, and has operations across Europe, North America and Australia. Thanks to its acquisition last year of cardiovascular drug maker CV Therapeutics, along with the 14 new drugs Gilead has in testing, Taner says he expects to see the company grow significantly over the next five years.

Genzyme Corporation (Nasdaq: GENZ) The last thing a drug company needs right now is a scandal, but in June biotech company Genzyme was forced to close down a plant due to viral contamination. That made it difficult for the Cambridge, Mass., company to produce a new drug it was developing to treat Gaucher disease. As well, U.S. regulators have handed the company a $175-million penalty. Despite all that, Taner likes Genzyme’s prospects. He says activist shareholders may force a change in management, which could drive the stock higher. Taner also likes the product diversification offered by the large-cap biotech. It has four main divisions: genetic diseases, cardiometabolic and renal, biosurgery and hematologic oncology. “It’s got a lot of good business platforms,” he says, “and a great asset value.”

Appeared in Canadian Business magazine’s June 14, 2010 issue.

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