Updated March 19, 2010.
In 1994, "Forrest Gump" was the movie of the year, health care stocks were as cheap and unloved as they are today, and the reason was exactly the same: Washington was considering health care reform.
But then the Clinton administration's proposals died, and stocks in the sector roared upward, enriching investors who'd been brave enough to make a contrarian bet on those stocks during the debate.
This time around, it looks like President Barack Obama's health care reform ideas might actually become law -- and as of this update, a vote in the House is expected Sunday, two days away. So betting on health care stocks would be dumb, right?
Wrong. Because this sector should benefit whichever way the decision goes. Here's why, along with 13 stocks and several funds that might benefit.
Pass or fail?
To understand this picture, start with a little Forrest Gump logic. While the details of health care reform were debated, investors looked at the sector's future like a box of chocolates: They didn't know what they were going to get, so they steered clear.At this point, there's limited risk that health stocks will fall if the bill passes because top money managers have already assumed legislation will be approved, according to a survey released last week by Deutsche Bank. This suggests passage is priced in -- already accounted for in stock prices.
In fact, the sector gained ground on Friday, the last trading day before the expected vote, in anticipation of a resolution.
"The market hates uncertainty," says Robert Hodgson, the portfolio manager at BlackRock Healthcare Fund (MDHCX), which has beaten the market and its benchmarks by a healthy margin over the past five years.
If reform passes, Hodgson says, investors can begin "putting numbers on what is nebulous right now." They'll like what they see, he believes, particularly because many of the changes won't go into effect until 2014.
Meanwhile, company "fundamentals are still robust, and valuations are cheap. For at least several years in the future, fundamentals aren't going to change a whole lot," Hodgson says.
Simply settling the issue will draw investors to health care stocks, says Derek Taner, the manager of AIM Global Health Care Fund A (GGHCX), another outstanding fund in the sector based on five-year returns.
Click graphic for interactive chart
BlackRock Healthcare Fund
If reform fails, on the other hand, the gains could be really big as the stocks catch up to the rest of the market.
Sector is 20% behind
"Since the March low of last year, health care has severely lagged the broad market by 20%," says Scott Callahan, the portfolio manager at Icon Healthcare Fund (ICHCX), making it the cheapest sector in the market. "We see tremendous value in a lot of these stocks."He calculates that you get $1.18 in value for every $1 you put into health care stocks right now, compared with just $1.04 for every dollar that goes into the S&P 500 Index ($INX).
Here's another way to look at the potential. Before the Clinton health care reforms surfaced, stocks in the group typically traded for 1.2 to 1.4 times the price-earnings ratio of the S&P 500, says Ed Yardeni of Yardeni Research. That's a common comparison used to decide whether stocks are cheap compared with the market.
By the time the Clinton reforms were introduced in April 1993, the relative P/E had fallen to a record low of 0.84. But look what happened next:
- By August 1994, with the plan losing support, the relative P/E for the group had recovered to 1.08.
- By the spring 1995, the sector was back in the 1.2-to-1.4 range.
- From the lows in 1993 through the next 10 years, health care stocks outperformed the S&P 500 by more than two times, Yardeni says.
Recently, the sector traded at a P/E that's 0.86 times the S&P 500's -- very similar to the low point of the Clinton years. This isn't to say history will repeat itself, but that's a sizable potential for gains compared with a very limited downside.
So how do you play this opportunity if you agree?