Health Care's Miracle Cure - insurance industry stocks flying high

Kiplinger's Personal Finance Magazine, June, 2001 by Mark McLaughlin

AS THE economy stumbles and stock prices shrink, you might think twice about splurging on a new car. But break your arm and you can't put off a trip to the emergency room. That, in essence, is what earns hospitals and other health-service providers a reputation for being able to deliver steady growth no matter what the economic environment. That perceived stability helped the group soar nearly 120% last year as tech stocks cratered. The medical group pulled back about 15% this year to April 12, but the sector's prospects remain bright (and aversion to technology remains high), so health care stocks may be just the right prescription for your portfolio.

Not surprisingly, demographics are working in favor of health-service providers as an aging population feeds demand for medical insurance and hospital care. Membership in the 45-plus age group is expected to increase by about 24% in the next decade, to 120 million. Hospital chains in particular stand to gain the most from growing demand. After 15 years of declining patient numbers, admissions have started to climb again. Any additional increase in patient volume boosts profits greatly, says Bank of America Securities analyst Gary Taylor.

After years of declining profit margins, the pricing environment for health care insurers is also improving. These companies make money by predicting future medical costs and by pricing their premiums high enough to cover their costs and generate some profit. From 1996 to 1998 insurers incorrectly forecast a cycle of declining costs. Instead, huge drug-price increases sent medical inflation spiraling, while the biggest payer into the health care system, the federal government, cut medicare reimbursements to comply with the Balanced Budget Act of 1997. That combination led to large losses for many insurers and subsequent industry consolidation.

But the tide turned in 1999 and 2000, as insurers began passing price increases along to their clients. In addition, the emergence of budget surpluses led to the passage of legislation that is expected to funnel $20 billion to $40 billion in medicare reimbursements to insurers and hospitals. "The wind is now at their backs," says John Schneider, manager of Pimco Renaissance fund.

The health-insurance business tends to move in three- to five-year cycles, with share-price increases lagging premium increases by 12 to 18 months, says Lehman Brothers. Premiums have been increasing for three years and are expected to peak in 2002, meaning that insurance stocks may not peak until 2003 or 2004.

Of course, predicting the fortunes of a particular sector is tricky business. Health stocks could return to sick bay if economic growth reaccelerates and investors begin focusing on more-cyclical groups, including tech. We've identified four health-services companies that should thrive over the next few years, no matter what happens to the overall economy.

Body-part insurance

NAME A BODY part and UnitedHealth Group probably has a plan to cover it. From the depths of a failed merger with rival Humana in 1998, UnitedHealth (symbol UNH; 952-936-7265) has risen steadily to become one of the biggest U.S. health insurers by market value and second-largest by sales and membership. It offers a complete range of health insurance, from restrictive HMO plans to open-choice networks, vision and dental plans, as well as health-information services.

That diversity has insulated the company from the perils of predicting insurance premiums and helped it exceed profit forecasts at least nine straight quarters. "Because HMOs are trading stocks, I would be wary of holding any of them for five years, except for United," says Lehman Brothers analyst Joshua Raskin.

United has reined in costs by cutting jobs and implementing more efficient technology. Its medical-loss ratio, which measures whether rate increases are outpacing costs, has fallen for the past seven quarters. Consequently, profit margins have increased.

At a recent price of $58, United sells at 23 times the consensus 2001 earnings forecast of $2.52 per share (all earnings forecasts in this article are from First Call/Thomson Financial). That's expensive compared with its peers. But for the price, you get a company that is pushing through healthy premium increases and shaving costs, while achieving good growth in its huge membership base.

Focus on rural hospitals

CONSOLIDATION is the watchword for Community Health Systems, which operates 52 hospitals in rural regions across 20 states. Community (CYH; 615-373-9600), which has existed in some form since 1985 and went public again in June 2000, has used acquisitions to build the largest network of for-profit, nonurban hospitals in the country.

Community buys hospitals that aren't performing up to snuff, then uses its management expertise and financial muscle to improve profitability. It adds staff, expands services, and trims expenses. This approach has helped Community post the highest patient-volume growth in the industry at facilities it has owned at least a year. As for earnings, analysts expect growth of 2555 per year over the next three to five years.