Where health care sector gets its strength

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(Editor's note: A version of this article appeared in optionMONSTER's Open Order newsletter of May 4. )

One of the most striking developments this earnings season is the jaw-dropping strength of health-insurance companies such as UnitedHealth Group, Aetna, and Humana.

UNH was expected to report profit of $0.89 a share but thrashed that number with net income of $1.22. Revenue was also well above consensus.

AET was even more impressive because its top line beat by a much narrower margin, while its bottom-line profit of $1.50 crushed the $0.96 estimate. That reflects a massive surge in profitability that no one expected.

HUM reported similarly strong results, and guidance from all three companies was significantly above forecasts.

XLV Several factors are driving this strength. One is that people are using medical services less: UNH and AET paid out 81.4 percent and 79.2 percent of premiums received in claims, respectively, which is 1 to 1.5 percentage points lower than the levels of 2006 and 2007.

Most readers have probably seen evidence of this in their own lives as co-payments have increased, discouraging visits to the doctor. Or perhaps you had to get interviewed by third-party before the insurer pays for a test like an MRI.

Income stagnation is another factor because a lot of health-care spending is discretionary: Joe Six-Pack hasn't had a raise in four years, and gasoline prices are killing him. He would like to see a knee doctor, but his out-of-pocket cost for the specialist just doubled. So he simply forgoes the care and lives with the pain.

In fact, we seem to be in the early stages of a new secular trend where health-care costs no longer run ahead of broader inflation. Monthly inflation data show that non-seasonally adjusted prices rose 0.98 percent for all items between February and March, the fastest gain since June 2006. There were also strong readings in January and February versus negligible changes throughout 2009 and 2010.

But in the category of health-care services, the opposite is happening. Prices increased just 0.1 percent, following a moderation of prices in the preceding 12 months. Health-care inflation averaged roughly twice the overall rate between 1980 and about 2005, so it's clearly slowing compared with the broader trend.

It's still a little early, but I will go out on a limb. As I have discussed in previous columns, I like to take a thesis that seems to be true, then try to ride stocks that manifest it. We won't know if it's correct until most of the money has been made, but the price action and earnings will give us a pretty good idea if we're right.

The new trend we're seeing is dramatic innovation in health care, an industry that has been fat and lazy for years. While sectors from retail to finance have experienced massive cost reductions, most doctors' offices are at somewhere back in the 1950s (if not the 1850s), clogged with paperwork, redundant processes, and uncountable instances of waste. This is where companies such as Cerner and McKesson are stepping in.

The consumers of health care--ordinary people plus state and local governments--are more squeezed financially than ever before. On top of that, you have baby boomers needing record amounts of cheap, commoditized care.

All of this offers huge opportunities for greater efficiency and wealth creation, so look for companies that will benefit from this massive change. (Pharmacy-benefit companies such as MedcoHealth Solutions and Express Scripts have also done so by cutting drug costs.)

Trust the charts and earnings more than analysts or the media, and don't fall in love with any one stock. It's better to have a broad familiarity with many names and a limited commitment than a deep knowledge of one or two companies and a major commitment to them.

(Chart courtesy of tradeMONSTER)



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.


This article appears in: Investing , Options

Referenced Stocks: AET , CERN , HUM , MCK , UNH

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