Imagine a stack of $1 bills that reached from Earth to the moon, with another stack that reached from the moon's surface 85% of the way back to Earth. The total would be roughly $6.5 trillion. That is how much money is spent globally on healthcare every year, according to the World Health Organization (WHO).

With that much money going toward healthcare, it stands to reason that healthcare would be an area of great interest for investors. But how do you get started investing in the healthcare industry? Here's everything you need to know about the healthcare industry and what kinds of stocks and ETFs to pick for your portfolio.

Hand placing a wood block on top of a pyramid of wood blocks, all of which have healthcare-related images printed on them

Image source: Getty Images.

What is the healthcare industry?

Healthcare is huge. The industry includes a wide range of companies, both large and small. These companies can be broadly categorized into three groups:

  • Healthcare providers
  • Payers
  • Suppliers of products and services to the healthcare industry

The good news for investors is that there are plenty of stocks to choose from in all three categories, many of which have solid growth prospects.

Healthcare providers consist of organizations and individuals that provide direct care to patients, including hospitals, outpatient clinics, physician practices, dentist and orthodontist practices, pharmacies, dialysis centers, home health agencies, long-term care facilities, and senior living centers.

Payers assist in covering the costs of healthcare for patients. Government payers such as Medicare and Medicaid in the U.S. provide healthcare coverage for many individuals. Private payers include health insurers, managed care companies, and pharmacy benefits managers (PBMs).

Suppliers of products and services to the healthcare industry include some that develop products that are directly used to treat patients, such as drug companies and medical device makers. This group also includes companies that provide products and services used in diagnosing diseases, for example, lab services providers and medical test makers. There are also plenty of companies providing technology services to the healthcare industry, supplying providers with the infrastructure they need to treat patients and keep their data safe.

The healthcare industry, in general, is growing significantly. One key factor driving this growth is demographic trends of aging populations in many parts of the world. As individuals age, they're more likely to need healthcare products and services.

Another factor that has impacted growth in the U.S. healthcare industry is the Affordable Care Act (ACA), also known as Obamacare, which was signed into law in 2010. The ACA increased access to health insurance for millions of Americans through the expansion of state Medicaid programs and the establishment of a health insurance exchange where individuals without employer-sponsored health insurance can purchase health insurance. Individuals with lower incomes receive federal subsidies to obtain health insurance coverage.

The ACA is just one example of how government regulation impacts the healthcare industry. Currently, efforts are underway in Washington, D.C., to control drug prices. In addition, several Democrat presidential candidates support a proposal called Medicare for All, which would offer healthcare services to all Americans with the federal government as the sole payer. 

The U.S. Food and Drug Administration (FDA) oversees the healthcare industry in the U.S. and this is the regulatory agency that healthcare companies work with to get drugs, devices, and services approved for use on American patients.

Key trends in healthcare

Several key trends will be impacting the healthcare industry for years to come.

1. Aging demographics

Global populations getting older is the single most important key trend in healthcare. An average of 10,000 baby boomers in the U.S. reach age 65 every day, according to AARP. But the populations of other countries are aging, too, including many nations in Europe and Asia. 

Aging demographics driving demand for healthcare could boost revenue for companies throughout the healthcare industry. However, it's also likely to spur renewed efforts to put downward pressure on rising healthcare costs, so people can afford the care they require. Pricing pressure benefit companies that offer products and services that help contain or reduce overall healthcare costs, but changes in drug pricing policies could negatively impact companies with high-priced healthcare products and services.

2. Advanced medical device technology

Tremendous progress continues to be made in developing medical devices using advanced technology. Some of these devices are used by healthcare professionals to treat patients, while other devices are worn by patients (like Continous Glucose Monitors or CGMs) or operate inside patients (like artificial heart pumps and artificial heart valves).

One example of advanced medical device technology used by healthcare professionals to treat patients is a robotic surgical system, which enables surgeons to precisely control surgical instruments mounted on a robotic arm. 

3. Gene editing and gene therapies

There are more than 10,000 diseases caused by an alternation (known as a mutation) in a single gene in the human DNA, according to the WHO. Two types of treatments that have a lot of promise in treating these genetic diseases are gene editing and gene therapies.

Gene editing involves the insertion, deletion, or replacement of DNA within a gene. Gene-editing treatment is not yet available to patients, but several biotechnology companies are developing gene-editing treatments for various genetic diseases, including hemophilia and sickle cell disease. Biotechs are also using gene-editing approaches called CAR-T to modify the body's immune cells to fight cancer.

Gene therapies involve the insertion of a healthy gene into cells. Several gene therapies have been approved in the U.S., including Spark Therapeutics' Luxterna, which treats a rare genetic form of blindness. Roche Holding, a Swiss healthcare company, announced it will buy Spark for $5 billion.

4. Liquid biopsy

Some diseases could be treated more effectively if they could be detected earlier. Liquid biopsy is an especially promising approach for the early detection of diseases, particularly for certain types of cancer.

Liquid biopsies work by obtaining blood samples to find biomarkers -- substances in the blood or tissue that point to the presence of cancer. Although the use of liquid biopsy isn't widespread yet, significant progress could be made over the next few years in improving the approach to detect more types of cancer and other diseases in very early stages.

5. Precision medicine

Another genetic-related trend that's already impacting healthcare and should grow in importance is precision medicine (also sometimes called personalized medicine), which involves the tailoring of medications to individual characteristics of a patient. The genetic characteristics of patients is an especially key area of focus for precision medicine.

In 2018, precision medicines accounted for 42% of all drug approvals. This approach of developing drugs that focus on specific genetic mutations is likely to become even more prevalent in the future as genetic research progresses. 

Who are healthcare investors?

Before examining what to look for in healthcare stocks, let's think about what kinds of investors should be looking at healthcare stocks in the first place.

Historically, some healthcare stocks -- notably including big pharmaceutical companies, pharmacy retailers, and health insurers -- have been viewed as relatively stable alternatives for conservative investors interested in value stocks. On the other hand, growth stocks in the healthcare space, small biotechs without any approved products for instance, have been seen as suited only for aggressive investors willing to take on significant risk, in order to lock in the potential upside of these early-stage multibaggers.

To some extent, these historical views are still applicable. Conservative investors should still avoid the stocks of small biotechs with no steady revenue. However, the changing dynamics in the healthcare industry could make healthcare stocks more volatile than they've been in the past. Should the U.S. implement a single-payer healthcare system such as Medicare for All, it would almost certainly hurt health insurers but could also negatively impact other companies throughout the industry. As with all investing, never invest money you'll need within the next three to five years. With small growth healthcare stocks, you'll need plenty of time for your investment to pay off.

How to find the best healthcare stocks

So what should you look for in healthcare stocks if you're an investor willing to handle what's likely to be a more volatile market for the industry? The factors you'd look for with any kind of stock still apply, including growth prospects, dividends, financial strength, and valuation.

Remember, though, that the growth prospects for healthcare stocks could be dramatically impacted if the U.S. switches to a single-payer system. Why? Most healthcare companies that operate globally rely on the U.S. for much of their revenue and profits. A single-payer system in the U.S. could limit prices for companies' products and services. Because of this risk, the stocks of healthcare companies that help lower healthcare costs could perform better than others.

As with the stocks of any industry, don't just focus on the dividend yield of healthcare stocks. Also evaluate the likelihood that the company will be able to keep on paying the dividend at least at current levels. One useful metric for making this determination is the payout ratio, which measures dividends as a percentage of earnings.

There are several ways to assess the financial strength of a given stock. You should look at revenue and earnings growth. The company's cash position, including cash, cash equivalents, and short-term investments, is also important. One of the best gauges of financial strength is the free cash flow (FCF) generated, which measures the cash left over after paying for operating expenses and capital expenditures.

The most commonly used metric for determining the intrinsic value of a stock is the price-to-earnings (P/E) ratio. However, because many healthcare stocks are delivering rapid growth, looking at historical P/E ratios might not be as useful as the forward P/E ratio, which relies on estimated earnings one year into the future. The price-to-earnings-to-growth (PEG) ratio, which factors in projected earnings growth rates (usually over a five-year period), can also be helpful. The downside of these metrics is that the estimates for earnings growth can be too high or too low. 

Also check out our articles on how to invest in pharmaceutical stocks and how to invest in biotech stocks.  

Top healthcare stocks to buy

There are far too many great healthcare stocks to discuss in one article, but these five healthcare stocks that especially stand out for consideration are:

Company

Market Cap 

Forward P/E Ratio  

Illumina (NASDAQ:ILMN) $46.9 billion 42.43
Intuitive Surgical (NASDAQ:ISRG) $56.7 billion 35.13
Johnson & Johnson (NYSE:JNJ) $367 billion 15.10
Teladoc Health (NYSE:TDOC) $3.9 billion N/A
Vertex Pharmaceuticals (NASDAQ:VRTX) $43.1 billion 27.09

Data source: Yahoo! Finance. All data as of April 22, 2019. N/A = not available.

1. Illumina

Illumina is the worldwide leader in gene sequencing. In January 2019 CEO Francis deSouza said, "the ubiquity and impact of genomics will dwarf everything we've seen to date" in the future. If this optimistic viewpoint proves to pan out, Illumina investors will be handsomely rewarded.

The company's systems are already critical tools used in developing liquid biopsies and precision medicines -- two key healthcare trends. Several other areas present tremendous growth opportunities for Illumina, notably including consumer genomics, noninvasive prenatal testing (NIPT), population genomics, and rare and undiagnosed disease research and treatment. 

You can think of gene sequencing like putting together a jigsaw puzzle. The kind of gene sequencing that Illumina specializes in is short-read sequencing, which is known for its high accuracy and throughput. But long-read sequencing involves fewer "puzzle pieces" to put together than short-read sequencing and is better suited for some types of applications.

Illumina hopes to add long-read sequencing to its repertoire through the pending acquisition of Pacific Biosciences of California. The company hopes to close the deal later in 2019, although regulators in the United Kingdom have thrown a wrinkle into those plans with an investigation into the transaction.

2. Intuitive Surgical

Intuitive Surgical dominates the robotic surgical systems market with its da Vinci system. One of the many reasons to like Intuitive is its tremendous head start over rivals in this market. There are nearly 5,000 da Vinci systems implemented worldwide.

The company is especially poised to benefit from the demographic trend mentioned earlier. As individuals age, they're more likely to require surgical procedures -- including several of the types of procedures where da Vinci is most used today.

Intuitive Surgical also thinks that the use of robotic surgery can help lower overall healthcare costs. The company frequently highlights studies that have found that the use of the da Vinci system reduces length of stay in hospital visits, reduces complications associated with surgical procedures, results in fewer hospital readmissions, and lowers infection rates.

The company's primary growth opportunities for growth are to continue expanding the types of procedures that can be performed using robotic technology and to increase sales in international markets. 

3. Johnson & Johnson

Johnson & Johnson is the largest healthcare company in the world. The giant conglomerate has more than 260 operating companies that conduct business in at least 60 countries and are organized by three business segments: consumer, pharmaceutical, and medical devices.

J&J's consumer segment markets a wide variety of household brands including Band-Aid, Benadryl, Neosporin, Aveeno, StayFree, Tylenol, and Zyrtec. Although the company hasn't generated significant growth from its consumer segment in recent years, the business makes annual revenue of more than $13.8 billion.

The company's pharmaceutical segment is its strongest growth driver and its biggest moneymaker. The segment has multiple approved prescription drugs that are blockbuster successes, notably including immunology drugs Remicade, Simponi, Stelara, and Tremfya, and cancer drugs Darzalex, Imbruvica, and Zytiga.  

Johnson & Johnson's medical devices segment focuses on devices for orthopedic applications, surgical procedures, interventional solutions such as cardiovascular and neurovascular, and eye health. The segment is also becoming a bigger player in the robotic surgical systems market thanks to its acquisition of Auris Health.

Any discussion of J&J must include the company's dividend. J&J's dividend yield currently stands at nearly 2.6%. The company has increased its dividend for 56 consecutive years. More dividend hikes are likely, with J&J's payout ratio at a reasonable level of 63%.

4. Teladoc Health

Teladoc Health provides telehealth services to patients in more than 125 countries across the world. The company's 12,000-plus customers include 40% of the Fortune 500. 

You might think that the convenience telehealth offers to patients is a big advantage for Teladoc Health, and it is. However, an even bigger plus for the company is that its services actually reduce costs for customers. As those aging demographics discussed earlier push healthcare costs higher, Teladoc could find even more customers lining up at its doors.

But aren't there lots of competitors in the telehealth services market? Sure. However, Teladoc is the biggest. It's the only telehealth services company with a global footprint. The company also offers virtual care services for more areas than its rivals do. It's not surprising, therefore, that major pharmacy retailer CVS Health picked Teladoc as its telehealth partner for its MinuteClinic outpatient clinics.

Teladoc Health is the most attractive player in what should be a fast-growing market. It also could be a solid winner even if the U.S. moves to a single-payer healthcare system.

5. Vertex Pharmaceuticals

Vertex Pharmaceuticals primarily focuses on developing drugs to treat the underlying genetic cause of cystic fibrosis (CF). The biotech has three CF drugs approved by the FDA: Kalydeco, Orkambi, and Symdeko.

Vertex is arguably the best biotech stock on the market for several reasons. The company basically enjoys a monopoly in CF. No other drugs that address the underlying cause of the disease have been approved in the U.S. or in Europe. Vertex also has plenty of room to grow.

The biotech should be able to increase its addressable market by more than 75% over the next few years with the introduction of triple-drug combination therapies targeting CF. Vertex could win its first FDA approval for a triple-drug combo next year.

Vertex is also developing drugs for treating other diseases. It could be a key player in gene editing thanks to a partnership with Crispr Therapeutics. The two biotechs are developing gene-editing treatments for rare blood diseases beta thalassemia and sickle cell disease. In addition, Vertex's pipeline includes experimental drugs targeting the treatment of pain and rare genetic diseases.

Healthcare ETFs

If picking individual healthcare stocks seems too daunting, you have another good option for investing in the healthcare industry. Healthcare-focused exchange-traded funds (ETFs) provide a way to buy multiple stocks in one fell swoop, which gives you instant diversification and exposure to the sector's upside. An ETF is a marketable security that tracks a certain index and trades on a major stock exchange. 

The largest healthcare ETF is the Health Care Select Sector SPDR Fund (NYSEMKT:XLV). This ETF attempts to track the Health Care Select Sector Index, which includes over 60 healthcare stocks that are in the S&P 500 Index. If you're looking for broad exposure to the healthcare industry, this ETF could be a good pick for you.

There are also ETFs that enable you to focus only on a specific area within healthcare. For example, the SPDR S&P Biotech ETF (NYSEMKT:XBI) includes 120 biotech stocks in its portfolio. The iShares U.S. Medical Devices ETF (NYSEMKT:IHI), as its name indicates, owns 58 U.S. medical device stocks.

The primary benefits of buying a healthcare ETF rather than individual healthcare stocks are simplicity and diversification. The main downside is that ETFs charge management fees. The healthcare ETFs referred to have expense ratios (operating expenses divided by assets in the ETF) between 0.13% and 0.43%. 

Risks

Healthcare stocks and ETFs that hold healthcare stocks face several risks. We've already mentioned the risks associated with governmental regulatory changes, particularly the possibility that the U.S. could implement a single-payer healthcare system.

Another major risk for healthcare stocks is the possibility of competition. Drugmakers, for example, continually face the prospects of another company developing a less expensive or more effective treatment. Medical device companies encounter similar challenges.

Some healthcare stocks also face the risk that their products and services could be viewed as unsafe. Johnson & Johnson is currently embroiled in litigation over allegations that its baby powder and other talc products were contaminated by asbestos. It behooves investors to dig into a company's annual report and read the risk factors section, paying close attention to consumer issues and product liability lawsuits. 

Healthcare companies that develop drugs or medical devices must obtain regulatory approvals for their products by the FDA, European Medicines Agency (EMA), or other regulatory bodies. Failure to win these regulatory approvals can hurt the companies business prospects and cause their shares to fall.

Some healthcare companies also face challenges in securing reimbursement for their products. Vertex still hasn't won reimbursement for some of its CF drugs in the United Kingdom despite having previously obtained regulatory approval.

Big potential rewards, too

Despite these risks, healthcare stocks can also provide a significant opportunity for investors to generate strong long-term returns. Healthcare stocks like Illumina, Intuitive Surgical, Johnson & Johnson, Teladoc Health, and Vertex Pharmaceuticals appear to be in great shape to deliver such returns thanks to their innovative products and key trends working in their favor.