Companies That Will Thrive Under Obamacare

In a year where most sectors have participated in a serious rally off of the market's spring time low, it's a fact that health-care stocks have been left in the dust. According to Morningstar, health-care stocks are ahead of only sleepy utilities year to date. Yawn.

Lagging sectors tend to have "mean-reverting performance" which is a fancy way of saying that this year's dog is likely to be next year's thoroughbred. Combine that market anecdote with severely depressed health-care earnings multiples and value hounds should have their noses sniffing overtime. If you believe, like I do, that the place to find tomorrow's winners is where no one is looking today, then health care is a good place to do some old-fashioned treasure hunting.

Where to start
Despite my experience covering the sector, I don't claim to have any special ability to predict how health-care reform will shake out. With all of the lobbying, concessions, and negotiations still to come, I'm not sure those in the halls of Congress even have a firm idea. All that is clear is that the pressure is on to get legislation on the president's desk. Soon.

What that means is that investors looking to profit from uncertainty in health care have a closing window of opportunity. The time to act is now. But which stocks put the odds in your favor, given that we know change is coming?

Even though Big Pharma is on board with health-care reform, I have serious doubts about the future growth prospects of companies like Eli Lilly (NYSE:LLY), Pfizer (NYSE:PFE), and Merck (NYSE:MRK). Big Pharma could benefit from the new customers that would come with broader insurance coverage, but that doesn't fix its broken R&D model.

But I am looking in the sector at other companies that have an exceptionally low probability of seeing their businesses disrupted by legislation. Who may that be? One option is the firms providing a real social benefit while standing on politically safe ground. Specifically, health insurers providing Medicaid coverage for the poor, the elderly, and for children. This is one area you can take to the bank that won't see budget cuts. If anything, services in this area will only expand.

A CEO speaks out
Consider this quote from Amerigroup (NYSE:AGP) CEO James Carlson: "Most of what we're reading would grow our business dramatically. I don't think you can say that about a lot of other participants in the health care system."

In my view, Carlson is right on the money. Why? Because Amerigroup works with the states to provide Medicaid benefits to the elderly and children. This focus is in contrast to large insurers like UnitedHealth Group (NYSE:UNH), WellPoint (NYSE:WLP), and Aetna (NYSE:AET), who do a lot of business with corporate America. Amerigroup's offerings include the State Children's Health Insurance Program, which provides coverage for those under the age of 19 who do not have health insurance. This is the third rail of politics, and you can bet your elected officials don't want a career change in November 2010. I don't see government spending getting cut here. If anything, it will increase.

Amerigroup isn't the only player in the space. Here's a list of small-cap health insurers to start your research:

Source: Capital IQ, a division of Standard & Poor's.

None of these insurers appears to be trading at a lofty valuation, and on the surface, it appears there could even be some bargains in the group. These companies are not recommendations, but a list of firms for further investigation. As a general rule-of-thumb starting point for small-cap health insurers, I look for a price-to-book ratio close to one and a price-to-earnings ratio close to 10. Most companies on this list meet one or both of those criteria, and that gets me pretty excited.

Some factors to keep in mind with these small-cap insurers is that contracts with the states they operate in have to be renewed on a regular basis. The negotiated rates they get for providing their services usually end up with the insurer only earning a slim profit margin, as I mentioned above. The downside there is that profits can rapidly disappear if health-care costs happen to spike in a given year. Do your due diligence, Fool.

Foolish final thoughts
A casual survey of the small-cap health insurance landscape shows that there could be some very attractively priced opportunities available. Investors with the courage to handle the uncertainty of the environment and the tenacity to sort out the winners could be rewarded with a few lucrative investments.

Analysts at Motley Fool Hidden Gems is actively looking for small-cap health-care stocks. They are looking for durable businesses which have been unduly punished by the market. Advisors Seth Jayson and Andy Cross have already added two health-care companies to Gems' real money portfolio and are looking for even more opportunities in the space. If you'd like to ride shotgun while some smart analysts do the legwork for you, you can read all of their top stock recommendations, risk-free for 30 days. To get started, simply click here.

Charly Travers is an Associate Advisor of Motley Fool Million Dollar Portfolio and a research analyst on Motley Fool Rule Breakers. He doesn't own shares of any company mentioned in this article.

Pfizer, UnitedHealth Group, and WellPoint are Inside Value recommendations. Amerigroup and UnitedHealth Group are Stock Advisor picks. The Fool owns shares of UnitedHealth Group and has a disclosure policy.