These Pros Aren't Scared of Obamacare. Why Are You?

When I'm searching for investment ideas, I always like to pick the brains of the world's "superinvestors," and there's no better way to get an idea of their convictions than to look at the largest holdings in their portfolios. As I began rummaging through the holdings of a few of my favorite gurus, I found something surprising. Several of these folks like health-care stocks -- a lot. To give you an idea of the level of their commitment, check out this chart:

Data provided by Morningstar.

My first thought was: "These guys have to be crazy. Haven't they heard the talking heads on TV arguing that Obamacare will destroy the health-care sector?" Then the contrarian in me started to become intrigued. Is it possible that if my initial reaction to health-care stocks is to throw up in my mouth, then other investors were having the same spasmic reaction, thus creating short-term opportunity?

I'll take the cash
So, many of you may be wondering, what could these superinvestors be seeing that the rest of the market is missing?

Bruce Berkowitz, whose Fairholme Fund has beaten the market by more than six percentage points annually over the past five years, gave us a good look at his reasoning during a recent Forbes interview. There he reveals one of his favorite metrics, free cash flow (FCF) yield, which is calculated by dividing free cash flow per share by the current share price. FCF yield shows the amount of cash that an investor can expect a business to generate for every dollar invested.

Berkowitz likes companies that sport double-digit free cash flow yields. He also tries to determine whether the earnings are sustainable and analyzes how well management is using that cash.

If you look at the five health-care companies that make up more than a quarter of Berkowitz's portfolio, you see two things in common: FCF yields above 10% and highly respectable return on invested capital (ROIC).

Data provided by Capital IQ, a division of Standard & Poor's.

What the ...
Did you notice that two of these companies are health insurers? Doesn't he know that Obamacare will bankrupt all the insurers? What is he thinking?

I'll tell you what. While Congress and the president call each other liars, and town halls are filled with infuriated citizens, several top investors are seizing this opportunity. Many investors are acting as if proposed legislation will drastically cut into the business of all health-care companies, but that's unlikely to be the case for a few reasons:

• Uncle Sam can't do it all. Many of the products and services that these companies provide cannot be replicated without spending an absurd amount of money or confiscating intellectual property.
• We're not getting any younger, or thinner. An increasingly obese and aging population will require more health services and medication.
• Americans don't like being put on a wait list. Or sitting in waiting rooms for that matter. A growing population will put significant strains on the current system unless capacity increases.

Now, don't get me wrong. I also believe that there is too much waste in the system, and that cuts will be made that impact these businesses. However, it's unlikely that these blows will be as large as these companies' low valuations reflect. While the current political storm may appear precarious for the health sector, long-term demographic trends are strongly in its favor.   

The small of it
The companies listed above are all huge corporations with heavy analyst coverage. If they are so cheaply valued -- as suggested by their large FCF payout ratios -- just imagine the dislocations that are taking place in the underfollowed companies you find in small-cap land. Many of these smaller companies dominate their respective niches, yet their share prices have suffered along with the rest of the sector.

Let's take a look at a few small-cap health-care stocks that fit the criteria we mentioned above.

Data provided by Capital IQ, a division of Standard & Poor's.

IMS Health is a leading provider of sales and patient data to the pharmaceuticals industry. Its proprietary information helps Big Pharma get the most bang for its R&D buck. inVentiv provides sales, staffing, and communications services to pharmaceuticals companies and counts all 20 of the biggest drugmakers as its clients. Amedisys helps provide at-home care to chronically ill and aging patients. These are all companies that are essential to the development and delivery of health services, and they can't be replaced easily. 

Berkowitz, Bruce, Dodge & Cox, and Muhlenkamp are apparently taking advantage of an opportunity to buy health-care stocks on the cheap. Likewise, we believe that this health-care fiasco has led to some severe, temporary mis-pricings. In fact, we've recently added inVentiv Health to our Motley Fool Hidden Gems real-money portfolio. The Hidden Gems analyst team is focusing its efforts to identify more small, beaten-down health-care gems. If you want to see more names like these with great businesses at bargain prices, you can take Hidden Gems for a free 30-day test-spin. Click here to get started -- there's no obligation to subscribe.

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Jeremy Myers is an analyst for Motley Fool Hidden Gems and owns shares of Fairholme. Fairholme, Dodge & Cox, and Muhlenkamp are all Motley Fool Champion Funds selections. inVentiv and UnitedHealth Group are Motley Fool Stock Advisor selections. Pfizer, WellPoint, and UnitedHealth Group are Motley Fool Inside Value picks. inVentiv Health, IMS Health, and Muhlenkamp are Motley Fool Hidden Gems recommendations. The Fool owns shares of inVentiv Health, Fairholme, Dodge & Cox, UnitedHealth Group, and IMS Health. The Fool has a disclosure policy.