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Investing in Healthcare Stocks

Updated: May 26, 2021, 5:18 p.m.

Everybody needs healthcare -- or will at some point. And, when there’s something everyone needs, that means a huge opportunity for investors.

More than $7.8 trillion is spent on healthcare globally. Nearly half of that total -- roughly $3.5 trillion -- is spent in the U.S. With the healthcare sector growing significantly faster than the overall global economy, these numbers will almost certainly be much bigger by the end of the decade.

How can investors profit from this growth? Here’s what you need to know about investing in healthcare stocks.

Different types of healthcare stocks

The healthcare sector is so broad that there are several different kinds of healthcare stocks. Four of the most important types are:

  1. Drug stocks: Drugmakers focus on developing drugs for treating diseases. Biotechs use live organisms such as bacteria or enzymes to develop drugs, while pharmaceutical companies use chemicals. Drug stocks range from huge companies with billions of dollars in sales each year to small biotechs with no products on the market yet.
  2. Medical device stocks: Medical device companies make devices used in the care of patients. These devices range from simple ones such as disposable gloves and thermometers to the very complex, including artificial heart valves and robotic surgical systems.
  3. Payer stocks: Payers, including health insurers and pharmacy benefits managers (PBMs), play an especially important role in the U.S. healthcare system. Insurers charge premiums to individuals and employers to pay for healthcare costs, while PBMs administer prescription drug benefits for employers and health plans.
  4. Healthcare provider stocks: Healthcare providers stand at the front lines delivering healthcare services to patients. They include hospitals, physician practices, home health companies, and long-term care (LTC) facilities.

Top healthcare stocks

  • Vertex Pharmaceuticals (NASDAQ:VRTX) stands out as one of the top biotech stocks on the market. The company primarily focuses on developing drugs that treat the underlying cause of cystic fibrosis (CF), a rare genetic disease that damages lungs and other organs. Vertex’s newest CF drug, Trikafta, could boost the number of patients that its drugs can treat by more than 50%. The company is also developing drugs targeting other rare genetic diseases as well as more common diseases including type 1 diabetes.
  • Intuitive Surgical (NASDAQ:ISRG) is a great example of the robotic surgical system type of medical device stock. The company’s da Vinci robotic surgical system has been used in more than 7.2 million procedures since its introduction in 1999. The COVID-19 pandemic hurt the company’s business, as elective surgeries were postponed. However, the availability of vaccines should help bring the pandemic to an end and return Intuitive’s business to its previous strong growth. Over the long run, the company should have tremendous growth opportunities ahead with more older people requiring the types of surgical procedures for which da Vinci is frequently used.
  • UnitedHealth Group (NYSE:UNH) ranks as the largest health insurer in the world. It also operates one of the biggest PBMs. The company’s size, stability, and dividend make UnitedHealth Group one of the most attractive payer stocks on the market.
  • Teladoc Health (NYSE:TDOC) is arguably one of the best healthcare provider stocks. The company provides telehealth services, delivering healthcare remotely through the internet and over the phone. Teladoc’s acquisition of Livongo Health in 2020 gave the company a digital health platform for helping people manage chronic conditions such as diabetes. The COVID-19 pandemic has driven increased adoption of virtual care services. Teladoc’s growth prospects should be very good even after the pandemic ends. Individuals, employers, governments, and health insurers are seeking to control healthcare costs -- which telehealth and chronic disease management help achieve.

What to look for in healthcare stocks

How can you find the best healthcare stocks to buy? There are four key things to look for:

1. Growth prospects

The most important thing you’ll want to check out with any healthcare stock you’re considering is the company’s growth prospects. Determine how quickly revenue has grown in recent years. The future doesn’t always mirror the past, but if a company hasn’t been able to deliver strong revenue growth so far, it probably won’t in the future either.

Read the investor presentations on companies’ websites to learn what their strategy is for growth and how big they think their potential market is. Check out the companies’ rivals to see if their strategies seem to be just as good or even better. Note that companies will often mention specific competitors by name in their 10-K annual regulatory filings to the U.S. Securities and Exchange Commission (SEC).

Don’t overlook the possibility that mergers and acquisitions (M&A) could boost a company’s growth prospects. Companies that have grown through M&A in the past could be looking for new deals to make in 2021 and beyond.

However, deal-making doesn’t necessarily include an outright purchase of another company. Larger companies sometimes collaborate with smaller players instead of buying them. For example, Vertex Pharmaceuticals teamed up with small biotech CRISPR Therapeutics (NASDAQ:CRSP) to develop gene-editing therapy CTX001 to treat two rare blood disorders, beta thalassemia and sickle cell disease.

2. Financial strength

Those regulatory filings to the SEC also include financial statements that can help you evaluate the financial strength of a given company. Ideally, a company will already be profitable. If it isn’t, make sure you learn how it plans to achieve profitability and how quickly it expects to do so.

A company’s cash position, which includes cash, cash equivalents, and short-term investments, can be found on the balance sheet (a financial statement that lists all the company’s assets, liabilities, and shareholder equity) in its annual and quarterly regulatory filings. Think about cash position the same way you’d think about the amount of money in your checking, savings, and retirement accounts. The more, the better.

Another important gauge of financial strength is the free cash flow (FCF) a company generates. FCF is the cash left over after operating expenses and capital expenditures (money spent on things such as buildings, equipment, and land). As with the cash position, the higher a company’s FCF, the stronger its financial position.

3. Valuation

You’d want to know how much a new car is worth before buying it. Determining the valuation of a healthcare stock before buying it is also important so you can make sure you’re paying a fair price.

There are quite a few valuation metrics here. The most popular is the price-to-earnings (P/E) ratio, which measures the price of a stock in relation to its earnings per share -- what you get in earnings for every dollar you invest.

Some P/E ratios are backward-looking, reflecting earnings over a prior period (typically the past 12 months). Forward P/E ratios, which use earnings estimates for one year into the future, can be more helpful in assessing the valuation of fast-growing healthcare stocks. Comparing P/E ratios with other stocks in the same industry will help you determine if the stock is relatively cheap or relatively expensive.

But just because a stock’s P/E ratio is higher than those of its peers doesn’t mean it’s not a good buy. It could indicate that the company’s growth prospects are much better than those of its rivals. Be sure to also check out the stock’s price-to-earnings-to-growth (PEG) ratio, which incorporates projected earnings growth rates (typically over five years). Stocks with lower PEG ratios (especially when the ratios are less than 1) are more attractively valued than those with higher PEG ratios.

4. Dividends

Some healthcare stocks pay dividends -- a portion of earnings the company returns to shareholders. Dividends can boost the overall return you receive from owning a stock.

The dividend yield tells you how large a stock’s annual dividend payments are as a percentage of the current share price. Consider the stock’s payout ratio, which measures dividends as a percentage of earnings and indicates how much of the company’s cash is being used to cover the dividend. The lower the payout ratio, the greater the likelihood that the company will be able to keep paying dividends in the future.

Your dollars and mine, our capital, is helping shape the world.

David Gardner, cofounder, The Motley Fool

What are the risks of investing in healthcare stocks?

Investing in any kind of stock comes with risks, including the possibility that competitors will develop products and services that are more successful in the marketplace. Healthcare stocks face these risks, as well as others more specific to the sector.

Healthcare is highly regulated. Drugmakers and medical device makers could fail to secure the necessary regulatory approvals to market new products, and regulatory changes could drastically alter a healthcare stock’s growth prospects. In the U.S., the Food and Drug Administration (FDA) oversees the regulation of drugs and medical devices. It’s smart to pay attention to any FDA action related to stocks you’re watching.

Many healthcare stocks also face significant litigation risk. For example, biopharmaceutical companies, medical device makers, and healthcare providers can be sued if patients think the companies’ products and services have caused them harm.

In addition, drugmakers and medical device makers must convince payers, including health insurers, PBMs, and government agencies, to pay for their products. If companies aren’t successful in obtaining reimbursement approvals, their growth prospects could be reduced.

Many healthcare companies are also highly dependent on Medicare reimbursement levels. The Biden administration has called for changes to Medicare to allow the program to negotiate prices with drugmakers. If these changes are made, drugmakers’ revenues and profits could potentially fall as Medicare pays less for some drugs.

Healthcare stocks should have healthy returns

Despite these risks, the overall outlook for healthcare stocks appears very good for the long term. Aging demographic trends across the world, combined with advances in technology, should open up tremendous opportunities for healthcare stocks -- and provide healthy returns for patient investors.

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