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Everybody needs healthcare -- or will at some point. And, when there’s something everyone needs, there’s a huge opportunity for investors.
About $8.3 trillion is spent on healthcare globally. Almost half -- roughly $3.8 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 larger 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.
The healthcare sector is so broad that there are several different kinds of healthcare stocks. Four of the most important types are:
Strong companies can be found within each type of healthcare stock. We’ll break down an example of each below with a look at Vertex Pharmaceuticals (NASDAQ:VRTX), Intuitive Surgical (NASDAQ:ISRG), UnitedHealth Group (NYSE:UNH), and Teladoc Health (NYSE:TDOC).
How can you find the best healthcare stocks to buy? There are four key things to look for:
The most important thing you’ll want to check out with any healthcare stock 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 their strategies for growth and the size of their potential markets. Check out the companies’ rivals to see if their strategies seem to be 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 the future.
Keep in mind that dealmaking 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 beta thalassemia and sickle cell disease, two rare blood disorders.
The SEC filings also include financial statements that can help evaluate the financial strength of a 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) generated by a company. FCF is the cash left over after operating expenses and capital expenditures (which includes money spent on buildings, equipment, and land). As with the cash position, the higher a company’s FCF, the stronger its financial position.
You’d want to know how much a new car is worth before buying it. Determining the value 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. The price-to-earnings (P/E) ratio is the most popular, measuring the price of a stock in relation to its earnings per share -- or 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 a good or bad 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 one) are more attractively valued than those with higher PEG ratios.
Some healthcare stocks pay dividends -- a portion of earnings that 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.
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Investing in any kind of stock comes with risks, including the possibility that competitors will develop more successful products and services. Healthcare stocks face these risks as well as others that are more unique to the sector.
Healthcare is highly regulated. Drugmakers and medical device makers can fail to secure the necessary regulatory approvals to market new products, and regulatory changes can 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 medical 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 buy their products. If companies aren’t successful in obtaining reimbursement approvals, their growth prospects can 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 fall as Medicare pays less for some drugs.
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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