For bargains, check out high-quality healthcare stocks

Drug pricing concerns have indiscriminately weighed on healthcare stocks; these names look undervalued.

Karen Wallace 14 September, 2016 | 5:00PM
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If you're searching for stocks selling at reasonable valuations, you may have your work cut out for you. According to the Morningstar Market Fair Value chart, the average stock in our global coverage universe is about 3% overvalued (at 1.03)--just below the 52-week high of 1.04. 

But there are some sectors that haven't been as buoyant as others. For one, healthcare has faced its share of headwinds, mainly surrounding drug pricing. A high-profile recent example was the criticism surrounding price increases for  Mylan's (MYL) EpiPen emergency allergy shot. Presidential candidate Hillary Clinton also made headlines outlining her proposed plan to respond to what her campaign refers to as "unjustified price hikes" in established treatments that have been on the market for a long time--by making alternative treatments available and imposing fines for unjustified price increases. 

But we think many healthcare stocks that aren't likely to be as impacted by pricing control legislation are being unfairly punished by these concerns. Morningstar sector director Damien Conover points out that the passage of the plan in Congress would be very uncertain, but even if the plan were to be implemented in some form, innovative generic drugs and older branded drugs would be most greatly impacted by price controls. 

"We believe the core element of patent protection supporting drug prices is still intact, supporting our moat ratings in the pharmaceutical and biotechnology industries," Conover said. He adds that our current moat ratings reflect "our skeptical outlook on less innovative companies and their weaker prospects for pricing power." Conover points to no-moat and negative trend ratings for Ireland-based  Endo International (ENDP), which has a considerable presence in established pain-management medications, and UK-based  Mallinckrodt (MNK), which focuses on generics.

To find some high-quality undervalued stocks in the healthcare sector, we screened for stocks on our coverage list that were rated 4 or 5 stars, which indicates that we think they are undervalued relative to our estimate of their fair value. We then we looked for companies with a fair value uncertainty rating of medium or lower, which means we think we can more tightly bound the fair value because we can estimate the stock's future cash flows with a greater degree of confidence. Finally, we looked for stocks with an economic moat rating of wide or narrow--we think they have advantages that will fend off competitors for at least 10 years.

Roche Holding AG
Ticker RHHBY
Current yield -
Forward P/E 15.0
Price US$30.88
Fair value US$42
Data as of Sep. 12, 2016

Strategist Karen Andersen thinks  Roche's (RHHBY) combination of a strong drug portfolio and industry-leading diagnostics results in sustainable competitive advantages. In the pharmaceutical segment, Andersen points out that blockbuster cancer biologics acquired with Genentech--including Avastin, Rituxan, and Herceptin--continue to grow quickly as they gain market share in approved indications, and they have also gained approval in new indications as well as in emerging-markets. Roche's diagnostics business is also industry-leading: With a 20% share of the global in vitro diagnostics market, Roche holds the number-one spot in this industry. The firm's wide moat owes to its status as the leader in oncology therapeutics (30% market share) as well as in vitro diagnostics (20% share); further, Andersen points out that Roche "has a promising strategy of combining its expertise in both areas to generate a growing personalized medicine pipeline."

Express Scripts Holding Co.
Ticker ESRX
Current yield -
Forward P/E 10.4
Price US$72.10
Fair value US$100
Data as of Sep. 12, 2016

The contract for  Express Scripts' (ESRX) largest client, Anthem, will be soon up for renewal, which has created some uncertainty for the pharmacy benefits manager, says senior analyst Vishnu Lekraj. But even in the face of this uncertainty, the firm issued a largely positive outlook for the remainder of 2016 and 2017 during its second-quarter report. Express Scripts is the largest PBM, with more than 1.3 billion adjusted claims processed in 2015. This gives the firm unparalleled supplier pricing power and scale advantages (supporting its wide economic moat rating), says Lekraj.

ResMed Inc.
Ticker RMD
Current yield 1.87%
Forward P/E 18.9
Price US$65.64
Fair value US$77
Data as of Sep. 12, 2016

As one of the key players in the market for sleep apnea,  ResMed (RMD) is well positioned in an "underpenetrated" market, says equity analyst Chris Kallos. Kallos points out that ResMed has a strong track record of innovation in sleep apnea and respiratory disorders, and the company spends heavily on research and development, which should allow it to continue to maintain its technological edge and continue develop new treatments going forward. He believes that growth should continue on a strong trajectory as more patients incorporate ResMed's noninvasive treatments into their sleeping patterns. In addition, Kallos says ResMed's marketing and education efforts are raising the clinical profile of sleep-disordered breathing and increasing awareness of sleep apnea in particular. 

McKesson Corp.
Ticker MCK
Current yield 0.62%
Forward P/E 12.1
Price US$180.47
Fair value US$222
Data as of Sep. 12, 2016

Lekraj points out that  McKesson (MCK) is the largest pharmaceutical distributor by revenue and is the main supplier to large pharmacy outlets CVS Health mail order pharmacy and Wal-Mart. The firm is facing a significant near-term client loss with the acquisition of Rite Aid by Walgreens, as well as partial losses of its Target and Omnicare contracts. But Lekraj believes the firm has been able to offset some of these pressures: "First, the firm has been able to backfill a good amount of lost generic wholesale volume through the expansion of its Albertsons and Wal-Mart client relationships. Secondly, we believe the drug distributor's recent restructuring enhanced its already highly efficient procurement and distribution operations." He believes that pharmaceutical distributors such as McKesson possess a wide economic moat because as they are able to translate their significant market share into key competitive advantages. 

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
McKesson Corp580.13 USD0.29Rating
ResMed Inc203.15 USD-0.36Rating
Roche Holding AG ADR39.27 USD-0.18Rating

About Author

Karen Wallace

Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.

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