A Healthcare Portfolio for an Aging Society

The greatest unknown in retirement planning is the uncertainty of future healthcare expenses. On average, they will total between $250,000 and $300,000 for the typical retired couple. And this is for out-of-pocket spending—after all the insurance and other benefit programs have helped pay medical bills. Although it's admittedly a bit whimsical, one way to cushion the impact could be to invest in a portfolio of healthcare companies that cater to an aging population. These are firms whose products and services are particularly keyed to an aging population. Think of it as the perfect hedge against those unknown healthcare expenses.

[See 3 Industries Riding the Wave of Aging Boomers.]

Jay Nogueira, a healthcare analyst at T. Rowe Price, says the reality of an aging society has not yet sunk in. Even though we see the numbers all the time—78 million baby boomers nearing retirement, 80-year-olds becoming the fastest-growing segment of our population—they remain "future tense" in our minds. "The general perception is that we keep getting older," he says, but the transition has been gradual so far. Looking at the share of our population that's age 65 and older, Nogueira says, "We've been somewhere around 11 to 12 percent since 1980." But in 2011, when the first baby boomers begin to turn 65, this portion will begin surging, and it will hit 20 percent in only 20 years. "That is just enormous on the scale of what we're talking about."

Nogueira, Morningstar's Paul Larson, and Todd Rosenbluth of Standard & Poor's each provided four healthcare picks they expect to flourish in a graying society. Rosenbluth recommends two healthcare funds that invest in stocks S&P likes—DWS Health Care fund (symbol SCHLX) and Fidelity Select Medical Equipment & Systems Portfolio (FSMEX).

We've already seen a surge in healthcare's share of the economy. One in every 6 dollars we spend is for a medical expense. That's widely forecast to rise to $1 in every $5—or even higher—before it levels off. While a lot of this spending is related to sustained inflation in what we pay for healthcare, the future propellant for healthcare spending will be the huge rises in the number of older people needing increasingly extensive, and expensive, medical care. "It's pretty stunning," Nogueira says, referring to the greater use of healthcare by those over the age of 65. "They use three times the number of prescriptions per capita . . . and five times the number of hospital bed days."

[See Your Guide to Maximizing Medicare.]

From an investment perspective, this rising tide will not lift all healthcare stocks, he cautions. First, investors should look for "pure play" companies that do all of their business in attractive healthcare markets. Nogueira recommends passing up big conglomerates. GE, for one example, is investing heavily in expanding its healthcare business, but the company is so big and diversified that the gains it achieves will most likely be a modest percentage of its overall profitability.

Second, the healthcare opportunities generated by changing demographics may be hurt by other trends. Large pharmaceutical companies, for example, may have a great upside, but they're facing serious erosion of their business base as their proprietary drugs lose patent protection and must compete with generics. There also may be serious curbs on the profitability of pharmaceutical companies because of government reimbursement rules. "Don't buy the brand drug companies for the demographics," Nogueira warns. "The patent question is a train wreck."

Larson says medical device makers involved in joint replacements will benefit from soaring numbers of people seeking replacements. Millions of obese Americans will need replacements because they've exercised too little; many others will want replacements because they've exercised too much and want to continue their active lifestyles. And though Larson agrees that patent expirations are a challenge to prescription drug companies, some pharmaceutical makers have thrived in this environment, and he expects them to continue to do so.

Rosenbluth says S&P analysts like the medical device category as well as companies involved in cardiovascular procedures and those whose business is linked to laboratory tests, which are expected to grow in volume along with the surging senior population.

To do really well, Nogueira figures, a healthcare company not only needs a demographic boost from the aging but also must be the low-cost provider in its industry. Anticipating long-term lower economic growth and continued pressure on consumer spending, he says, "You need to find the lower-cost option, or else the [demographic] equation doesn't work."

Look for winners within the hospital, medical device, and healthcare information technology industries, he says. The easiest bet is on low-cost makers of generic drugs. "Generics provide a no-brainer value proposition," he says. "I like the private-label market as well." Perrigo Co., for example, is the world's largest maker of store-brand products for over-the-counter drugs, a category that Nogueira says will surge in an aging society. "People will have fewer dollars, but they will need to buy the same stuff," he says. Right now, the market share for store-brand OTC drugs is only 25 percent, he says.

Here are stock picks for a healthcare portfolio for an aging society (data and descriptions are from S&P MarketScope Advisor as of October 31).

Paul Larson, Morningstar equity strategist and editor, StockInvestor:

• Johnson & Johnson (JNJ) provides pharmaceuticals, medical devices and diagnostics, and consumer care products. Price: $59.05; 52-week range: $46.25 to $63.01; market capitalization: $162.7 billion.

• Novartis AG (NVS) provides branded and generic pharmaceuticals, eye-care and consumer health products, and animal health drugs and products. Price: $51.95; 52-week range: $33.34 to $52.78; market capitalization: $118 billion.

• Stryker Corp. (SYK) provides medical devices in the orthopedic implants and medical and surgical equipment markets. Price: $46; 52-week range: $30.82 to $56.22; market capitalization: $18.3 billion.

• Zimmer Holdings Inc. (ZMH) designs, develops, makes, and markets orthopedic and dental reconstructive implants, spinal implants, trauma products, and related surgical products. Price: $52.57; 52-week range: $30.67 to $55.76; market capitalization: $11.3 billion.

Jay Nogueira, healthcare analyst, T. Rowe Price:

• Cerner Corp. (CERN) provides healthcare information technology services, healthcare devices, and related services. Price: $76.04; 52-week range: $30.37 to $85.97; market capitalization: $6.2 billion.

• Eclipsys Corp. (ECLP) provides integrated clinical, financial, and management information software to hospitals and other healthcare organizations. Price: $18.75; 52-week range: $7.39 to $21.15; market capitalization: $1.1 billion.

• Healthways Inc. (HWAY) provides disease management, prevention, and wellness services to consumers through health plans, employers, hospitals, and other institutional partners. Price: $16.08; 52-week range: $5.35 to $19.44; market capitalization: $540 million.

• Perrigo Co. (PRGO) is the world's largest maker of over-the-counter pharmaceuticals for the store-brand market and also has prescription pharmaceuticals, nutritional products, active pharmaceutical ingredients, and medical diagnostic products. Price: $37.19; 52-week range: $18.54 to $38.95; market capitalization: $3.4 billion.

Todd Rosenbluth, Standard & Poor's equity and mutual fund analyst:

• Boston Scientific Corp. (BSX) provides minimally invasive medical devices in interventional cardiology, cardiac rhythm management, peripheral intervention, electrophysiology, gynecology, oncology, urology, and neuromodulation. Price: $8.12; 52-week range: $5.41 to $11.77; market capitalization: $12.2 billion.

• Celgene Corp. (CELG) develops and markets pharmaceuticals to treat cancer, immunological disorders, and other diseases. Price: $51.05; 52-week range: $36.90 to $66.50; market capitalization: $23.4 billion.

• Edwards Lifesciences Corp. (EW) develops, makes, and markets products and technologies that are designed to treat advanced-stage cardiovascular disease. Price: $76.94; 52-week range: $44.76 to $78.60; market capitalization: $4.3 billion.

• Medtronic Inc. (MDT) provides medical devices in categories that include cardiac rhythm management, spinal therapies, vascular therapy, neurology, and cardiac surgery. Price: $35.70; 52-week range: $24.06 to $41.29; market capitalization: $39.5 billion.