NEW YORK (MarketWatch) -- The prospect of U.S. health-care reform creates a dilemma for investors: Avoid medical-related stocks due to political concerns or buy into growing companies with some strong qualities.

Despite the sector's robust performance over the past few weeks and positive earnings outlook, politics weighs heavily on health care. On Tuesday, House Democrats unveiled a bill that would make health insurance available to almost all Americans and lead to sweeping industry-wide changes.

The impact of reform will likely be felt in different ways. Some mutual-fund managers who've looked at the industry say that hospitals should prosper while insurance and drug companies may suffer. Others say big pharmaceutical makers offer opportunities, along with medical technology companies.

The key for investors is that it's important to distinguish within the health-care sector itself.

"Certain sub-sectors are much more high-margin, and the more profitable ones may be bigger targets of the government," said Rob Junkin, senior portfolio manager of Evergreen Health Care Fund (EHABX) .

Seven of the 10 sub-sectors that make up the broader health-care sector posted positive returns this year through July 10. Health-care facilities led the pack, up 32%, while life sciences tools and services rose 16%, according to Standard & Poor's Equity Research. The health-care sector was the fourth-best performer among S&P's 10 market sectors, down 3% -- in line with the S&P 500.

Yet health-care stocks are expected to post the best second-quarter earnings, according to Thomson Reuters, albeit down 1% year-on-year. Thomson Reuters predicts health-care services earnings to rise 12% and biotechnology to climb 9%.

The industry was also the one so-called defensive sector that significantly beat the market in the wake of last year's crash.


Choosing carefully

But politics still clouds the investment prognosis.

"Democrats can put through whatever they want" because they have the numbers in Congress, Junkin said. While he expects the Senate's proposal to be less radical than the one put forward by the House, the question is whether a public-plan option is in the final bill.

The public option would be a "pathway to getting nationalized health-care in the next five- to 10 years," Junkin predicted.

Ironically, concern and confusion about the future of health care is exactly why many stock-fund managers like the sector now. Share prices have been discounted as the market prices in investor worries about earnings -- and managers see bargains.

Health-care "stocks had been too discounted, almost to the worst-case scenarios," said Uri Landesman, head of global growth at ING Investment Management, a unit of ING Groep (ING) .

Landesman said he's recently been buying health-care stocks, moving to overweight from underweight on the sector. "It's very unlikely that you'll see revolutionary change," he noted. "Anything that even comes close to universal coverage would be amazing."

Peter Langerman, chief executive of Mutual Series, a group of value-stock funds offered through Franklin Templeton Investments, said he has mixed feelings about health-care, recognizing problems but still holding companies in the space.

He's bullish on hospitals, pointing out that while some hospitals have debt, moves toward universal coverage should be positive because "the uninsured population has been a drag" on hospital revenues.

Indeed, the health services sub-sector, which includes hospitals, was one of the few areas of health care that was consistently popular with money managers.

"If there's going to be meaningful reform then health services [such as hospitals] need to make more money," said Dan Chung, chief executive and chief investment officer of Fred Alger Management. Chung added that 43% of all U.S. hospitals lost money in the first quarter, up dramatically from a year earlier, when one of every four lost money.

Critical conditions

Evergreen's Junkin, though, warned that while hospitals should be a "net beneficiary" from any industry makeover, "there's going to be pressure on margins in most of the [health-care] sector's companies."

Chung said reform that helps hospitals earn profits will be less controversial than one that helps insurance companies, while Junkin speculated that reform would hit the managed care sector -- including insurance companies and HMOs -- harder than any other area of health care.

Managed care is the one area where Junkin is significantly underweight; he's most enthusiastic biotech and medical technology.

Langerman, meanwhile, said he favors shares of major pharmaceutical companies for what he calls an arbitrage angle.

"It's less specific to health-care and more about mergers and acquisition deals," he said. "If you put aside reform questions, big pharma has issues with patent expirations, smaller number of drugs and big marketing, research and development and distribution costs."

This situation can push companies into making deals to save costs and diversify, such as Pfizer Inc.'s (PFE) purchase of Wyeth (WYE) . Langerman expects more health-care M&A deals in the future.

Chung also applauded the Pfizer-Wyeth deal, but said he's otherwise skittish about large-cap pharma. He shies away from companies such as Merck & Co. (MRK) , Schering-Plough Corp. (SGP) and Eli Lilly and Co. (LLY) .

ING's Landesman is more hopeful about pharmaceutical manufacturers in part because he doesn't see reform hitting drug prices. The focus on cost control, he said, will be on "unnecessary medical tests, which will hurt makers of expensive medical devices."

Junkin said cost control is a factor in the stocks he likes -- companies that can help cut costs are likely to be popular. Health-care technology provider Cerner Corp. (CERN) is one such outfit, he said, as streamlining systems should help reduce expenses.

Chung said he likes smaller drug firms -- often biotech companies -- because unlike the larger players they're finding new drugs.

Optimer Pharmaceuticals Inc. (OPTR) is a favorite, in part for an antibiotic it has in development that could counteract "superbug" infections. Chung also named Auxilium Pharmaceuticals Inc. (AUXL) , which is in late-testing of the drug Xiaflex, which treats a hand deformity.

Both Chung and Langerman also recommended Community Health Systems Inc. (CYH) , which operates hospitals in non-urban markets.

Community Health Systems is expected to see earnings per share of $2.51 in 2009, according to analysts surveyed by FactSet Research, which would reflect 15% year-on-year growth. Analysts project earnings per share of $2.81 in 2010, which, based on a current P/E of about 13, would suggest a share price in the mid-$30 range.


But while Langerman likes both Community Health Systems and Tenet Healthcare Corp. (THC) , he approaches them with some caution.

"For different reasons they both have significant debt," said Langerman. "Apart from the potential benefits from [political] reform, each must continue to execute on their operational plans in order to pay down and/or refinance their debt.

"If they are successful, the equity has significant upside," he added.

It's important for investors eyeing health-care investments to take a look at their existing portfolio. For the most part, diversified stock funds already have a healthy slice of their holdings in the sector -- a large-cap stock fund such as Mutual Series' Mutual Beacon Fund (TEBIX) , for example, recently had about 10% of its assets in health care, according to investment researcher Morningstar Inc.

For investors who want direct access to health-care stocks, there are dozens of specialized mutual-funds and exchange-traded funds.

Among ETFs, the largest broad sector funds are Health Care Select Sector SPDR ETF (XLV) , iShares Dow Jones U.S. Healthcare ETF (IYH) and Vanguard Health Care ETF (VHT) .

Morningstar recommends three health-care mutual-funds: Hartford Global Health Fund (HGHAX) , T. Rowe Price Health Sciences Fund (PRHSX) and Vanguard Health Care Fund (VGHCX) . Reflecting the sector's variations, these three funds were down 0.7%, up 6.5% and up 0.8%, respectively, this year through July 14.