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        Investing in Healthcare Stocks

        Updated: Oct. 5, 2020, 5:13 p.m.

        Everybody needs healthcare. Or at least they will need it at some point in their lives. And when there’s something that everyone needs, there’s a huge opportunity for investors.

        Over $7.8 trillion is spent on healthcare globally. Nearly half of that total -- $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 of healthcare stocks 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 to develop drugs. 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 that are used in the care of patients. These devices range from simple, such as disposable gloves and thermometers, to 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 line delivering healthcare services to patients. They include hospitals, physician practices, home health companies, and long-term care (LTC) facilities.

        Top healthcare stocks

        Strong companies can be found within each of type of healthcare stocks, and we're breaking down an example of each below with more on Vertex Pharmaceuticals (NASDAQ:VRTX), Intuitive Surgical (NASDAQ:ISRG), UnitedHealth Group (NYSE:UNH), and Teladoc Health (NYSE:TDOC).

        • Vertex Pharmaceuticals (NASDAQ:VRTX) stands out as one of the top pharmaceutical 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 and 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. Intuitive should have tremendous growth opportunities ahead with higher numbers of older individuals 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 and stability 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 growth prospects appear to be very good, with individuals, employers, governments, and health insurers seeking to control healthcare costs -- which telehealth helps achieve.
        Physician using a stethoscope to focus on icons of a person, heart, pills, and additional medical iconography.

        Image source: Getty Images

        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. See how quickly the company’s 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, it probably won’t be able to do so going forward.

        Read companies’ investor presentations on their 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. By the way, companies will often mention specific competitors by name in their 10-K annual regulatory filings to the U.S. Securities and Exchange Commission (SEC).

        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 the company 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 of the company’s assets, liabilities, and shareholder equity) in its annual and quarterly regulatory filings. Think about this in 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) that a company generates. FCF measures the cash left over after paying for operating expenses and capital expenditures (money spent on things like buildings, equipment, and land). As is the case with the cash position, the higher a company’s FCF is, the stronger its financial position is.

        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 is also important so you can make sure you’re paying a fair price for it.

        There are quite a few valuation metrics that can be used. The most popular one 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 of time (typically the last 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.

        Just because a stock’s P/E ratio is higher than its peers doesn’t mean that it’s not a good one to buy, though. It could indicate 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 a five-year period). Stocks with lower PEG ratios (especially when the ratios are less than one) are more attractively valued than those with higher PEG ratios.

        4. Dividends

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

        The dividend yield tells you how much 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 is, the greater the likelihood is 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 other risks more specific to the healthcare sector.

        Healthcare is highly regulated. Drugmakers and medical device makers could fail to secure the necessary regulatory approvals to market their new products. Regulatory changes could drastically alter a healthcare stock’s growth prospects. In the U.S., the Food and Drug Administration (FDA) oversees regulating drugs and medical devices. It’s smart to pay attention to any FDA events related to stocks that 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 that 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, it could reduce their growth prospects.

        Healthcare stocks should have healthy returns

        Despite these risks, the overall outlook for healthcare stocks appears to be very good over 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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