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Updated daily. All values annualized from Jan. 2008.

Coming in at #2 in our Magic Formula Business Sector Rankings is the Healthcare sector. This sector accounted for 628 stock days tallied by 25 different stocks. The industry breakdown was as follows:

Morningstar Industry	Stock Days	Unique Stocks
Drugs	329	13
Medical Equipment	148	5
Biotechnology	73	3
Home Health	45	2
Medical Goods & Services	30	1
Managed Care	3	1

Healthcare is one of MagicDiligence's very favorite sectors for investment. There are a lot of attractive qualities in general. First, this is not a particularly cyclical industry - people will spend on healthcare regardless of budget concerns. Second, the demographics in the United States, Europe, and Japan are skewing heavily towards an older population, a result of the "baby boom" after World War II. This demographic trajectory is a strong organic growth driver for healthcare firms, as older people generally require more medical attention. Last, the sector still has a lot of opportunity for exciting breakthroughs, which can be very profitable for early shareholders. The list of uncurable conditions is long, and new products that address these conditions have great potential for big earnings gains.

Drugs and Biotechnology

Easily the largest sub-sector by stock days and unique stocks was the Drugs (Pharmaceuticals) industry. I've also included Biotechnology as these firms are essentially pharma companies, just with different product formulations. Some examples of the 16 Magic Formula stocks from here range from global giants like Amgen (AMGN) to small, focused drug firms like Obagi Medical Products (OMPI).

There are a number of reasons this industry has been largely ignored by the market in recent times. A lot of the blockbuster drugs of the early 2000's are nearing the end of their patent protection, leading to generic competition and huge revenue losses for their developers. Also, "lame duck" election years are difficult for these companies as investors are uncertain as to the level of government intervention to expect from the next administration. A crackdown on medical costs can seriously hamper the profit margins for research driven pharmaceutical companies.

That said, drug companies, especially large ones with diverse pipelines and big R&D budgets, have been extremely successful investments over the past 50 years. Drug development is an expensive and time consuming task (it averages $800 million and 10 years to bring a drug to market), limiting new competitors. Also, since many of these firms pay significant dividends, the cyclical nature of their stock prices due to patent expirations lead to large share accumulations when those dividends are reinvested. Watch out for the small producers with just one or two successful products. When these drugs go off-patent, replacing them with limited R&D resources is a tough chore.

Medical Equipment

Medical Equipment ranked second under healthcare, with 148 stock days tallied by 5 stocks, including laser vision correction company LCA Vision (LCAV) and also laser based aesthetic procedure equipment maker Cutera (CUTR).

Medical equipment is an interesting field, but the potential for economic moats vary based on what kind of equipment we're dealing with. The best moat potential comes from equipment providers that are proprietary and require skill to use. For example, a doctor who specializes in hip replacement surgery is well trained on the equipment of a specific provider (say, Zimmer (ZMH)), and is reluctant to put forth the time and effort to learn a competing product, unless it provides very significant advantages. It is more difficult for providers of every day medical products such as syringes, hospital beds, or the like to have the same kind of competitive advantages.

Home Health

Magic Formula Home Health companies are primarily staffing firms that supply home care aides such as Allied Healthcare (AHCI) or home based equipment providers like Lincare (LNCR), who produces oxygen tanks for home use. Moats are difficult to come buy in the Home Health sector, as barriers to entry are low and service providers can easily be changed. Lincare has been hit by fears of lowered reimbursement costs from Medicare, again highlighting one of the risks to investing in healthcare firms.

The Rest

The final two industries, Medical Goods & Services and Managed Care, each were barely represented on the Magic Formula screen, each with just 1 stock each. It's surprising that Managed Care even made it onto the screen, as Greenblatt specifically filters out insurance companies. In fact, the one Managed Care company, DaVita (DVA), could more accurately be described as a Services provider, being a dialysis equipment and service company. The one Medical Goods/Services Magic Formula stock was AmerisourceBergen (ABC), a pharmaceutical distribution firm.

So why are these stocks on the screen, and might they make good buys? Built-in moat potential is rather low for these two industries, so we have to look for the generic moat drivers - the big fish in a small pond or low cost provider attributes. Looking at AmerisourceBergen, it's certainly not a big fish in a small pond. Drug distribution is big business, and the company not only competes with direct competitors Cardinal (CAH) and McKeeson (MCK), but also with it's own customers who may try to source their own supplies directly from providers. AmerisourceBergen also isn't exactly a low cost provider - they are more of a middleman between the drug manufacturer and the drug seller, not unlike a wholesaling unit between a clothes maker and department store. So, without any real advantages, it's difficult to rely on AmerisourceBergen to continue to be able to drive high returns on capital. This is not to say they won't, only that the odds don't seem to be overwhelmingly with them.

Healthcare - Summary

Healthcare is an attractive field for investment. Demographic trends will inevitably lead to increased healthcare spending, which should benefit companies in this sector. The most promising prospects within healthcare are pharmaceutical and biotechnology firms with large drig pipelines, research and marketing budgets, and providers of medical equipment that is used in specialized clinical procedures instead of general use. It is not unusual to find attractive healthcare investments in the other industries, but more examination is needed to determine if a competitive edge exists to protect recent high returns on capital.

Magic Formula Business Sector Countdown

#9 - Energy

#8 - Software

#7 - Media

#6 - Consumer Services

#5 - Hardware

#4 - Industrial Materials

#3 - Consumer Goods

#2 - Healthcare

#1 - Business Services

MFI Business Sector Project

Steve owns no position in any stocks discussed in this article.

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