Health stocks have faded, but recovery is now prescribed

If they're right, it will reverse a trend whereby the MSCI World Health Care index fell by 19 per cent over the five years (to the end of July, in sterling terms).

There are several reasons why health stocks have performed weakly - and good reasons to be positive that better times lie ahead. Paul Ilott, an independent financial adviser at Bates Investment Services, says many large pharmaceutical companies have struggled as their drugs came off patent. This has badly affected sentiment.

There have also been problems relating to individual drugs. Vioxx, an important osteoarthritis drug, was recalled, leading many to expect an even tougher stance from the US Food and Drugs Administration (FDA). Tysabri, a multiple sclerosis treatment, was withdrawn after a patient in clinical trials died from a rare neurological disease. This damaged the entire biotech sector. The weak US dollar in recent years has had a negative impact; 64 per cent of the world's health companies by capitalisation are US-based.

Ilott says that even the big UK pharmaceutical groups have high exposure to the US. GlaxoSmithKline earns 47 per cent of revenue from the US, 25 per cent from Europe and only 8 per cent from the UK. AstraZeneca's earnings are sourced 45 per cent from the US, 35 per cent from Europe and 5 per cent from the UK.Returns for UK-based investors have duly suffered.

But now the picture for health shares looks far brighter. The uncertainty of the US Presidential election last year has passed. Although patents will continue to expire, this is discounted into share prices.

Over the longer term, Ilott says, healthcare-related stocks should benefit from the ageing demographic. By 2050, the number of people aged over 65 in developed countries is set to increase by 50 per cent. Those aged over 65 typically buy five times as many healthcare products as the under 65s, meaning that spending on health products will rise significantly.

Tom Digenan, manager of the UBS US Equity fund, is particularly optimistic about the sector. Although he manages a broad US fund, Digenan has dedicated 20 per cent of his portfolio to the healthcare sector, which accounts for 13 per cent of the S&P 500.

His positive view is predicated on finding value in individual health companies. However, he expects the US's 2006 Medicare Prescription Drug Benefit Programme to provide significant price pressure for some, but opportunities for others, such as the pharmacy benefit managers who will gain higher sales volumes. Examples of stocks that should benefit include Caremark, Medco Health Solutions and United Health Group, Digenan says.

In the UK, some fund managers have gone positive on GlaxoSmithKline. They include Adrian Paterson, manager of Artemis UK Growth, and Neil Woodford, manager of Invesco Perpetual Income. Woodford says GSK has had many disappointments in the last few years, with several high quality drug failures close to launch and a number of patents expiring.

But now he believes that is changing. "The concentrated patent hit GSK sustained over the last three years has come to an end. I believe this company now has the best research and development pipeline of any major global pharmaceutical and will be able to talk in much more upbeat tones about some of the drugs that are near to market," he says. He cites Cervarix, a cervical cancer vaccine, as one exciting new product.

A good way to invest in healthcare is via a fund of dedicated health stocks. However, Ilott says you need to have a fairly high degree of conviction to invest in a fund specialising in just one sector of the market. Such funds should be a small holding within a diversified portfolio. It is worth noting that many investors already have sufficient exposure to healthcare via UK, global and US funds. Pharmaceuticals and biotechs now make up 10.7 per cent of the FTSE All Share Index.

If you want to be more specialised, there are the biotech-specific funds. These should not be confused with mainstream health funds, where the pattern of performance is very different. Most mainstream funds tend to have most of their money in pharmaceutical companies, which dominate the sector, with 64.1 per cent of the MSCI World Health Care Index.

"As investments, pharmaceutical companies tend to exhibit more defensive qualities when the global economy is slowing," Ilott says. "That is because even when consumers cut back on other areas of expenditure, most are reluctant to cut spending on healthcare.

"In contrast, biotech companies make up a much smaller part of the MSCI World Healthcare Index - 8.5 per cent - and tend to be far more volatile investments. Nine out of 10 products they develop never make it on to market, which means the potential risks of investing in pure biotech funds can be very high, but so can the rewards."

Gareth Powell, manager of Framlington's Biotech fund, says the sector became very unpopular, and hence cheaply valued, after the Tysabri withdrawal. "Many investors sold out on the back of this news and this creates a good opportunity. The larger, profitable biotech companies are the cheapest they've been for 10 years and small and mid caps are very undervalued."

Also, exciting new products are coming on stream. "There are more than 1,000 products in trials from biotech firms, and more profitable companies. Prospects are more exciting than they have ever been," Powell says.

Five funds for investing in health

* Framlington Health: managed by Deanne Donnigan, this fund aims to hold between 25 and 45 per cent in biotechnology-related stocks (currently 26 per cent), with the balance in more defensive sub-sectors, says Mick Gilligan, a funds analyst at Killik & Co. He says that research is highly focused on bottom-up analysis, in that there is a great emphasis on the underlying businesses. Paul Ilott, an independent financial adviser at Bates Investment Services, adds: "It has a deliberately large weighting in medical devices where regulatory risks are much lower, unlike other types of company in the sector."

* Schroder Medical Discovery: Ilott says performance appears to be turning around since John Bowers took charge of the fund in March 2004. More of the fund is being weighted in large pharmaceutical companies now the outlook appears to be improving. It has 43.8 per cent of assets in pharmaceuticals and 7.5 per cent in biotech, so tends to be more defensive than many funds in the sector.

* Franklin Biotechnology: this is Bates's pick for those who want a specific fund dedicated to biotechnology, says Ilott. This is a highly specialist area, and Franklin is the second largest biotech investor in the United States. It also has offices in San Meto, California, which is situated in the largest biotechnology community in the world. The manager, Evan McCulluch, has been running the US Mutual fund version of this fund since it was launched in 1997.

* Framlington Biotech: managed by Gareth Powell. Gilligan says growth opportunities in this sector remain attractive and valuations are currently low. He has faith in the management team, which he says rarely invests in a company before meeting the management. However, he warns that the fund will be volatile.

* UBS US Equity: this is a broader US fund, but the manager Tom Digenan is very positive on health stocks, which account for 20 per cent of the portfolio. Juliet Schooling, an adviser at Chelsea Financial Services, says this group has a strong team of global equity analysts which carries out extensive research. Currently, UBS favours healthcare stocks based on individual stock-specific opportunities.