Health care among early leaders in the S&P 500

NEW YORK (AP) -- Health care stocks have started off the year on a tear.

The industry group that includes health care providers, drugmakers and biotechnology companies has advanced 7.3 percent this year, making it the second-best in the Standard and Poor's 500 index, trailing only energy companies. Even drugmakers, traditionally considered a safe-haven play, are outperforming the market.

The rally has solid foundations, but not all companies will benefit equally from the influx of cash. Also, the wide range of stocks in the sector offer investors vastly differing risk and return dynamics.

U.S. health care spending is projected to climb at a faster pace than economic growth in coming years as the population ages and President Barack Obama's Affordable Care Act gives millions of Americans greater access to care.

The Centers for Medicare and Medicaid Services projects that total health care spending will rise 70 percent over last year's estimated level of $2.8 trillion to $4.8 trillion by 2021. That's almost 20 percent of U.S. gross domestic product.

"There's just a lot more money flowing into health care and we're seeing the markets react accordingly," says Derek Taner, a portfolio manager at Invesco.

President Obama's re-election in November gave the sector a boost by removing the uncertainty surrounding the implementation of the Affordable Care Act. Republican candidate Mitt Romney had said that he would overturn the act if elected.

The biggest beneficiaries of the act will likely be hospital companies, which have the potential to increase their earnings significantly, says Taner, who manages Invesco's Global Health Care fund.

So-called managed-care companies should also benefit from the increase in spending, though they also face higher taxes and restrictions on how they can price their coverage, so the law will be challenging to them too.

HCA Holdings Inc., a bellwether for the hospital industry, has gained 25 percent so far this year. Tenet Healthcare Corp., a Dallas-based operator of acute care hospitals, has advanced 20 percent.

Drugmakers, often regarded as defensive growth companies by analysts, are also emerging from the doldrums after lagging the broader index for much of the last decade.

Pfizer Inc., the world's biggest drugmaker by revenue, has returned 31 percent over the last 10 years, compared with 113 percent for the S&P 500.

The big pharmaceutical companies were shunned by investors as they faced challenges from rising research costs and the economic slump in Europe, which prompted governments to try to rein in health care spending.

Drug companies were also hurt by what the industry dubbed the "patent cliff," as an unprecedented number of patents expired on drugs worth billions of dollars in sales. The expiration of patents allows cheaper generic versions of drugs to replace blockbuster products. That hurts sales.

Pfizer lost exclusivity for its cholesterol-fighting drug Lipitor in the U.S. in November 2011. In its most recent earnings report, Pfizer said that U.S. revenues from the drug plunged 87 percent in the third quarter of 2012 to $192 million. The company will release its fourth-quarter earnings Tuesday.

The worst of the impact of patent expiration may now be over for the drugmakers, and the market has already factored it into stock prices, says Mark Bussard, a health care analyst at fund manager T. Rowe Price.

"The 'patent cliff' for most of the companies has now come and gone," says Bussard, who is a physician by training. "Some of the largest losses to generic competition are in the rear-view mirror now."

Approvals for first-of-a-kind drugs have also been climbing as drugmakers continue to pursue an emerging business model focused on treatments for rare and hard-to-treat diseases.

The Food and Drug Administration approved 39 new drugs last year, up from 30 the year before and the highest annual tally since 1997, when the agency also approved 39 drugs.

In addition to being relatively low-risk investments, due to the steady demand for drugs, Big Pharma also pays big dividends.

The largest drug companies in the S&P 500 have higher dividend yields than the broader index, which yields 2.1 percent. Pfizer currently has a 3.6 percent yield and Merck & Co. yields 4 percent.

Biotechnology companies are possibly the most exciting companies in the sector and are also advancing.

Investing in this sector can be challenging, though, as the vast majority of drugs being developed don't work out.

"It's probably unwise ... to try to pick the individual winner," says Sam Isaly, the manager of Eaton Vance's Worldwide Health Sciences Fund. "It depends on whether you're a lotto player or not."

While the Affordable Care Act ensures that money will flow into the industry in the near term, that spending can't keep rising exponentially. At some point, the focus will turn to the cost of the reforms, particularly if the initial spending estimates are exceeded, causing renewed uncertainty for the industry.

"That's a longer-term concern that is going to come into play at some point," says Invesco's Taner. "Right now we're in the honeymoon period. People aren't thinking about that."

And if history is a guide, the cost estimates will likely prove too low.

Upon passing the Medicare bill in 1965, the House Ways and Means Committee estimated total program expenditures would amount to $1.3 billion in 1967. That estimate proved to be "wildly optimistic," with the actual cost coming in at $4.6 billion, according to research by Citigroup health care analysts.

To counter the rising costs, governments and employers will increasingly try to shift more of the cost to individual consumers, transforming the industry from an "employer-driven insurance market" to an "employee-driven consumer market," says Eddie Yoon of Fidelity.

"The companies that are the most innovative in helping drive costs down are going to be the growth companies of tomorrow," says Yoon, who manages the investment firm's Select Health Care Portfolio.

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AP Business Writers Matthew Perrone and Linda Johnson contributed.