The 3 Best-Performing Healthcare Stocks in the S&P 500 in 2017

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The S&P 500 ETF had a remarkable year in 2017, but its returns were nothing compared to the returns enjoyed by Align Technology (NASDAQ: ALGN), Vertex Pharmaceuticals (NASDAQ: VRTX), and Centene Corp. (NYSE: CNC) investors. Those three stocks delivered eye-popping gains last year that more than tripled the broader index. Can their winning ways continue in 2018?

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In this episode of The Motley Fool's Industry Focus: Healthcare, analysts Kristine Harjes and Todd Campbell discuss why investors were tripping over themselves to buy shares in these companies in 2017 and what could be on tap for these stocks in 2018.

A full transcript follows the video.

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This video was recorded on Jan. 3, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Wednesday, January 3rd, 2018. I'm your host, Kristine Harjes, and I'm joined via Skype by healthcare expert Todd Campbell. Todd, Happy New Year! Did you get some holiday family time in over the holidays?

Todd Campbell: Happy New Year! Oh, yeah, absolutely! I don't know about how cold it is down there at world HQ, but we stayed nice and quiet, relaxed, stayed inside the house, it's just too cold up here in New Hampshire to go anywhere.

Harjes: I feel like I should complain about how cold it is in Alexandria, Virginia, but it has to be worse by you.

Campbell: Well, I know we're the Healthcare podcast, but I can't help but think, with all the oil that I'm burning through heating my home, that I should be hedging some of that exposure by buying some energy stocks.

Harjes: Yeah, seriously. I turned my fireplace on this morning for the first time all year.

Campbell: Oh, first time all year!

Harjes: You're like, tell me about it, I've been doing that for months. [laughs]

Campbell: You can't complain. [laughs]

Harjes: So, it's the new year, as we mentioned, so we thought today's episode, we'd do a little bit more reflecting on 2017, which you're probably all groaning because we just did that on the last two shows. But, a different take on it for this show. We're doing a top performing healthcare stocks from the S&P 500 throughout the year of 2017. So, we'll be highlighting the top three stocks by performance in the S&P 500, which is the 500 largest U.S. companies by market cap. So, that means it's companies that are at least $6 billion in size, so you're not going to hear a lot of the tiny biotechs that, Todd, you and I love talking about. But, it's definitely larger, more established companies that still had killer returns in 2017.

Campbell: Yeah, I think it's relevant, right Kristine? It was a remarkable year for the S&P 500 last year.

Harjes: Seriously, total return of 22%.

Campbell: You don't see many of those, and I had the grey hair to prove it. [laughs] You don't see many of those. The stocks we're going to be talking about today, which a lot of people will own in their portfolios even if they're not healthcare investors, because they are part of the S&P 500, and I know a lot of our listeners probably have an S&P 500 Index fund somewhere in their retirement portfolios or whatever. So, this is going to be relevant to them, and it's also going to be relevant to the Healthcare listeners. These three stocks are not necessarily the three that may jump to mind as being stocks that are front and center in your mind when you think of the sector.

Harjes: Yeah. Even when you think of the top performers. When I got this list from you, I was like, really? It's those? I was thinking, of course it's going to be three biotechs that had crazy clinical trial results, and they grew 800% overnight. But as I mentioned, these are larger stocks in size, so they're not the pre-commercial-stage biotechs. Actually, only one of them is a biotech at all. One of them is a medical device maker, and the other one is an insurer.

Campbell: Remarkable. And we'll dive into how weird this is, especially that insurer, later on in the show, I'm sure, especially what we were anticipating coming into 2017. But, it's a really interesting list of names. And what's really wild is, when you think about the returns that these things generated -- yeah, the S&P was up a remarkable 22%, but the returns of these stocks trounced the S&P.

Harjes: Mm-hmm. The first one on our list is Align Technologies, that's ticker ALGN. They were up 132.3%. This is the aforementioned medical device maker. They are trying to disrupt the world of braces, which is an admirable mission, but for some reason in my head, this is a comical stock to me. Like, who really thinks too much about braces? Unless you're a kid with braces, or a parent paying for your kid to have braces, or an adult going through the process of braces, it's just not something that you think about day to day. But, it turns out there's a huge market for this, and they're trying to totally overhaul the system of the metal and the wiring and all the constant tweaking and the pain that comes with traditional braces.

Campbell: Right. People probably don't know the name Align Technology, but they may very well know the name of their product, Invisalign.

Harjes: It's like Band-Aid, it's the brand name when it comes to invisible dental corrective wear.

Campbell: Right. Think about that. You have these metal braces, they're big, they look prehistoric, like something from a Medieval ages' torture room or something. And now you have this product that you can put on your teeth that will straighten your teeth that's clear, and it's not so noticeable. You can take a selfie and have it not glinting with flashbulb lights. It's a very disruptive product. And it's not a new product. It's been around for years, Kristine. I think in 2017, people finally woke up to the story of just how big the market is for metal braces, and how disruptive this could be not just in North America, the U.S., but globally. I mean, this is a global company.

Harjes: I think the company itself opened its eyes to the real opportunity here. When they first started out, they were only focused on adults in the United States. And now they're starting to expand that vision a little bit. They're looking internationally, as you mentioned. China just overtook Canada as their largest market. Meanwhile, they're still pursuing Canada very heavily. They opened an office there in August, and they're looking at other countries as well. They're also looking at teens. Teens are increasing as a portion of their total patients that are using the Invisalign product. And that's not to say that the adult population isn't growing. This one is particularly interesting to me, because I think the teen market is even harder to enter, since it's the parents paying, and as a parent -- I say that like I'm a parent. I'm not a parent. If I were a parent, I don't know if I would trust my teen to use Invisalign properly. I mean, it's a device that you can take out, so there is a compliance factor here. But they've been doing really well marketing to teens and their parents and expanding that addressable patient population.

Campbell: Yeah. And you know what, Kristine? I think the two big trends of 2017 that helped catapult this stock higher were, indeed, China and teens. Those two -- just think about the patient population, the addressable market in China. It's huge. And as that country gets wealthier, more and more people are going to start looking at these kind of vanity things, like, how straight are my teeth. With the teen markets, it's interesting, too, because when you think of Invisalign, or I do, I think of it when it first came out. Like you said, it was for adults, it was for repairing or straightening teeth that weren't really that crooked. It was kind of a niche product. Well, over the course of the last few years, they made advances in the technology, and that's now allowing these things to be used, like you said, in more and more complex, including in teens. I wanted to highlight this, because I think this is a good example of how the innovation is driving demand for this, they now have the ability to be able to not only straighten teeth, but also to adjust the lower jaw. And that kind of complexity, previously, you couldn't use an Invisalign for something like that. It's estimated that 30-45% of teens require both teeth straightening and the movement of the jaw. And that was just something that couldn't be addressed before by Invisalign. Now it can be. I think they're still waiting for an FDA go ahead for here, but I think this is available in Canada and elsewhere on the planet, and I would imagine it would be available here very soon.

You mentioned the costs being prohibitive. This is a smart company. They're doing things to try to overcome that obstacle. You have a program out there right now that provides third-party financing. So, they're not taking on any bad debt expense risk, or anything like that. They're just using a third party to finance this stuff. And that helps to remove an obstacle to adoption. As they're doing that, they're selling more and more cases of Invisalign. It's an expensive product. And, like most of these companies, when volume rises, and you can leverage that against your fixed costs, you get greater profitability. So, you have a company that's growing gangbusters, some 30% year over year top line revenue growth, that's also now generating bigger and bigger operating margins. Operating margins are in the 25% range, and that's up around 3% year-over-year.

Harjes: And that's that strong brand name right there. They have pricing power. Braces in general are not cheap. You think about insurance coverage, most people in the U.S. don't have great insurance coverage. So, if you're covered at all for braces, maybe it's going to be 50% coinsurance, probably more than that. So, in general, these types of procedures are things that people are very used to spending thousands of dollars on. So, I think when you're already going to have that sort of line item in your medical expenses for the year, and you look at how much more comfortable and the aesthetics of this, and you can have less food restrictions because you can take them out, I can see why, particularly a lot of adults who will often not be covered for braces at all by insurance if you're over the age of 18 will turn to Invisalign.

Campbell: Yeah. And the other thing we should probably mention is, they make the scanners that orthodontists can use now to map out the mouth and figure out what kind of a treatment plan they should be using with Invisalign. And sales of those scanners are rising really rapidly, too. So, you have to imagine that, as more of those scanners get embedded in these offices, you're just naturally going to get tailwinds toward demand and use of Invisalign by these practices. It's a really nice, I don't know if it's kind of a weird twist on the razor and blade model, but it's a nice symbiotic relationship. They sell you the scanner, and now, selling the scanner, you can drive volume for the Invisalign to all of your patients. The thing that's really remarkable about this company -- and full disclosure, I own it, so I was very fortunate this past year. I've owned it since 2014. The thing that's really interesting to me about this story is, they really still have a lot of running room. They estimate their market share of all the patients that can treat globally at just 8%.

Harjes: That's crazy! That's really nuts!

Campbell: So, think about, they're growing 38% on the top line, year-over-year, on the most recent quarter. They're probably going to go 30% roughly at the midpoint year-over-year in the fourth quarter when they report. And yet, they only have 8% of the global market?

Harjes: That's incredible!

Campbell: Yeah. I think of this as a really interesting story. Yeah, you always look at a stock, it's up 130%, could I buy it now? Well, I don't recommend chasing anything, but we are Foolish investors and we like to look long-term, and when you look long-term, you have to look at that addressable market and the market share today and say, well, there's still opportunity for growth here, so this is a name maybe to put on the watch list.

Harjes: Yeah. $18 billion company and still growing like bonkers. Our second stock of the day that we want to discuss is the biotech, and this one is Vertex. They were up roughly 100%, 103.4%, in 2017.

Campbell: A nice double. People who followed this stock long-term, for a number of years, they may remember that this stock made a lot of news in 2012 and 2013 when it came out with a new hepatitis C drug. Well, Gilead Sciences is basically ended demand for Vertex in that indication, but they have reinvented themselves. In 2017 they made a tremendous amount of headway in addressing a disease called cystic fibrosis.

Harjes: Todd, I know you know a lot about how this disease functions. Can you give us a little bit of background about the patient population and how the disease works?

Campbell: Sure. There are about 75,000 people in the world with cystic fibrosis. It's a genetic disorder and unfortunately, there is no cure. There's limited treatment options, and sadly, because of that, the median age of that people live to is in the low 40s, which is sad. This is an indication where there's a big unmet need for new treatments that can extend patient life. And to understand what we're talking about as far as the disease and what it does, primarily what this causes, to give a very high-level feeling of this, is that you have mucus in your lungs, and that mucus thickens up in cystic fibrosis patients, because they have mutations to a gene that's important to allow how much salt is in the cells within the lungs. And as that mucus builds up, it gets harder and harder, and thicker, and it's harder to cough it out, and you can get infections, and eventually have a really hard time breathing. It can also cause some problems in the digestive tract. It's a tough disease. Fortunately, Vertex has rolled out a couple of drugs that are starting to be used in more and more patients, and hopefully changing the paradigm for these patients and what they can expect over the course of their lives.

Harjes: Yeah. It's important to realize that there are 2,000 known mutations in the gene that we're talking about here. The disease is caused when a child inherits two of the problematic defective genes, one from each parent. So, there's a lot of variability in the patient population. So, it's not the kind of disease where one drug will be effective for every single patient. So, that's really where Vertex's growth has come from. They initially won approval in 2012 for their first drug for cystic fibrosis caused by a very specific gene mutation, and this is Kalydeco. Since then, they've been able to expand the label of Kalydeco a good bit, and then move forward in experimenting with different combination drugs to try to treat an even wider and wider patient population.

Campbell: Yeah. I think now they're able to be used to treat up to 33 different mutations. And essentially every year since that first approval, they've won FDA approval to get used in more and more people. Originally it was for use in older patients, and now you can use the drug in younger and younger patients. They rolled out a second drug, Orkambi. That opened up even more patients to this therapy. And they have a pipeline that's making a lot of progress in 2017, and positions them to treat even more patients over a time. I think that's probably one of the big stories of 2017 that drove this stock up, was the fact that they reported very good results from mid-stage trials of a three-drug combination that could eventually allow them to address up to 90% of the 75,000 people diagnosed with this disease. To put that in perspective, Kristine, that would be more than a double of the addressable market that they can treat with their two drugs today.

Harjes: Which is absolutely incredible. They do have a long way to go. They're in Phase II currently with these triple combination therapies. But as you mentioned, they had an absolutely phenomenal year in the clinic, really, positive result after positive result. One note that I do want to discuss with this company, because we've lately been talking a lot about gene therapies, it got me thinking. Right now, their drug is a chronic drug, where it eases your symptoms, but it doesn't necessarily cure the disease. So, that got me thinking, are they going to be out of business when and if a gene therapy comes along for this disease? So, I was poking around trying to see whether anybody is working on that, and it turns out they are. They're actually collaborating with CRISPR Therapeutics using the CRISPR/Cas9 technique to treat the disease via gene editing. And this is so, so early stage that there's hardly any information out there about it. But, I still think it's a kind of cool thing to note.

Campbell: Yeah. Obviously, if you can figure out a way to rewrite the genes so it's producing the protein adequately, that's the holy grail for the indication. If you go back, listeners who are interested in this stock, and check out the third quarter earnings conference call, read through the transcript, in the question and answer section, I believe they talk a little bit about this, it's a very complex problem to solve. I wouldn't expect we're going to see anything in the way of gene editing or the CRISPR drug or anything like that for a while. It could be years before that comes out. But still, that would be just remarkable, a remarkable event. Nearer-term for investors, I think what they have to focus on is a potential approval in February of a two-drug combination from Vertex that could increase the addressable patient population to 44,000, so a 50% increase from where we are today as far as addressable market. That could drive sales up in 2018 into 2019. And as we talked about with the prior stock, again, as you're increasing sales and leveraging them against fixed costs, that's going to translate into greater and greater profitability for this company. So, you have some pretty bold expectations for bottom line growth at Vertex. Again, I hate to say chase a stock up 100%, but it's a very intriguing company that's targeting a very important unmet need in cystic fibrosis. And they're already doing about $2 billion a year in sales. That's not even treating half of patients.

Harjes: Alright, let's turn to our third and final stock of the day, which is Centene Corporation. They're up 78.5% over 2017, and they're an insurer, which is just crazy. All you hear about is how insurers have struggled due to Obamacare. But these guys have been the total opposite. They have found success in the Affordable Care Act.

Campbell: This is kind of surprising. After the Republicans swept Washington D.C. in 2016, I think everybody came into 2017 thinking repeal and replace of Obamacare is not going to be good for insurers that still participate on the exchanges, and thus not good for a company like Centene, which has its roots in Medicaid, but over the past two years has been making a very big push into the marketplaces. So, for it to more than triple the return of the S&P 500 this past year is indeed pretty remarkable.

Harjes: And the reason for it, as you just alluded to, is that they have their roots in managed Medicaid. This is a patient population that is fairly similar to the Obamacare patient population. Generally, the types of businesses that dabble in Medicaid need to be pretty lean, because they'll typically spend out a higher percentage of the premiums that they take in from the people that they insure on patient care for those same people. So, if you're going to be spending out a higher percentage on the care itself, you need to keep your other spending, your SG&A, as a percentage of revenue, fairly low. And they're pretty good at this. If you look at those numbers, their SG&A as a percentage of revenue is under 10%. You compare that to some of the bigger insurers like UnitedHealthcare, or Anthem, and these companies are spending 15% and 14% respectively. That's delivering fairly important savings, when you consider that Centene also spent about 88% of premiums on member healthcare in Q3. You compare that to UnitedHealthcare at 81% and Anthem at 86%, and you can see why it's important that this business nails that low-cost strategy, and how they've been able to then translate that into an effective strategy on the Obamacare Exchanges.

Campbell: Right. I think the media coverage has pretty much said, wow, you can't make money if you're an insurer on Obamacare. Well, that's not necessarily true. What we've seen is, the Medicaid companies that have embraced Obamacare have done OK. As a matter of fact, I think Centene, industry analysts are projecting they'll make about 5% profit margin on the Obamacare plans.

Harjes: Which, compared to so many other insurers that aren't even profitable ...

Campbell: Yeah. UnitedHealthcare got out of the business entirely, because they were losing hundreds of millions of dollars on it. Again, they had a much higher cost structure because they got most of their business through the employer-based insurance market. That's where they can generate most of their business. It's a very different market than Centene. And what's interesting about Centene is, you had all of this talk this past year in 2017, heading into 2017, the first quarter of 2017, repeal replace, repeal replace. But, as those efforts failed, investors started to say, maybe the fact that Centene has expanded into Obamacare, and these efforts to repeal Obamacare are kind of falling flat, maybe they're still going to be able to make as much money in 2017 as they did in 2016. And if they expand in 2018 in the marketplaces -- which they are, they're going into three more states in 2018 -- then 2018 will be an even better year for them than 2017. Now, make no mistake, Kristine, this is still a Medicaid company. I think that's about 70% of their membership, is still Medicaid. But this is an important new market for them. I think they get about $4 billion in premiums from the insurance marketplace. And they're using this growth, the revenue that's coming in, and leveraging it, again, against their low-cost structure, to fuel other interesting ways of expanding their business. For example, in September, they announced that they were entering the New York market with an acquisition of a company called Fidelis, which is one of the fastest-growing managed care handling government programs in New York. And that's going to put them in a leadership position in the four largest Medicaid states. You have a company that's gone from $11 billion in revenue back in 2013, to $48 billion or something like that in 2017. And they're now projecting that in 2018, they'll see their revenue go to $60 billion. So, this is one of those situations where you have an insurer, which you think of as being kind of a slow-growth business, that's really knocking the cover off the ball and growing very quickly.

Harjes: Yeah, it's interesting. Going forward with all the political uncertainty, do you think they will be able to deliver in 2018 and beyond?

Campbell: I do. One of the interesting parts, you can say, there's been a few things that have happened that still disrupted the Obamacare Marketplace in 2018. You had the cost-sharing issue, removing those payments that are used to reduce coinsurance and copays for some low-income enrollees, and that's the sweet spot of who Centene helps in the exchanges. Removing those could theoretically be a headwind. And, getting rid of the mandate could theoretically be a headwind in 2018 for Centene. But, I think you look at both of those and you say, Centene knew that the cost-sharing reduction stuff was going away, so they priced their plans and premiums for 2018 to reflect that. So, I don't think that's going to be a headwind for them in 2018. And even though the Obamacare enrollment period was shrunk considerably, Kristine, compared to last year, you still had roughly the same amount of people sign up through the healthcare.gov marketplace this enrollment period. So, I think they're probably still going to deliver their one million members in 2018. If they can do that and continue to control costs like they have been, then yeah, I think they have a really good shot at growing their EPS next year. I think they're looking at $4.86 to $5.04 for 2017, and I think in 2018, at their December conference, they got it for $5.47 to $5.87 in EPS. That's over 20% EPS growth.

Harjes: Yeah, that's pretty awesome. All right, Todd, thank you a bunch! Before we sign off, next week is the JP Morgan Healthcare Conference, and I know plenty of our listeners work in the medical field, so if any of you are going to be there, drop me a line. I will be there as well, and I would love to say hello. Our email address is industryfocus@fool.com. And even if you're not going to be there, make sure to be checking fool.com, because Todd and all of our Healthcare writers will certainly be covering all of the news sure to come out of the conference. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Big shout out to our producer, Austin Morgan, for making us sound far better than we otherwise would in 2018 and beyond. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes owns shares of Gilead Sciences. Todd Campbell owns shares of Align Technology and Gilead Sciences. The Motley Fool owns shares of and recommends Align Technology and Gilead Sciences. The Motley Fool recommends UnitedHealth Group and Vertex Pharmaceuticals. The Motley Fool has a disclosure policy.