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Hot Stock Economic Moats in Health Care
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Health care companies often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale. This makes it tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability: The market-weighted return on equity for health care firms has averaged 23 percent over the last five years, despite the economic recession.

For example, in big pharmaceutical companies, patent protection often prevents direct competition, so firms charge the highest price the market will bear for prescription drugs. And because most costs are paid by insurance plans, there's even less price sensitivity for the end consumer. These higher prices—combined with economies of scale—have led to gross margins often surpassing 75 percent to 85 percent.

Size is another barrier to entry for drug companies. Developing a single drug can take 15 to 20 years to get through the entire research, development, and regulatory process and can cost hundreds of millions over that time frame. Few scientists and entrepreneurs have access to that kind of capital. Even if they surmount the time and money hurdles, going head-to-head against a Pfizer or Merck when selling to physicians requires a large salesforce and lots of advertising dollars. In contrast to, say, software or restaurants, where start-up costs are low and new entrants spring up frequently, consolidation has been the trend for many health industries in the last several decades, and established players usually have an edge. Smaller firms often can't compete.

Health care's vast size and rapid expansion makes investing in the sector look like a no-brainer. But it is also fraught with complex relationships, intense controversy, and political pressures to regulate who gets what and who pays for it. Unlike clothing, computers, or consulting services, health care consumers are frequently not the ones writing the check for the products and services they use, and many times they aren't even the ones making the buying decision.

Whereas Wal-Mart shoppers can easily see which brand of paper towels is cheapest and works best on big spills, pricing is often opaque to health care consumers and irrelevant to physicians helping make the decisions. Thus, there is little incentive to shop around for the best price to keep costs lower. (This trend has shown some signs of changing, as companies have been shifting a greater percentage of the health care burden to their employees. But overall, price generally isn't the primary consideration for a patient seeking medical care or a doctor prescribing a drug.)

In the following sections, we explore the dynamics and trends of some of the major health care industries. We "won't cover every corner—health care is too broad and diverse to cram everything into a couple of dozen pages—but we'll Introduce you to the sector's biggest industries.

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