From Gareth Stokes, MoneyWeek editor, SA

Dear Money Morning reader,

Companies in the healthcare sector are generally regarded as ‘safe as houses’ defensive investments. The theory goes that people fall ill and require medical assistance from private hospitals or pharmacies regardless of the prevailing economic conditions. Times change, however, and the ‘safe as houses’ adage has proved itself a bit untrustworthy. Can we still place our trust in healthcare shares? As US President Barack Obama likes to say, “Yes we can!” But there’s a big “IF” attached.

We can trust companies in the private healthcare industry to provide profit IF government allows them to conduct their businesses free of excessive regulation. In light of this qualifier we’re particularly concerned about prospects in the South African private healthcare industry. We’ve already witnessed a number of disastrous interventions by the department of health in the pharmaceutical sector. And now government has taken an ‘in principle’ decision to implement a National Health Insurance (NHI) solution in the country within five years. It’s early days; but experts agree a fully functioning NHI would fundamentally change the private healthcare environment. The astute investor needs to make some calls as to which segment of the industry will outperform if government gets its way. Should you invest in pharmaceutical companies, companies with medical scheme exposure or private hospital networks?

We’ll issue a quick disclaimer before we continue this discussion. The details around a likely NHI implementation in South Africa haven’t been fleshed out yet – so we’re going on gut feel given what we’ve heard to date. Our first observation is the move won’t be favourably received by private medical schemes. We’ve already witnessed a parting of ways between the Board of Healthcare Funders (a local medical scheme representative body) and Discovery Health (the country’s largest open medical scheme) over the issue. The doomsayers reckon NHI will signal the death of private medical aids as we know them. The reason is each citizen will have to contribute a chunk of their gross salary to the NHI, leaving precious little for contributions to private medical cover. And that means companies like Discovery (which earns a big slice of income from its Discovery Health operation) and Metropolitan (which has a lucrative contract to administer the government medical aid scheme GEMS) could suffer a drop in revenue.

What about private hospital networks? South African investors can choose from two locally-listed operations with significant international interests. The best known is Netcare Limited (JSE: NTC) which has weathered the recent economic turmoil admirably. Netcare shares are 11.9% higher compared to a 33% decline in the JSE All Share Index on a one-year rolling basis. The private hospital group increased revenue by 12% (to R11.6bn) in the six months to March 2009. Nino Frodema, a portfolio manager at Metropolitan Asset Management, dismisses the threat of regulation. He told Fin24 that “government would shoot itself in the foot if it [removes the profit incentive for] private healthcare providers to supply services or products at a fair and reasonable return level.” Some analysts go so far to say government needs private healthcare more than they need government. We doubt management at Netcare or its local peer Medi-Clinic Holdings (JSE: MDC) share this view.

But both companies remain attractive after taking steps to diversify their business interests offshore. Medi-Clinic generated the bulk of its latest interim revenue through its investment in the Hirslanden group in Switzerland while Netcare owns a 50.1% stake in UK-based General Healthcare Group, which operates 58 hospitals under the BMI brand. And ironically Netcare (through its UK division) works closely with the UK National Health Service (NHS) to provide medical assistance to UK citizens. Either company gets the nod on a three to five year view – by which time offshore operations should be in full bloom!