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How to Invest in Healthcare

Ten thousand Americans will turn 65 years old every day from now through 2029. As those Americans age, they will transform our country's healthcare system -- to the tune of a 5.8% annual increase in our national health expenditures from now through 2025, according to the Centers for Medicare and Medicaid Services.

That's really the key component in thinking about healthcare as an investment: The rising tide of spending will lift many boats across the sector. Drug prices will remain a flashpoint in the public consciousness, but even if discounts are offered, drug companies will win on increased medical volume. Healthcare is a sector designed to produce some big winners -- including investors smart enough to stay invested over the long haul.

Image source: Getty Images.

If all of this has you thinking about investing in the healthcare sector, I have three easy (and relatively safe) ways you can start today.

But first... how NOT to invest in healthcare

As you read through the ideas below, you'll note that I've steered clear of many major sectors of healthcare: health insurers, hospitals, medical device companies, and software providers. There's a reason for each, and I wanted to give you a flavor for the sector by explaining why I personally avoid these companies.

Health insurers and hospitals are subject to enormous regulatory risk -- if you have followed the news around health reform these last several years in the United States, you know that the number of people insured in America could change drastically depending on which political party controls the government. That leads to lots of uncertainty for many hospitals and health insurers. Additionally, hospitals are often forced into quick (and expensive) software and hardware upgrade cycles to attract patients.

Medical device companies are generally slow-growth. Their products are in constant demand, so they always have a business, but there just isn't a lot of upside there. Meanwhile, although software providers have an enormous opportunity in helping hospitals automate and protect their systems, it's difficult to gain insight into which products are the most user-friendly, and I view that whole section of healthcare as open to disruption by a new entrant.

That isn't to say that there aren't great companies in each of these sub-sectors, but I find that there are much more attractive ways to invest in healthcare -- and I'll explain each of them below.

Option 1: Big pharma

When approaching any new sector, I tend to recommend investing in large-cap stocks. Sure, they don't have the explosive growth opportunities of their smaller brethren, but they also aren't as fundamentally risky.

Drug companies producing innovative treatments are an attractive way to invest in healthcare because of their ability to command high prices (and big margins) on new treatments. When searching for large-cap drug companies, you find a small group of stocks known collectively as "big pharma." These companies, which include household names like Johnson & Johnson (NYSE: JNJ), Pfizer, and Eli Lilly, invest in research across a number of diseases, which means investors get automatic exposure to several different areas of healthcare. (And they all pay dividends.)

Johnson & Johnson is easily my favorite big pharma stock -- and it's one I hold in my portfolio. Even compared to its well-diversified peers, the company is particularly diversified: Over half of J&J's revenue comes from medical devices and over-the-counter products (think Tylenol), which gives a new investor broad exposure to healthcare. The other half of the company is made up of a well-stocked clinical pipeline and portfolio of approved drugs for treating major health issues like cancer, diabetes, stroke, and autoimmune diseases. Plus, J&J belongs to a special group of companies known as Dividend Aristocrats -- stocks that have raised their dividends annually for at least 25 years. Think about how fundamentally stable and growing your business must be to hold a record like that. I think it's a slam dunk for new healthcare investors looking to gain exposure to the sector.

Option 2: Healthcare real estate

As healthcare spending ramps, the sector as a whole is going to need more office, lab, and residential care space. That's one of the big arguments for investing in healthcare real estate investment trusts (or REITs): They buy properties, lease them out, and collect rent -- often on leases lasting many years. REITs are also required by law to pay out 90% of their otherwise-taxable income as dividends, making them a favorite investing option for anyone seeking income in the stock market.

My favorite healthcare REIT is Welltower (NYSE: HCN), which earns 70% of its net operating income from senior housing. It's a pure play on America's aging population, and as more people move to senior living arrangements, Welltower and its operators are poised to benefit. Welltower's properties are focused in urban markets where it's difficult to build lots of new buildings (think Los Angeles, New York City, and Boston), which, combined with the overall quality of its portfolio, will hopefully help give it pricing power and ever-better returns on capital.

As the Federal Reserve increases interest rates, the REIT sector as a whole will suffer. That's because REITs borrow money to buy properties and then lease them out to pocket the difference between that loan cost and the rental income. That's when quality will really start to matter. Welltower's balance sheet is in good shape -- with BBB+ credit ratings from Fitch and S&P, and Baa1 from Moody's -- which should give it a cost advantage over much of the competition when it's taking out loans to buy properties. Think of it like a credit score: The better yours is, the cheaper the APR your bank will offer, because you're a lesser risk. All of that combined with a 5% dividend yield makes Welltower a solid way to play the healthcare sector -- and the aging population of America -- as a whole.

Option 3: Healthcare ETF or index

Many investors don't feel comfortable picking individual stocks. That's fair enough -- and, fortunately, there are ways to invest in the whole healthcare sector at once. Index funds and exchange-traded funds (or ETFs) are designed to track the performance of the healthcare sector (or different subsectors, like biotech), and they provide an easy way to get exposure without having to know as much about the individual companies.

When picking an index fund or ETF, you want to get a low expense ratio -- preferably 0.25% or lower -- because fees are a brutal killer of returns. Every dollar you're paying out in fees is a dollar that isn't working for you.

My favorite ETF in healthcare is the Vanguard Health Care ETF, which offers broad exposure across the entire sector for a 0.09% expense ratio. If you're looking for something a bit more targeted toward growth, the SPDR S&P Biotech ETF has a 0.35% expense ratio -- a little higher than I usually like -- but focuses in on the high-growth biotech sector. While an investment there will undoubtedly be more volatile than the Vanguard Health Care ETF, investors are still well-diversified across over a hundred biotech stocks.

The key to investing in healthcare

While the healthcare industry provides juicy theoretical returns given the massive demographic tailwinds pushing up national healthcare spending, the fact of the matter is that picking the right healthcare stocks can be quite hard -- particularly if you're new to the sector. My two cents is that your best option is to get your toes wet with a few big-caps or a sector ETF before you start wading toward the deep end of incredibly volatile small-cap biotechs.

But the most important thing you can do is to get invested. Healthcare has a long growth runway ahead of it, so don't let its complexity deter you from taking advantage of that massive opportunity.

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Michael Douglass owns shares of Johnson & Johnson. The Motley Fool owns shares of and recommends Johnson & Johnson. The Motley Fool recommends Welltower. The Motley Fool has a disclosure policy.