Vital signs for healthcare stocks are improving at the expense of what is shaping up to be a watered down government health reform initiative.

But the sector, which is heavily weighted to U.S. healthcare companies, is still struggling to regain its footing with more investor cash leaving the group than is coming in while the reform debate rages across the United States.

Data show investors have pulled nearly $2 billion, or roughly 10 percent, out of funds investing only in healthcare stocks year-to-date, even as the benchmark S&P500 index has recovered 50 percent from 12 year lows seen in March this year.

When you look at year-to-date performance healthcare has really been passed over by the rest of the market... This certainly catches your attention especially in such a bullish market, said Jeff Tjornehoj, U.S. and Canada research manager at Lipper Inc.

During much of the financial market meltdown in the second half of 2008 and through late February this year, healthcare stocks overall provided some protection for investors suffering severe losses in other sectors due to the global economic downturn.

But after U.S. President Barack Obama outlined his budget proposals earlier this year and put into play various reform initiatives for the $2.5 trillion healthcare system, including a government-sponsored health insurance option, the sector underperformed the broader market.

The rate of the sell-off is pretty odd too. When you look at earnings in Q4 (2008) and Q1 (2009), healthcare was right up there in terms of a sector that was making money, said Cameron Brandt, analyst at fund tracker EPFR Global in Boston.

Against this uncertain legislative backdrop the Standard & Poor's healthcare index .GSPA, which broadly tracks the sector, is trading at a 35 percent discount versus the S&P 500 stock index .SPX on a price-to-earnings (p/e) basis.

You can have a group of companies that clearly are targets (to sell off) but their stock prices become really too cheap relative to a reasonable expected outcome, said Kris Jenner, portfolio manager for the $1.95 billion T. Rowe Price Health Sciences fund. PRHSX.O

Blackrock's Bob Hodgson, who manages the $331 million BlackRock Healthcare fund MDHCX.O in New York cites low p/e ratios and rich dividend yields as another attractive element for healthcare company shares.

The sector however, Hodgson says, is battling not only fears about reform but also a thin product pipeline in an era where innovation rules and many companies face a big round of patent expirations in the 2010-2012 period.

WINNERS OR LOSERS?

Fund managers agree the heated debate make it likely any plan to expand coverage to the nearly 46 million uninsured citizens won't be fixed in one bill.

Nor will it be as onerous as feared in February because of the compromises expected to emerge from the three healthcare overhaul bills that seek to make major changes to insurance industry rules.

While prices for treatment might come under more control, this is balanced to a degree by more people being insured, thereby reducing the number of charity cases that act as a drain on hospital operations.

It is not going to be a win-lose situation, overall, said David Farhadi, co-portfolio manager of the $265 million Fred Alger Management Health Sciences fund AHSAX.O in New York.

It is naive to think that it is like a car factory where a few tweaks fix it. The system has been running inefficiently for years, he said.

Congressional lawmakers return from their summer recess on September 8. Farhadi expects investors will ultimately wait for the final bill to emerge from the legislative process, at which point, I think we'll see a relief rally.

In the equity options market the outlook for healthcare stocks remains muddled, but has improved over the last two months, said William Lefkowitz, a strategist with vFinance Investments in New York.

Looking out six months or less, the calls (right to buy) are basically indicating investors are not expecting healthcare stocks to make a major move in either direction, he said.

Healthcare is still an uncertain industry that investors are still afraid to take speculative shots with and the options are reflecting that, compared to technology shares which seem to be the richest, Lefkowitz added.

While fund managers like Jenner say no one sub-group in healthcare is bullet-proof, some such as the managed care companies were priced unrealistically low on the assumption the government was going to put them out of business.

Across the board you can make a very good case that all of them are (still) between 20-25 percent undervalued, he said.

Jenner said the list included Wellpoint (WLP.N), a top-10 holding in his fund, as well as United Healthcare (UNH.N) and Humana (HUM.N).

He is also bullish on pharmaceutical benefit managers (PBM's) such as Medco Health Solutions (MHS.N) and Express Scripts Inc (ESRX.O). The companies administer prescription drug benefits for employers and health plans and operate large mail-order pharmacies.

In the biotechnology sector, the name at the top of many analysts' lists is Celgene Corp (CELG.O), the maker of the blood cancer-fighting drug Revlimid.

You look at the biotechnology area and you have companies that in a number of cases have very rapid growth rates in terms of earnings... Companies like Celgene, said Hodgson.

Options trading for Celgene's stock show a steady increase in bullish sentiment. As of Wednesday's close, the number of existing call positions held by investors is now 106,434 contracts compared to 55,227 put open positions, according to data from Boca Raton, Florida online brokerage TradeKing.

We have seen a steady increase in call volume which was definitely apparent yesterday, when we saw four times the number calls traded versus puts, said Brian Overby, options analyst at TradeKing.

But not all fund managers are hot on biotech stocks.

We show a lot of value in biotechnology but it really hasn't performed off that low and doesn't have the market leadership that we are looking for before we buy in, said Scott Callahan, manager of the $110 million ICON Advisors Healthcare fund ICHCX.O in Greenwood Village, Colorado.

Instead, he favors managed care and healthcare equipment distribution companies over the next 12-24 months.

Using a model based on Benjamin Graham's famous formula for value investing, Callahan says the managed care subgroup, broadly, is undervalued by 44 percent, that is for every $1 invested there is potentially $1.44 in value. Members of that area such as Wellpoint are trading at a 74 percent discount and Cigna Corp CI.O is undervalued by 54 percent, he said.

While many sectors have come back toward fair value, the uncertainty over legislation has meant healthcare has been slow to realize its value, Callahan said.

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