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The broader healthcare industry is generally one of the first places investors look when trying to identify growth stocks. The logic that ties together the healthcare sector and growth is undeniable—demographic trends, specifically the graying of America and the aging of the baby boomers, will lead to strong demand for a wide range of products and services. The two main clinical laboratories, Laboratory Corporation of America (LH) and Quest Diagnostics (DGX), which provide an array of diagnostic testing services, are a very small slice of the healthcare pie. However, this niche subsector is one of the most compelling growth stories around, offering investors solid buy-and-hold options.

Healthcare, as well as the business of healthcare, has come a long way. Nowadays, diagnoses play a major role in modern medicine, and the clinical laboratories provide the services that make this possible. Indeed, accurately pinpointing ailments and diseases allows healthcare professionals to better treat patients, which reduces costs across the board and generally leads to better patient outcomes. While we’d like to think that better patient outcomes is the driving force behind the growth prospects here, the cost savings derived from avoiding a  guessing game diagnosis approach,  and avoiding unnecessary and expensive treatments, is the bottom line.

A Look at the Numbers

Laboratory Corporation of America (LabCorp) has experienced explosive growth over the past decade. Indeed, over the past 10 years, share earnings have grown at a 30% annual rate (15% over the past five years).  Looking ahead, we expect share profits to expand at about a 10% clip between now and 2015-2017. Stock price appreciation has been similarly impressive, rising from a low of $18.50 back in 2002 to the current level of almost $90.00.

Quest Diagnostics and DGX holders have had similarly good fortune.  Share earnings have expanded at a 27% clip since 2001, and 10% since 2006. Going forward, we expect the bottom line to grow at a 7% rate over the 3- to 5-year pull. These shares have risen from a low of $18.30 in 2001 to almost $60.00 today. (Quest’s growth has been slightly less impressive than LabCorp’s, but Quest pays out a modest dividend. Both companies repurchase shares at a considerable rate, but LabCorp has pared the float by 34% and Quest by just 26%, which aids LabCorp’s per-share results.)

Bio-Reference Laboratories (BRLI), which is currently housed in The Value Line Small & Mid-Cap Survey, is a much smaller player in the diagnostic testing sector (it has a market cap of $600 million versus Quest’s $9.3 billion and LabCorp’s $8.6 billion). Still, it is worth mentioning in this space as an excellent buy-and-hold candidate, thanks to its immense growth potential. Looking at its gaudy statistics, Bio-Reference has posted annual share-net growth of 24% over the past five years, and shareholders have watched the price of BRLI stock rise 65% over that same timeframe.

Why The Good Times Will Continue to Roll

The aforementioned clinical laboratories provide necessary, cost-saving services in a growth industry. Indeed, according to Uncle Sam, healthcare spending is approaching the $3 trillion-a-year mark, and spending on testing accounts for approximately 3% of that. Management at LabCorp estimates that diagnostic testing and other laboratory services presently affect 70%-80% of physicians’ decisions, so, based on this alone, it is likely that testing will become even more widely used than it is today and grow as a percentage of total healthcare spending.

These companies are also heavily investing in research & development, working to acquire new tests and better technology. For example, the labs are using genetics to potentially develop designer medicine based on DNA sequencing. They are also discovering new tests for all types of cancers, renal conditions, etc.

Conclusion

When you put it all together, it is not difficult to see why we like the growth potential of the diagnostic testing sector. Quest and LabCorp are high-quality companies, which offer good appreciation potential at moderate levels of risk based on their current price/earnings valuations.  Finally, we like Bio-Reference, since it is an emerging player in this field and is also furthest along on the DNA sequencing front. The main risk here is that healthcare is becoming more politicized and Medicare/Medicaid cuts are possible. Still, from both a “value” and “growth” prospective, we like this healthcare niche.

At the time of this article’s writing, the author had no positions in any of the stocks mentioned.