One of the very weakest sectors in the market is Healthcare. So far in 2010, the sector is down 8%, which puts it on par with Materials (-8.2%) and Utilities (-8.5%) and pretty close to the worst sector of all - Telecom Services (-10.2%). The very short-term chart of the SPDR for Healthcare (XLV) is downright scary (click to enlarge):
Note that with all of the concerns over reform, the sector diverged greatly from the rest of the market and failed to move to a new high after the February weakness in the market. Then, it undercut its February low. I think we can all agree that the sector is sick, but my question is why?
Before I address the cause, let's take a longer-term view to put things into perspective (click to enlarge):
OK, that helps, as it is clear that the sector, which has been a "market performer" for the past 5 years, was just giving back the big gains it had relative to the market in 2008 and early 2009. It's not entirely clear what's driving the market these days, but I think that the YTD ranking in returns as displayed below helps to begin to explain the relative weakness in Healthcare (click to enlarge):
I believe that the Healthcare sector has been hurt by two macro factors: Strong dollar and low beta. On the dollar, which has clearly been the story of the year, it is clear that Materials and Energy get hurt. Healthcare and Technology derive a significant amount of their sales from overseas. That Staples are doing better (think Wal-Mart (WMT) and CVS instead of just the multinationals) is a bit of an anomaly. Same with Industrials. Consumer Discretionary and Financials have very little currency exposure. The second factor I detect is a reach for cyclical exposure - hence Industrials are doing well along with Financials and Consumer Discretionary. At the other end, it doesn't get much less cyclical than Telecom, which is really a junk bond if you ask me. Utilities and Healthcare - who needs them in an improving economy? I actually continue to believe that Utilities are very attractive, especially relative to REITS, and investors are missing out on some hidden industrial exposure there.
So, given the strength of the dollar and a preference for cyclical exposure, the returns in Healthcare make sense. With that said, there's a lot more to the story. I find it very interesting to look at the composition of the sector - it is extremely heavy on pharmaceuticals. The value of the entire sector is $1.15 trillion. The largest stock, representing over 15%, is Johnson & Johnson (JNJ), which I own in the foundation I manage and in both model portfolios, and it is down 5.5%, a bit below the average. While it has a large pharmaceutical component, it's not the majority. Check out the these other stocks though:
- Pfizer (PFE), 10% of sector, -15.3%
- Merck (MRK), 8% of sector, -12.3%
- Abbott Labs (ABT), 6% of sector, -13.1%
I think we have found our culprits! Big Pharma is causing the problems here, though not exclusively. Some other big dogs include Gilead (GILD), Baxter (BAX), and Boston Scientific (BSX), all down more than 15%. Many of these stocks are near 52-week lows. A client of mine suggested that Obama may be about to renegotiate the deal that these guys signed earlier. Quite frankly, I think it's just that investors are figuring out what I have known for quite some time: The model is busted. Patent expirations loom, innovation is lacking and the political environment is poor for Big Pharma.
I don't believe that the story is so bad for the entire sector. I continue to like the devices industry, which doesn't face those structural challenges. While Medicare reimbursement will likely continue to dog the service providers, many of them seem priced to account for that pressure. PBMs still seem solid.
We continue to have relatively high exposure to the sector in the Top 20 Model Portfolio, though it is much less than it was at the beginning of the year. In addition to JNJ, we have two other large-cap medical device companies as well as two small-cap device companies. Yes, I like devices!
Interestingly, the picture looks incredibly different for smaller Healthcare stock performance. In the S&P 400 (Mid-Cap), the sector is actually up 6.6% YTD (second only to Consumer Discretionary). In the S&P 600 (Small-Cap), it is up 2.9%, which puts it below the average but in the middle of the pack (actually 5th place out of the 10 sectors). The better performance here is most likely related not to the absence of Big Pharma (though that helps!), but rather the fact that M&A activity is so strong this year, especially in devices.
So, the XLV is certainly being dragged down, but I don't think that it is representative of what's going on in Healthcare. Investors typically think of the sector as non-cyclical, but fundamental performance, especially for devices and medical equipment (capital equipment as well as consumables), was certainly impacted by the Great Recession. I continue to think that there are plenty of stocks with both growth and value characteristics despite the dead-weight of Big Pharma.
Disclosure: Long JNJ in a foundation I manage and in both model portfolios at Invest By Model