Building a Model Income Portfolio Sector by Sector: Part 5 - Health Care

by: Clay King

In the fifth article in our series on building a model income portfolio by sector, we turn to health care. Drug, hospital, medical supplies & equipment, and REITs are the primary investment choices in this sector. The S&P 500 (NYSEARCA:SPY) sector weightings are shown in the table below.

S&P 500 Sector Weights
Consumer Discretionary 10.7%
Consumer Staples 10.7%
Energy 12.6%
Financial 15.0%
Heath Care 11.9%
Industrials 11.2%
Information Technology 17.7%
Materials 3.6%
Utilities 3.4%
Telecom Services 3.1%
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The healthcare sector is perhaps best known for the high profile diversified drug companies such a Johnson & Johnson (NYSE:JNJ), Abbott Labs (NYSE:ABT), Pfizer (NYSE:PFE), and Merck (NYSE:MRK). Once dividend powerhouses, both Pfizer and Merck fell victim to lawsuits and mergers and were forced to either cut or maintain the dividend therefore losing their luster as dividend gainers.

The majors have given much of their star power in growth over to the up and coming biotechs such as Celgene (NASDAQ:CELG), Genetech (NASDAQ:GENE), and Amgen (NASDAQ:AMGN). However, the slow and steady companies are the ones that dividend growth investors seek. The major risk to health care stocks is the unknown of government spending on health care with the looming debt crisis in the United States.

Over the last 20 years the healthcare sector has produced a return of 9.4% with a high/low range between -31% to +58%. The S&P 500 returned 6.1% with a range between -44% to +50%. Therefore this sector has produced 50% better returns than the market with less risk to the downside and superior performance on the upside. Of course, the sector includes some great growth non-dividend paying stocks that contributed to the sector returns.

Our screen for candidates to diversify our income portfolio in this sector consisted of the following criteria:

  • A yield in excess of 3%.
  • A payout ratio below 60%.
  • 5 consecutive dividend increases.
  • A dividend growth rate over the last five years in excess of 6%.

The following table lists the data for the companies surviving the screen:

Health Care Dividend Criteria
Company Current Yield Dividend Growth Rate Previous 5 Years Payout Ratio Current P/E Est. Long Term Growth Rate
Abbott Labs 3.6% 10% 42% 11.5 8%
Astrazeneca ADR 5.1% 12% 37% 6.9 3%
Johnson & Johnson 3.4% 9% 45% 13.4 6%
Novartis AG. ADR 3.8% 19% 46^ 11.2 4%
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The yield levels over the past 25-30 years finds all of these companies at the higher end of their historical levels as shown in the following table.

Historical Yield Ranges
Company Current Yield Monthly High Monthly Low Median
Abbott Labs 3.6% 3.9% 1.28% 2.23%
Astrazeneca ADR** 5.1% 6.49% 0.50% 2.32%
Johnson & Johnson 3.4% 3.83% 1.01% 1.98%
Novartis Ag. ADR*** 3.8% 5.36% 0.4% 0.7%
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** Beginning 1999

*** Beginning 1996

With the long history of dividend increases both Abbott Labs and Johnson & Johnson stand out as must own securities. Both current yield levels are close to the historical highs and should be strongly considered holdings for dividend growth investors.

In addition to the companies above are several health care REITs that are worthy of consideration for the income investor. In this screen I wanted to find consistent dividend increases over the past ten years, with future growth rates above 4%. Most of all, I wanted REIT companies that had shown steady earnings and increasing dividends over the last ten years.

The following three companies cleared the screen:

REIT Criteria
Company Current Yield Payout Ratio Dividend 5 Yr. Growth Rate Est. Long Term EPS Growth Rate
Universal Health Realty 5.7% 95% 2% 2%
Health Care REIT 5.3% 92% 2% 5%
HCP, Inc. 5.1% 83% 2% 8%
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From the numbers on the table above, HCP seems to fair the best in terms of overall yield, lowest payout ratio, and best estimate of future growth. The individual investor, depending on income needs, should purchase REIT's based on income needs, and not based on superior growth potential.

Conclusion: The healthcare sector represents 11.9% of the S&P 500 sector weights. Considered to be a safer and conservative sector for investors I would overweight this industry in one's portfolio for the attractive yield and dividend growth potential.

Disclosure: I am long ABT, JNJ.