Top 10 Health Care Stocks: Which To Buy? Part 3

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Includes: AAPL, ABBV, ABT, AEP, AGN, AMGN, AMZN, BMY, CMCSA, CSCO, D, DIS, DUK, FB, GILD, GOOG, GOOGL, HD, INTC, JNJ, LOW, MCD, MDT, MRK, MSFT, NEE, NKE, PCLN, PFE, SBUX, SO, SPY, T, TWX, UNH, V, VZ, XLK, XLU, XLV, XLY
by: Canadian Dividend Growth Investor

Summary

Year to date the health care sector has underperformed the market.

Over the last 5 years and 10 years, the health care sector has outperformed the market.

Short-term underperformance warrants investigating in the health care sector.

Which of the top health care companies may be good buys here?

If not, what are better entry points? And which offer safe and growing dividends?

With so many stocks to choose from, it can be difficult to filter through them and decide which to buy at any given time.

Earlier this month, I went through a similar process by looking up the top companies from the Utilities ETF (NYSEARCA:XLU) and Technology ETF (NYSEARCA:XLK) in the first article and the Consumer Discretionary ETF (NYSEARCA:XLY) in the second article.

Specifically, these utilities were covered:

NextEra Energy Inc (NYSE:NEE), Duke Energy Corp (NYSE:DUK), Southern Co (NYSE:SO), Dominion Resources, Inc. (NYSE:D), and American Electric Power Company Inc (NYSE:AEP).

And these technology companies were covered:

AT&T Inc. (NYSE:T), Verizon Communications Inc. (NYSE:VZ), Apple Inc. (NASDAQ:AAPL), Alphabet Inc (NASDAQ:GOOG)(NASDAQ:GOOGL), Microsoft Corporation (NASDAQ:MSFT), Facebook Inc (NASDAQ:FB), Intel Corporation (NASDAQ:INTC), Cisco Systems, Inc. (NASDAQ:CSCO), and Visa Inc (NYSE:V).

Thirdly, these consumer discretionary companies were covered:

Amazon.com, Inc. (NASDAQ:AMZN), Home Depot, Inc. (NYSE:HD), Comcast Corporation (NASDAQ:CMCSA), Walt Disney Company (NYSE:DIS), McDonald's Corporation (NYSE:MCD), Starbucks Corporation (NASDAQ:SBUX), Nike Inc. (NYSE:NKE), Lowe's Companies, Inc. (NYSE:LOW), Priceline Group Inc. (NASDAQ:PCLN), and Time Warner Inc. (NYSE:TWX).

In this article, we shall explore the Health Care sector. Particularly, we will look at the valuations of the top 10 holdings (based on index weight) of the Health Care ETF (NYSEARCA:XLV). The ETF yields 1.8% compared to SPDR S&P 500 Trust ETF's (NYSEARCA:SPY) 2.01%.

Year to date, the SPY has outperformed the XLV. The SPY has risen 6.6%, while the XLV has appreciated 4.1%. However, over the periods of 5 years and 10 years, the XLV has outperformed the SPY. So, now that the Health Care sector as a whole underperforms the market, it may be time to consider investing new money in the sector.

XLV outperforms SPY in five year and ten year periods
Source: Google Finance - 5-year graph

Johnson & Johnson (NYSE:JNJ)

Investors who bought Johnson & Johnson shares 10 years ago would have slept very well at night. Just look at the company's earnings and dividends that continue to grow steadily like clockwork in the graph below. (Earnings = orange line; dividends per share = light green line below the earnings line)

In fact, an investment 10 years ago would have returned 136.4% for an annualized return of 9%. About 27% of the returns were from dividends.

Click to enlarge

J&J is a recession-proof company, as signified by growing EPS during recessionary periods (the grey columns).

As high quality as J&J is, it trades at 19.5x earnings with an expected EPS growth of about 5.7% per year in the medium term.

So, investors buying J&J today are essentially getting a very safe and growing dividend but with no margin of safety for the invested capital due to the high valuation.

If J&J traded at 16.5x at a price of about $106 per share and a yield of 3%, it'd be a good starting entry point.

J&J yields a safe 2.6% with a payout ratio of less than 50% of its estimated 2016 earnings. The firm just hiked its dividend by 6.7% in May. J&J should be able to continue growing its dividend at a minimum rate of 6% per year in the next three to five years.

Pfizer Inc. (NYSE:PFE)

Pfizer seems to be a better buy than J&J from a valuation perspective. At under $37 per share, Pfizer trades at 15.7x earnings with an expected EPS growth of 7.6% in the medium term.

It also offers a higher yield of 3.3% with a payout ratio of less than 50% of this year's estimated earnings. At the start of the year, the firm hiked its dividend by 7.1%.

Pfizer could continue to hike its dividend at a 7% rate. However, investors should note its earnings are more volatile than J&J's.

Pfizer fundamental analysis graph Click to enlarge

Merck & Co., Inc. (NYSE:MRK)

Similarly to Pfizer, Merck's earnings are more volatile than J&J's. At under $59 per share, Merck offers a yield of 3.1% with a payout ratio of less than 50% of its estimated 2016 earnings and trades at 16.1x earnings with an expected EPS growth of 8.3% in the medium term. Its dividend per share is 2.2% higher than a year ago.

UnitedHealth Group Inc (NYSE:UNH)

Despite appreciating 22% year to date, UnitedHealth is not exactly expensive. At about $144 per share, it trades at 19.8x earnings, while its EPS is estimated to grow 13.1% per year in the medium term. So, it could still be a potential investment today.

However, to invest at a margin of safety, I'd consider accumulating at about 16.5x forward earnings, which is about $120 per share. Technically, UnitedHealth is also overbought in its weekly chart.

UnitedHealth yields only 1.7% but it increased its dividend per share by 25% in June, and its payout ratio is only about 32% of this year's estimated earnings. So, UnitedHealth has the ability to grow its dividend at an above-average rate.

Bristol-Myers Squibb Co (NYSE:BMY)

Bristol-Myers's outlook looks bright. Although it trades near its 52-week high at 32.4x earnings, consensus analyst estimates its EPS to grow at a high double-digit rate of 20% per year in the medium term.

At under $76 per share, it yields 2% with a payout ratio of less than 60% of this year's estimated earnings. In the last five years, Bristol-Myers hiked its dividend by 3% per year. However, if the firm can realize the 20% rate of growth, it could lead to dividend growth in the teens range in the medium term.

Since high growth rates can't be maintained forever, for a safer entry point, interested investors can start accumulating on dips to $65-70.

Amgen Inc (NASDAQ:AMGN)

Amgen's fundamental analysis graph reminds me of J&J's graph above. However, Amgen differs by having higher growth potential and a shorter dividend growth streak.

Click to enlarge

At about $166 per share, Amgen trades at 15.4x earnings and yields 2.4% with a payout ratio of 36% based on this year's estimated earnings. Amgen trades at a reasonable multiple based on its estimated earnings per share growth of 7.8% per year in the medium term.

Since 2011, Amgen has hiked its dividend per share at a rate of 29% on average per year. Although at the same time, its payout ratio expanded from 11% to 36%, there's still ample room for its dividend to grow.

Assuming Amgen achieves a 7% growth rate and hikes its dividend at a rate of 15% for the next three years, its annual dividend would grow from $4 to $6.08 per share and its payout ratio of 45% would still be sustainable with a big cushion.

Medtronic PLC (NYSE:MDT)

At about $87 per share, Medtronic trades at 19.6x earnings, while its EPS is estimated to grow 8.3% per year in the medium term. It yields 2% with a payout ratio of less than 40% based on its fiscal year 2016 earnings. Medtronic's dividend per share is 13.2% higher than a year ago.

For a safer entry point, interested investors can start accumulating at 16.5x forward earnings, which is about $78 per share.

Gilead Sciences Inc (NASDAQ:GILD)

Gilead Sciences trades at a cheap multiple of 7 at about $87 per share. However, that's because it's expected to grow its earnings by 3% in the medium term.

With low expectations from the investing community and a low multiple, Gilead Sciences is a plausible investment for future growth and multiple expansion potentials. It also initiated a dividend last year and hiked it by 9.3% this year. Currently, it yields 2.2% and has a payout ratio of about 16% based on this year's estimated earnings.

Allergan plc (NYSE:AGN)

The top 10 companies all have A-grade credit ratings except for Allergan, which has an S&P credit rating of BBB-. So, interested investors who can stomach higher risk may be compensated by Allergan's relatively cheap multiple of 18x earnings and a relatively high expected EPS growth rate of 15% in the medium term.

AbbVie Inc (NYSE:ABBV)

Lastly, there's AbbVie which was spun off from Abbott Laboratories (NYSE:ABT) in 2013. Since then, AbbVie has hiked its dividend per share at a rate of 12.5% on average per year.

At under $64 per share, AbbVie trades at 14x earnings with a payout ratio of about 48% based on this year's estimated earnings. AbbVie's estimated earnings per share growth of 13.4% are above average.

The firm trades at a relatively cheap multiple and is expected to grow at an above-average rate; however, interested investors should watch its debt levels. As of now, its debt/cap is 80%.

Conclusion

Out of the three major drug manufacturers, Johnson & Johnson is the highest quality and provides the steadiest growth and returns. However, it's also the most expensive. To get a better value, consider Pfizer and Merck which trade at lower multiples with higher dividend yields to start.

To get more value and to maintain high quality, consider Amgen which trades at a reasonable multiple with an estimated growth of north of 7% per year and pays a safe and growing dividend.

UnitedHealth, Allergan, and AbbVie are expected to deliver above average growth rates of more than 13% and they're priced at reasonable valuations. However, investors should note AbbVie's above-average debt levels and Allergan's below average credit rating of BBB-.

Bristol-Myers and Gilead Sciences are opposites. The former trades at more than 30x earnings with a growth rate of 20%. The latter trades at 7x earnings with a growth rate of 3%. Bristol-Myers is a growth play and Gilead Sciences is a value play.

Up next

I'm considering discussing the sectors of Financials, Consumer Staples, REITs and Industrials in future articles.

Share your thoughts in the comments below

  • Which Health Care companies are you buying today?
  • Which other sectors/companies are you buying today?
  • Which sectors/companies are you avoiding from buying today

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Disclaimer: This article consists of my opinions and is for educational purposes only. Please do your own research and due diligence and consult a financial advisor and or tax professional if necessary before making any investment decisions.

Disclosure: I am/we are long AAPL, ABBV, AMGN, FB, GILD, NKE, AND SBUX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.