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Since the beginning of the last decade, a major transformation has been underway in the equity markets. A new class of growth stocks that were created in the 1990s has been transitioning from a period of high growth to low growth. Classic healthcare growth stocks such as Pfizer (NYSE:PFE), Eli Lilly (NYSE:LLY), United Healthcare (NYSE:UNH), Amgen (NASDAQ:AMGN), and Cardinal Health (NYSE:CAH) have now moved into new territory as valuation compression has taken hold. The lofty price/earnings ratios that were once awarded to these companies are no longer viable as the revenue and earnings growth expectations have been permanently altered. As these classic growth stocks have faltered, the healthcare sector weight in the S&P 500 has slowly declined. The sector weight advanced to a 50-year high in 2002, registering a 15 percent weight of the S&P 500. But in the past 10 years, as many healthcare stocks have suffered, the sector weight has dropped to just above 11 percent.

Sector

Market Share 1957

Market Share 2012

Market Share Expansion/ Reduction

Consumer Discretionary

14.58%

10.98%

-3.60%

Consumer Staples

5.75%

11.13%

5.38%

Energy

21.57%

11.12%

-10.45%

Financials

0.77%

14.33%

13.56%

Health Care

1.17%

11.77%

10.60%

Industrials

12.03%

10.09%

-1.94%

Information Tech.

3.03%

20.14%

17.11%

Materials

26.1%

3.30%

-22.80%

Telecom

7.45%

3.20%

-4.25%

Utilities

7.56%

3.53%

-4.03%

Source: Standard & Poors Comstock Data

You might believe that with the accelerating growth in healthcare services that the sector would continue to expand as a percentage of the S&P 500. Health spending in fact has continued to increase much faster than the overall economy (i.e., gross domestic product, or GDP). Since 1970, health care spending has grown at an average annual rate of 7.9%, or about 3.5 percentage points faster than GDP. This no doubt had an impact on the return of the healthcare sector since the advent of the S&P 500 in 1957. During that period, healthcare sector stocks offered the second highest return of any sector, 11.3%. In recent decades, the growth rates for health spending and GDP have slowed, but health spending growth remains consistently above GDP growth. The Centers for Medicare and Medicaid Services (CMS) estimates that health spending between 2012 and 2020 will grow at an average annual growth rate of almost 6.2% (2.3 percentage points faster than optimistic annual GDP growth), with total health spending in that period of about $30.3 trillion. As a share of the economy, health care has risen from 7.2% of GDP in 1965 to over 16% of GDP today, and it is projected to be 20% of GDP just 10 years from now. With all the spending increases made in the past and with the lack of controls on overall healthcare spending, you would expect the healthcare sector to be outperforming most other sectors. However, three-year returns for the sector are below average, and on a 10-year basis, annualized returns fall to the bottom of the list.

Select Sector

Annualized

SPDR Fund

Three

Five

Ten

Year

Year

Year

Energy (NYSEARCA:XLE)

13.12%

1.74%

13.66%

Utilities (NYSEARCA:XLU)

13.93%

3.96%

10.16%

Technology (NYSEARCA:XLK)

15.77%

4.32%

8.62%

Materials (NYSEARCA:XLB)

8.92%

0.04%

7.93%

Cons Stap (NYSEARCA:XLP)

16.49%

9.08%

7.72%

Cons Disc (NYSEARCA:XLY)

21.70%

5.00%

7.31%

Industrials (NYSEARCA:XLI)

16.74%

0.32%

6.74%

Health Care (NYSEARCA:XLV)

13.43%

4.68%

5.33%

Financials (NYSEARCA:XLF)

5.55%

-13.16%

-2.27%

Source: Standard & Poors Data, As of 7/31/2012

If you examine the weights within the healthcare sector, pharmaceuticals account for 52% of the sector. Pharmaceuticals have been one of the worst performing industries in the past decade, dragging down returns of the sector. According to the Centers for Medicare & Medicaid Services, the per capital national growth rate in branded prescription drug growth has declined from a high of 16 percent in 1999 to less than 5 percent today. The slower growth in spending on prescription drugs stems from a number of factors including fewer new blockbuster drugs, patent exposure, tiered formulation by employers, and a more difficult pricing environment.

The Centers for Medicare & Medicaid also indicated for the first time since the 1980s, the percentage growth in per capita spending on branded prescription drugs dropped below the percentage growth in overall national health expenditures. The most critical of all factors in reduced branded pharmaceutical spending is the wide acceptance of generic drugs. Key patents have expired on a multitude of multi-billion dollar brand drugs during this past decade. The pharmaceutical industry faces an unprecedented number of patent expirations for its products between 2009 and 2013 as the industry expects to lose 18% of total sales, equal to roughly $137B . Seven major drugs go off patent this year, including Singulair, Lunesta, Lexapro, Plavix, Actos, Zometa, and Diovan. In 2013, only four primary drugs lose patents; Avandia, Actonel, Boniva, and Evista. The following two years (2014, 2015) are also years that will see a multitude of patent expirations for such major drugs as Nexium, Abilify, Crestor, and Gleevac. As these major branded drugs lose patent exclusivity, generic drugs will account for an even higher level of pharmaceutical spending. According to IMS Health statistics, generic medications accounted for 69% of all medications dispensed in the United States in 2011, representing a growth rate of over 22% for unbranded generic drugs. This is a substantial increase from the 21% rate of 2001. Experts predict that number will climb above 70% by the middle of this decade. It is hard to imagine the growth rates of most large U.S. branded pharmaceuticals returning to double-digit growth rates anytime soon. But the valuations within the sector now have priced in very sub-par growth. Witness the low price/earning ratios and high dividend yields of several of the largest pharmaceutical firms:

Company

P/E Ratio 2012

Yield

Bristol-Myers (NYSE:BMY)

13.8

5.0%

Eli Lilly (LLY)

11.9

4.4%

GlaxoSmithKline (NYSE:GSK)

12.1

5.3%

Merck (NYSE:MRK)

11.3

3.9%

Novartis (NYSE:NVS)

11.1

4.3%

Pfizer (PFE)

10.7

3.7%

Sanofi Aventis (NYSE:SNY)

10.8

4.3%

Source: Standard & Poors Data, As of 8/29/2012

Most other healthcare stocks have fallen into value territory in the past decade. Although the managed care index has had exceptional share price growth over the mid 2000s, the last five years have been as poor as pharmaceuticals. Valuations, however, are now less than many pharmaceuticals and are at levels not seen since the last insurance bust.

Bargains outside of these two healthcare industries are also prevalent. In biotechnology, Amgen now trades at 12 times this year's earnings. In the distribution business, Cardinal Health and AmerisourceBergen (NYSE:ABC) trade at 10 times earnings. Even the once high growth medical device industry now maintains several value candidates including Zimmer (NYSE:ZMH), Stryker (NYSE:SYK), and Medtronic (NYSE:MDT). Overall, the sector now offers a value investor a plethora of choices, whereas the growth managers have nearly abandoned the sector save for a few companies like Intuitive Surgical (NASDAQ:ISRG) and Biogen (NASDAQ:BIIB). Top ranked value fund shops like Dodge & Cox are now scooping up these stocks. Dodge & Cox Stock Fund (DODGX) now has nearly 20 percent of the fund devoted to healthcare stocks such as Merck, Sanofi, and GlaxoSmithKline. The healthcare sector might have finally entered its mature stage this decade, but with healthcare expenditures continuing to expand with the aging of the baby boomers and a new wave of covered Americans through Obamacare, these depressed stocks look like solid long-term values. Over a series of future articles, I will discuss my favorite areas and companies within this attractive sector.

Source: Healthcare: The New Value Sector