Undervalued Stocks In The Health Care Select SPDR: Best Of The Best

| About: Health Care (XLV)

A few days ago in this article (here) I presented a table showing the risk-adjusted relative performance of the nine SPDR sector ETFs. The clear winner in this contest was the SPDR Health Care Portfolio (NYSEARCA:XLV). Despite having a beta of .61, one of the lowest of all the sector SPDRs, XLV has chalked up a 10.3% gain since late June, when the latest solid rally in this ongoing bull market got started. This is 4.9 percentage points more than we would expect from XLV given the portfolio's lower risk profile.

I thought it would be nice to look at the top holdings in XLV to see if this outstanding ETF has any companies which are still undervalued. How? By comparing recent valuation parameters like PE and Price/cash flow to their historical averages for those companies.

This isn't finding diamonds in the rough: holding XLV hasn't been rough. This is looking for diamonds in the diamond mine.

A glance at the State Street website (here) shows some basic characteristics about XLV:

  • 45% of the fund is in pharmaceuticals.
  • Biotech, healthcare equipment and care providers share the remaining 55% almost equally.
  • Recent yield and P/E ratio were 1.51% and 16.6x, respectively.

Like many ETFs the top ten holdings are a vast majority of the weight of the fund, so we will look at these companies first. I used the following subjective criteria to scan these companies for value:

  • Steady growth in earnings over the last decade. The primary attraction of stocks in this sector is combination of solid growth and lack of cyclicality.
  • A trailing PE ratio nearer to the lows of the last decade. Companies selling at high or record high PEs are already fully valued.
  • A cash flow multiple also below traditional levels of the last ten years.

Admittedly, these criteria are subjective, not mechanical like a lot of stock screens. However, this allows the judgment of the analyst or the investor, which is essential if you are going to be comfortable with your stock holdings and risk profile. For example, XLV holding Abbvie (NYSE:ABBV) was eliminated from consideration since it is a recent spinoff from Abbott Labs (NYSE:ABT) and has less than a year of trading history.

Two companies passed muster: Amgen (NASDAQ:AMGN) and United Health Group (NYSE:UNH).

Amgen first. What isn't there to like about a biotechnology company which has a record of profitability going back to the early 1990s? It even pays a decent, well covered dividend. Imagine being able to pick up these shares at just over ten times trailing earnings, as you were able to for the two years after the crash, even though earnings growth barely blinked. Missed your chance? Well, trailing P/E is still modest.

Sure 20x is the not the extremes available a few years back, but it is still attractive given a stock whose profits have gotten back on track after a punk stretch earlier in this decade. While 35x-40x eps is probably not realistic, the 22x we saw prior to the crash appears doable. Applying this to projected 2013 earnings of $7.35 from Value Line or $7.25 from Yahoo Finance gives us a target price of $160 a share or so.

Even using the XLV average multiple of 16x (which has been a clear "buy" level over the last two years) gives us a price of $116, not far from current levels. So risk is quite limited.

Using cash flow multiples from Value Line the guidelines are less precise. Unlike PE compression, which stopped for the broad market and growth stocks a few years ago, "cash flow compression" is still evident for many shares. Using Value Line data, AMGNs cash flow multiple has been as high as 18x and as low as 6x since 2004. Right now it is selling for 12x, smack in the middle. That seems conservative, since 15x cash flow is the average for shares in this ETF. Let us just apply this 15x average to the 2013 cash flow estimate of $9.05 from Value Line (Etrade estimates $8.46). We get a range of $136 to $126. Say $130 as a midpoint. Blending this with the $160 target above and perhaps being a bit more conservative on PE multiples, we can still be comfortable with a target price for AMGN of $140 a share.

That is a 21% gain from current prices for one of the highest quality and lowest risk stocks in the biotech sector.

United Health Group is quite similar to Amgen. Hit hard in the crash though earnings quickly recovered, there is still room for some PE expansion without getting to the outrageous levels which prevailed over a decade ago.

I wish to apply XLV's average PE of 17x to the solid consensus estimate of $5.50 a share for UNH, giving us a target price of about $94 a share.

Like AMGN, UNH has also seen its cash flow multiple shrivel. Right now the multiple is 11x, though in the past it has been more than twice that and in the despair of the crash, as low as 5x. I do not feel comfortable using 15s like I did with AMGN, as insurance company UNH is a lot less sexy than AMGN will ever be. And believe it or not but the dividend yield is less. Thus I will just retain the current 11x cash flow estimates of $6.85 and $6.79 from Value Line and Etrade, respectively. This gives us price of about $75 a share.

Leaning toward the lower end of the two prices because of the lower dividend, we can come up with a blended target price of $83 a share. This is 15% higher than the current price. While not an eye popping return compared with the typical stock or Index, it has some appeal for shares that are less risky than average as these shares are.

Nonetheless AMGN appears to be the better positioned of the two.

So for investors who are a bit nervous given the great strength shown by XLV, especially in the last few months, you can improve your risk-return profile by choosing its most attractive actively traded component, AMGN.

Disclosure: I am long AMGN. 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.

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