Healthcare Sector: Stronger Than It Looks

by: Alan Brochstein, CFA

Investing in Healthcare hasn't been particulary rewarding over the past year, as the sector has been hurt by many factors. Of the 10 economic sectors in the S&P 500, Healthcare has been the worst by far over the past 12 months. As of 1/31, Standard and Poor's reports just a 0.67% return for the sector, lagging 9th-place Utilities by almost 7% and the price return of the overall market by 19%. 2011 looks to be more of the same, with the YTD return as of 2/7 at 2.28% compared with 4.88% for the S&P 500 (NYSEARCA:SPY).

The reasons for the inferior performance vary but are widely known, including patent issues in Big Pharma, concerns over the reform legislation that was passed last year, continued economic pressure and more investor interest in cyclical recovery stocks. I would argue that the sector, the fifth largest and about 10% of the overall S&P 500, is out of favor. As one who likes to look for opportunities masked by sector pessimism, I see some improvements that are worth noting.

While the quick look I shared (the overall return of the Healthcare sector for the S&P 500) looks negative, it's not as bad if we look a little deeper. First, while the sector trails also in the S&P 400 Mid-Cap and the S&P 600 Small-Cap, the short-fall is just 1% rather than the 2.6% gap in the Large-Caps. Second, if we look at the equal-weighted S&P 500, we learn that the sector is up a very healthy 4.7%, just behind the 5.1% return for the index.

What's going on is clear: A few big stocks are weighing down the overall sector. The sector has 51 names, but three of them account for 32% of the market capitalization, including Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE) and Merck (NYSE:MRK), each above $100 billion in value. While PFE is up, MRK is down just as much and JNJ is down slightly. The net impact is that almost 1/3 of the sector is unchanged in price and is dragging down the overall sector. Looking a bit deeper, it's very clear that Pharma and Biotech are overall weak, but almost every other sector is doing well, including Distributors, Equipment, Managed Care (especially), Services, Supplies and Technology. Facilities and Life Science Tools aren't down on a contribution basis the way Pharma and Biotech are, but they are up only modestly.

A few weeks ago, I shared a screen of 12 potential breakouts that included 3 Healthcare names, all of which were long beaten-down insurance companies, including Aetna (NYSE:AET), Wellpoint (WLP) and Wellcare Group (NYSE:WCG). The first two have moved sharply subsequently. With that in mind, I wanted to run a quick screen similar in nature but tailored to Healthcare to see if I could find some names based on the technical and fundamental strength. Similar to the prior screen, here are the parameters I employed:

  • Market Cap > $500mm
  • <50% above 52-week low
  • Within 10% of 52-week high
  • 3 month Return no worse than 5% below S&P 500
  • 3 month Return no more than 12% above S&P 500
  • PE <1.2X 5-year average
  • Earnings estimates stable to rising over past 3 months

The goal, then, was to find some stocks with roughly market or better than market price momentum (despite the big lag of the sector), not overextended, reasonably valued and stable or improving fundamentals. Here are the 32 names that made the cut:

32 HC Stocks

(Click to enlarge)

Consistent with my observations above, the stocks aren't coming from Biotech and Pharma. In fact the two Pharma names are generic companies. The biggest sector is "Health Care Equipment", an area I have favored for quite some time. We own C.R. Bard (NYSE:BCR) in the Conservative Growth/Balanced Model Portfolio, while St Jude (NYSE:STJ) is a key holding in the Top 20 Model Portfolio.

As a group, the stocks have an average PE ratio not too far from the market (15X), but a discount to their 5-year average. The group is up 6% YTD, but some are actually down a little. Most of the companies are solid Mid-Caps, with just two Small-Caps that made the cut as well as about 1/3 qualifying as small Large-Caps ($10-25 billion).

To summarize, I believe that the weakness in Healthcare over the past year is due to widely known reasons that have cast a pall over the entire sector. The screen I designed has uncovered many names that are close to 52-week highs, not overextended, reasonably valued and showing stable to improving fundamentals. In this type of market (one that just keeps going up), we can expect perhaps a little more focus on the potential winners as the sector benefits from some catch-up driven rotation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long STJ in Top 20 Model, BCR in the Conservative Growth/Balanced Model and JNJ in both models at Invest By Model

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