By Chris Worthington
Over the past five years, one sector has outperformed all others in the S&P 500: healthcare.
Biotech stocks have led the way, with the Nasdaq Biotechnology Index climbing a whopping 520% since early 2009.
The sector’s incredible run hasn’t dampened enthusiasm for the future, either. Healthcare stocks continue to receive bullish outlooks, and some are even taking on an air of invincibility.
In early 2015, InvestorPlace dubbed more than half a dozen healthcare stocks “immune” to market declines. And Mario Minotti of Minotti Group Wealth Advisors recently told TheStreet.com that he still sees “a lot of growth potential” in biotech right now.
The problem, of course, is that this seemingly unstoppable trend can’t last forever. Indeed, a number of healthcare stocks have become extremely overvalued, and eventually they’re going to correct. Don’t be left holding the bag when they do…
Far From Invincible
This warning is particularly salient for income investors, as healthcare stocks often pay solid dividends and may seem like attractive investments. Yet without doing the proper research, income seekers could end up with serious buyer’s remorse.
To avoid falling for supposedly invincible yet overvalued companies, we need to look at valuation metrics. Comparing a company’s valuation to the market or to its industry is fine, but it’s also important to compare the company’s current valuation to its 10-year averages. Let’s look at Merck & Co. (MRK) as an example.
Merck is one of the world’s largest developers, manufactures, and distributors of pharmaceuticals. Its product categories include heart and respiratory health, infectious diseases, and women’s health. At the moment, many of its biggest products are used to fight cancer.
Merck currently yields 3.1%, which is nothing to sneeze at. Of course, five-year dividend growth of 18% isn’t good, but management has bumped the payout every year since 2011.
However, problems arise when we start looking at Merck’s valuation:
Currently, the company is trading at a significant premium to the 10-year average of its EV/EBITDA ratio, price-to-sales (P/S) ratio, and price-to-earnings (P/E) ratio.
If you need a refresher on EV/EBITDA, make sure to check out my colleague Alan Gula’s piece here. Also remember that you can always find a company’s EV/EBITDA on the key statistics page at Yahoo! Finance. Here’s Merck’s.
You’ll notice that Yahoo! Finance lists a different EV/EBITDA than my table, which was sourced from Bloomberg. Yahoo! acknowledges that its calculations, made with Capital IQ, may differ from those listed by a company in its reporting.
Either way, it’s always worth comparing the current valuation to a longer-term average. Even some companies that appear to be trading at a reasonable P/E or EV/EBITDA might end up being extremely expensive compared to their average.
Bottom line: Don’t get caught up in the hype of supposedly invincible stocks. It’s always worth doing your own research to see whether a stock actually represents a good buy right now, regardless of the dividend yield or the industry’s supposed strength.