Healthcare continues to offer good returns

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Steven Goldberg

Healthcare stocks, traditionally defensive investments, are proving to be the market’s best all-weather sector. Since the start of the last bear market on October 9, 2007, Standard & Poor’s Healthcare index has been by far the best performing of S&P’s ten sectors, climbing 140.3 percent, or 12.2 percent annualized.

Over that period, health stocks beat the number two sector, consumer discretionary, by an average of 0.7 percentage point per year, and topped Standard & Poor’s 500-stock index by an average of 5.9 points per year.

Healthcare’s dominance, moreover, is long-lived. The sector held up remarkably well during the 2007-09 bear market. The S&P Healthcare index was the second top sector during the bloodbath, falling 38 percent, compared with a 55.3 percent tumble for the S&P 500.

And since the bear market’s nadir on March 9, 2009, healthcare has returned 287.4 percent, or 24.3 percent annualized. That beat the S&P 500 by an average of 1.7 percentage points per year.

Endless demand

Healthcare has long been one of my favorite stock sectors. Why? Because of the unquenchable demand for healthcare products and services, and the continuing breakthroughs in medical science that further spur demand.

Just ask yourself one question: Would you rather have a new BMW or two more years of life?

That’s why healthcare is the classic defensive sector. Most people don’t cut their health spending much, even during a recession. After all, if you have a heart attack, you’re going to the hospital regardless of the state of your finances.

What’s more, several strong tailwinds have propelled health stocks to record heights. Obamacare has swelled the ranks of Americans with health insurance by more than 11 million. Aging populations in most of the developed world, including the U.S., are boosting demand for healthcare. Incomes are rising in many emerging countries, further swelling spending on healthcare.

In addition, after a long dry spell during the ‘00s, biotech breakthroughs are now coming at a breakneck pace, and biotech stocks are on a rampage.

But here’s the rub: In the stock market, everything has a price. And major parts of the healthcare sector — biotechnology and some drug companies — have seen their shares rise too far, too fast.

High price-earnings ratios

Consider a few price-earnings (P/E) ratios (the ratio of the company’s current share price to its earnings per share). The S&P 500 Healthcare sector boasts a P/E of 19 based on analysts’ earnings estimates for the coming 12 months. The Nasdaq Biotechnology index carries a P/E of 31. The P/E of Regeneron Pharmaceuticals (symbol REGN) is 46, that of Alexion Pharmaceuticals (ALXN) is 33 and that of Illumina (ILMN) is 58.

By contrast, the long-term average P/E of the S&P 500 is 15.5. Yes, many biotech and pharmaceutical companies will see sharply rising earnings in the coming years. But their stock prices already reflect a whole lot of future growth. According to Alec Lucas, a Morningstar analyst, “Scientific breakthroughs can boost stock prices, but they can’t immunize them from sell-offs.”

Stock sectors almost never turn around on a dime when they reach an inflated P/E. More typically, their stocks continue to rise for months or years, becoming increasingly overpriced — and only falling when some catalyst precipitates a sell-off in the sector.

What to expect in the future

What does all this mean for you, the investor? Unfortunately, it’s a complicated picture. The P/Es of many biotech stocks are crazy, and I wouldn’t buy them. Hundreds of companies have developed promising compounds only to have them fail in late-stage trials, often because of deleterious side effects. (The U.S. Food and Drug Administration must find a product to be both safe and effective before approving its use.) Hundreds of other biotech companies have simply run out of money.

But future growth in healthcare spending is inevitable, and some of these biotech firms will hit pay dirt. Shares of health insurers and some drug companies do trade at more palatable prices. Plus, mergers and buyouts should further help drive up healthcare stocks.

Healthcare accounts for 15 percent of the S&P 500. I think that’s a sensible allocation for most investors. You can find out what percentage each of your funds has in healthcare at Morningstar.com.

If your portfolio is light on healthcare, consider adding a dose of Vanguard Healthcare (VGHCX) to your investments. Run by Wellington Management, the fund has beaten the S&P 500 every year but one since 2007. Over the past 10 years, it has returned an annualized 13.6 percent — an average of 5.4 percentage points per year more than the S&P.

With a distinct value tilt relative to most healthcare funds, Vanguard has been 15 percent less volatile than the S&P over the past 10 years. Only 13.4 percent of assets are currently in biotech. The retirement in 2012 of longtime manager Ed Owens is a loss, but Wellington has plenty of good managers. Expenses are just 0.34 percent annually.

In sum, many health stocks appear to be overpriced, but over the long term, this sector will perform well — even if you end up buying at a peak. Just don’t overdo it, particularly now.

Steve Goldberg is a local investment adviser and former Beacon columnist.

All contents copyright 2015, The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.