– After five years underperformance, healthcare sector now shows recovery signs

– Coronavirus outbreak underscores importance of sector; headwinds fading

– ETFs like PJP, XLV, IYH, FHLC plus stocks like ABBV, AMGN, BIIB, HUM, PFE attractive

The rapid spread of the coronavirus from China to the rest of the world is a serious health challenge. It has everyone around the globe concerned about their own healthcare. Additionally, with the market down so much since the outbreak, about 3% at one point in just a few short days, it’s a worry for the health of the average investor’s portfolio as well.

Recently, my colleague Tom Lee made some very strong points about why healthcare stocks could outperform in 2020. He upgraded the sector to an Overweight rating from Neutral, his stance since Dec., 2015.  We’ll recap the reasons below as well as some individual healthcare stocks that look attractive on our approach.

Some investors, however, prefer to use exchange traded funds (ETFs) in their portfolios, for numerous reasons, whether to lower the portfolio’s single stock risk; gain exposure to many stocks in one group or theme, or to reduce costs versus comparable mutual funds. I’ve put together a list below of healthcare sector ETFs that could outperform if, as we believe, the sector will make a comeback in 2020.

The healthcare sector isn’t timely simply because of the coronavirus headlines, though this certainly points out how important the sector is to investors and non-investors alike.  I think these stocks are attractive for a number of reasons, as outlined below.

• The healthcare sector is a laggard one and now inexpensive compared to its own history, as well as the broad market. For example, healthcare has underperformed the Standard & Poor’s 500 index (SPX) by about 1,700 basis points (+46% vs 63% for SPX) over the past five years. That’s been the result of the combined headwinds of political backlash in Washington, D.C., extended valuations (for a time) and an overly optimistic sentiment that offset the sector’s fairly strong top-line and EPS growth.

And even though the stocks generally provide dependable growth, with an EPS CAGR of nearly 10%, the price/earnings (P/E) multiples have contracted under the weight of the cumulative headwinds to 16.9 times (-2.3 times discount to SPX) from 17.8 times (+0.3 times vs SPX).   Consider that the P/E of pharmaceuticals, the largest weight in this sector, is on a 14.9X P/E with a 2.6% dividend yield.

• Global demographics favor this group. Much of the world, particularly the developed nations—which are the biggest consumers of healthcare—is aging. According to the Population Reference Bureau, there are more than 46 million older adults age 65 and older living in the U.S. Between 2020 and 2030 alone, the time the last of the baby boom cohorts reach age 65, the number of older adults is projected to increase by almost 18 million. This means by 2030, 1 in 5 Americans is projected to be 65 years old and over.  All these people will be consumers of healthcare in ever increasing numbers, so this is a powerful growth driver for the sector, I think.
  

•  Signs the sector is turning around. Supporting my view is that the underperformance seen over the past five years could be reversing. Since mid-2019, and especially in the 4Q19, healthcare stocks have begun to regain relative performance. This could be a prelude to a breakout in 2020. (See chart nearby.)
  

 On a shorter-term tactical view, there are expectations that 4Q EPS reports for the sector will be strong.  According to Zack’s Investment Research, for example, the sector is expected to see about 4.4% EPS growth in 4Q19. That should provide short term support to the group.  What’s more, many of the big-name drug companies that will report in coming days and weeks also make up a large portion, a fifth or more, of the various ETFs that track the sector.

This isn’t to say this is a short-term call.  I think this sector could provide outperformance in 2020 and perhaps beyond. The stocks we find attractive are listed at the bottom of the page, but, as noted, there are numerous ETFs that track the sector and many more subsector ETFs.  Below is a table of some of the biggest (by market cap) and best-known healthcare ETFs.  

However, investors sometimes make the mistake of lumping all ETFs together, says David Trainer, CEO of New Constructs, an independent forensics research outfit. The number of holdings in healthcare ETFs can vary widely (from 25 to 385), which creates potentially significantly different investment implications.

I’ll point out that New Constructs ranks the following healthcare ETFs as attractive or very attractive: Invesco Dynamic Pharmaceuticals (PJP); Health Care Select Sector SPDR Fund (XLV);  iShares U.S. Healthcare ETF (IYH), and Fidelity MSCI Health Care Index ETF (FHLC).

Finally, President Donald Trump’s populism and efforts to force drug companies to keep a lid on prices is a potential wild card for part of this group. Nevertheless, I see this as a surmountable issue for the companies.

Where could I be wrong: Political risk remains the greatest swing factor for healthcare and thus the Democratic primaries could create some turmoil. Senator Bernie Sanders could be elected President and the stocks would likely crater. However, in that case the entire stock market would go down, in our opinion. Five long years of underperformance are providing some downside protection.

Bottom Line: This sector looks ready to turn and we believe should outperform the broad market. The following 14 healthcare stocks ranked DQM 1 on our stock selection model. The tickers are ABBV, ALXN, AMGN, BIIB, GILD, REGN, CAH, XRAY, ANTM, HUM, WCG, BMY, JNJ and PFE.

Prior “Signals”