Upgrading Healthcare Rating to Overweight from Neutral
The omnipresent headlines about the deadly coronavirus underlines the importance of good, reliable healthcare in the modern world. For many other fundamental reasons it’s time for investors to take another look at the lagging U.S. healthcare sector. Thanks to a perspective drop in the sector’s equity risk premium (ERP), reduced federal regulatory risk and a potential sentiment reset, I upgrade the sector to an Overweight rating from Neutral (my stance since Dec. 2015). I’ll list 14 sector ideas for potential investment.
The past five years haven’t been kind to this sector, which has underperformed the Standard & Poor’s 500 index (SPX) by 1,710 basis points (+46% vs 63% for SPX). The combined headwinds of political backlash in Washington, D.C., extended valuations (for a time) and overly optimistic sentiment offset the sector’s fairly strong top-line and EPS growth.
Nevertheless, I believe the narrative around healthcare is likely to be improving in 2020, allowing investors to become more constructive on the sector.
- Healthcare produced dependable growth in the past five years (EPS CAGR +9.6%) but price/earnings (P/E) multiples contracted under the weight of the cumulative headwinds (above) to 16.9 times (-2.3 times discount to SPX) from 17.8 times (+0.3 times vs SPX).
In 2019, uncertainty around “Medicare for all” political chatter amplified the concerns.
However, in 2020 these risks have somewhat moderated as few Democratic presidential candidates (except Senator Bernie Sanders, perhaps) support such a move.
Diminished risks argue for the ERP to fall for healthcare and the P/E to expand. This is particularly interesting when the healthcare industry is improving both innovation and improving delivery models. According to the research team at broker William Blair, this is central to solving many of the industry woes (and the source of the Washington backlash).
- To illustrate the divergence between fundamentals (EPS) and return (price CAGR), we compared the 11 SPX sectors. Healthcare has impressive EPS growth, but the price underperformance reflects a de-rating of the equity. In other words, the equity risk premium increased in past five years.
Indeed, by my calculation, the healthcare’s ERP, 4.10%, is the highest for any sector in the SPX based upon z-score. At -0.9 times zscore (~0.9 standard deviation from 30-year long term average of ERP), healthcare has an even higher equity risk premium than industrials and cyclicals.
This is surprising in the light of non-cyclical, reliable revenue and EPS growth, but it also highlights the extent which those perceived risks outlined above have pushed investors to re-price the sector downward.
- This 0.9 z-score is very attractive. Healthcare stocks have upside if the ERP declines.
The current P/E of 16.9X implies an ERP of 4.1% and is elevated. I believe it is possible for equity risk premia to fall to around 3.0% in 2020, which is still above the long-term average and about where it topped out in 2014 and 2016.
This represents 23% upside— stronger than my anticipated rise for the S&P 500. I expect the equity broad market risk premium to decline in 2020, too, and logically the sector with the highest ERP should see the best gains: on the zscore that is healthcare. (On an absolute basis, communications services is the highest ERP.)
Supporting this is that the underperformance seen over the past five years could be reversing. Since mid-2019, healthcare stocks have begun to regain relative performance. I see this breakout taking place in 2020. See chart above.
- Today, the healthcare risk/reward is broadly attractive. Consider that the P/E of biotechnology is 11.6 times and the sector has a 2.7% dividend yield, 80 bps above the SPX. Pharmaceuticals, the largest weight in this sector, is on a 14.9X P/E with a 2.6% dividend yield.
What could go wrong? Political risk remains the greatest swing factor for healthcare and thus the Democratic primaries could create some turmoil. But five long years of underperformance are providing some downside protection.
Bottom line: We remain constructive on stocks and see upside to equities from both EPS growth (+10%) and P/E expansion (+5%-10%). I downgraded basic materials to Neutral (from Overweight) as I see short-term EPS risk as China GDP is impacted from the coronavirus outbreak.
The Fundstrat Quantamental stock selection model helps identify quality stocks and alpha generation opportunities. 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.
Figure: Comparative matrix of risk/reward drivers in 2020
Per FS Insight
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
More from the author
Articles Read 1/2
🎁 Unlock 1 extra article by joining our Community!
Stay up to date with the latest articles. You’ll even get special recommendations weekly.
Already have an account? Sign In 0ab910-2bea98-8cc483-1a8675-b9b9c9
Already have an account? Sign In 0ab910-2bea98-8cc483-1a8675-b9b9c9
