Warren Buffett speaks to an audience in 2011. His Berkshire Hathaway has about $50-billion in cash reserves.JEFF BUNDY/The Associated Press
The likely end of the 30-year bull market in bonds – one that most investors take for granted – is clouding the performance outlook for bonds and bond proxies like real estate investment trusts, utilities and other dividend-paying sectors. At the same time, the current "can't go any lower" yields have diverted portfolio assets into equity markets, raising valuation levels to prohibitive heights and reducing return expectations in the entire asset class.
Building a portfolio allocation strategy in terms of asset class, region and sector is remarkably difficult in this environment. Driven by predictable demographic factors and government support, U.S. health care stocks are one of the few promising areas for investors for the longer term.
A modified Warren Buffet stock screening method uncovers three attractive opportunities in the sector, all from the medical equipment subsector: Medtronic Inc.; orthopedics equipment manufacturer Stryker Corp.; and St. Jude Medical Inc. More risk-tolerant investors can consider biotechnology firm Celgene Corp.
Mr. Buffett favours long histories of stable cash flow growth. With this in mind, the first step in the selection process was calculating the 10-year standard deviation of cash flow growth for every member of the S&P Health care index. The intention is to uncover stocks with the most dependable growth in cash flow, rather than the highest.
Using the 15 most consistent stocks in the index (out of 55 total), I then looked for health care firms trading at a discount to historic valuation levels. Mr. Buffett looks for 30 per cent discounts to the 10-year average price to earnings ratio, but given the elevated state of equity markets, few of these were available. Celgene is trading at a 37 per cent discount, but the current trailing P/E of 47.8 times is hardly deep value territory compared with the rest of the market.
St. Jude Medical is most conventionally attractive of the low volatility options, trading at an 19 per cent discount to the 10-year average price earnings ratio. Stryker's current P/E of 19.5 times represents a 7.4 per cent discount to history. Medtronic is merely 2.2 per cent more attractive by P/E than the average.
Analysts are more optimistic about Medtronic and St. Jude Medical over the next twelve months than for the other options. The average annual target price indicates a 13 per cent and 16 per cent return respectively.
Scott Barlow