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I made a tidy profit off this trade this year - and there may still be time for you to do the same

The primary risk factor for the broader health-care sector is the possibility of new U.S. legislation limiting price increases.

Alexander Raths/Getty Images/iStockphoto

The most recent edition of Merrill Lynch's Research Investment Committee (RIC) report reiterates an investment idea I've already used to generate a significant short-term paper profit.

The Sept. 12 RIC report entitled Finding Value When Valuations Are High underscored the health-care-related bullishness of the company's chief quantitative strategist Savita Subramanian.

The strategist calculates that the sector is both under-owned by fund managers and undervalued: "[T]he health care sector is trading at a discount to the market – and it's inexpensive for the right reason: Earnings growth has outpaced price performance … we favour large-cap biotechs."

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Ms. Subramanian has been bullish on health care stocks for most of 2017, having most recently provided the full reasoning for her position in late August. The main selling point has been that biotechnology stocks were trading at a valuation discount to the S&P 500, a rare event in market history.

Based on an earlier Subramanian report, on May 12, I wrote a column called Why I Just Bought This Sector ETF, noting that I had bought the iShares Nasdaq Biotechnology ETF at a price of $293 (U.S.) per unit. The ETF closed Wednesday at $332.75 (U.S.).

The S&P biotechnology index is trading with a forward price-to-earnings ratio (Ms. Subramanian's preferred valuation measure for the sector) of 16.2 times, a 15-per-cent discount to the S&P 500 level.

The first chart below shows where this valuation fits relative to the past 15 years of market history, and the future performance investors can expect from the sector. The bar on the far left, for instance, shows that during periods when the S&P biotech index had a forward P/E multiple 15 per cent or more below the S&P 500, the average cumulative return in the next 24 months was 10 per cent.

The relationship between relative valuation levels and future performance did not turn out quite as linear and consistent as I would have hoped. For instance, the average two-year return of 34 per cent when the sector was trading at a 5-per-cent to 10-per-cent discount to the index was much higher than when the discount was even larger and more attractive.

Nonetheless, the general trend of cheaper valuations resulting in higher returns still holds. The deeply negative performance after periods where biotechs trade at a significant premium to the market indicates that valuations matter for investors in the sector.

Merrill Lynch also recommends pharmaceutical stocks as the strategist believes they offer outsized dividend yields at a reasonable price. Heavyweight incumbents such as Merck & Co. Inc. and Pfizer Inc. offer yields of 2.9 per cent and 3.6 per cent respectively, while also benefiting from demographic factors.

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Using the same method as the first chart, the second chart shows expected returns for the pharmaceutical sector based on relative P/E ratios. Pharmaceutical stocks are trading at a 10.3 per cent discount to the S&P 500, which suggests a substantial return of 36.5 per cent in the next 24 months.

The primary risk factor for the broader health-care sector is the possibility of new U.S. legislation limiting price increases. I personally do not believe this legislation is imminent, but investors should make up their own minds on the issue before investing.

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