In a world where valuations are excessive, the health care sector is one area that looks attractive, both on a stand-alone basis and relative to the broader market.
We strongly feel that an approximately 7-per-cent correction from the nearby highs offers a very attractive entry point and the current pricing does not reflect a very constructive earnings outlook.
On a forward P/E basis, health care trades at 16.8 times earnings, about average historically, and considerably less than the 20.3 times multiple for the S&P 500. In fact, less than 5 per cent of the time in the past has health care traded at such a steep discount.
Admittedly, this is just one metric. But when we look at a broader range of data – measuring profitability, other valuations, growth and volatility/risk – if anything the picture becomes even more compelling (see accompanying table). For example, while health care is roughly comparable with the S&P 500 from the standpoint of profitability (higher return on equity/return on assets but lower margins), it beats the broader market on nearly every valuation metric. In addition, it has delivered superior earnings and sales growth over the past 10 years, which bodes well for its ability to continue this success going forward.
Further to this point, earnings are expected to grow at a 12.3-per-cent annualized rate over the next three years, roughly the same as the S&P 500 despite the more attractive starting point on valuations, implying a higher price/earnings to growth (PEG) ratio. One final point worth highlighting – health care is less volatile than the S&P 500, reinforcing its reputation as a defensive sector.
However, when considering the health care sector, one has to understand that it is made up of very different industries with a wide range of investment attributes. For example, on one hand, biotechnology is a way for investors to “bet on the future” of health care but is traditionally considered to be high risk/reward. Conversely, an industry such as pharmaceuticals, which offers an essential product to consumers, is generally believed to be quite defensive owing to the lack of variability in demand.
Our research shows that biotechnology scores very well across many different data.
For example, not only does it have the most favourable forward P/E (10.9) and free cash flow yield (7.2 per cent), but it also is the most profitable industry within health care and has grown its earnings at the fastest rate. The only real negative about it is that expected future EPS growth is on the lower end of our health care list.
But, given the inherent uncertainty about future profits in this industry, we don’t put a lot of stock in these earnings estimates.
Beyond biotechnology, the picture is more mixed. Pharmaceuticals are average to slightly above average on profitability and valuations, but have delivered inferior sales and earnings growth over the past 10 years. However, the industry is expected to have the best future EPS growth profile, which means it trades at a PEG ratio of less than one. That said, arguably the best characteristics of this industry are that it has below-average volatility – a beta of just 0.7 – and the highest dividend yield. So, investors looking to play defence would be wise to emphasize stocks within this universe.
On the other side of the spectrum, health care equipment and supplies screens quite poorly across all categories. From our standpoint, the biggest red flag is that it is very expensive and yet it doesn’t have the growth rates – either past or future – to justify these lofty valuations. Consequently, this is an industry within the health care space we are less positive on.
Bigger picture, there is greater confidence in health care, relative to many other equity sectors, with respect to the forward earnings outlook. And health care fits in very nicely with our defensive-growth investment strategy. It also has the added benefit of having favourable valuations and strong fundamentals, which should provide additional support. Within the health care space, biotechnology looks particularly appealing, although pharmaceuticals also provide a good opportunity for more defensive-minded investors. Conversely, health care equipment and supplies – because of its rich valuations and weak growth rates – is an area we would look to have limited exposure to within a portfolio.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Brendan Livingstone is a senior market strategist with the firm.
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