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Pharma stocks are just what the doctor ordered for Canadian investors

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At ROB Insight we've spent considerable effort assessing whether the primary post-crisis drivers of Canadian equity performance – China and declining interest rates, primarily – are completely exhausted or just tired. But for Canadian investors looking to reduce portfolio risk it doesn't really matter whether the trends are in their seventh or ninth innings – the time to diversify is now. The U.S. health care sector may be just what the doctor ordered.

China's economy drives commodity prices and commodity prices determine profit growth for almost 40 per cent of the S&P/TSX composite. At this point, global research firms are racing to downgrade GDP growth estimates for China. Most recently, Goldman Sachs estimated that China's growth pace will fall to 4.5 per cent annually over the next seven years.

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After a decade of strong Chinese economic growth and higher commodity prices, most Canadian investors are now massively overweight the economically sensitive resource sectors.

Declining global interest rates have been the other dominant investment theme since 2009. Central bank intervention has pushed government bond yields to historical lows and this has spurred huge rallies in yield-based sectors like real estate, utilities and high-yield debt.

The month of May, which saw sharp spikes in U.S. and Canadian bond yields, suggests the trend of declining rates is coming to a close. For domestic investors overweight in yield-oriented sectors, the interest rate environment has switched from positive force to significant headwind.

The global health care sector provides a compelling investment destination for investors looking to diversify away from the flagging themes of emerging markets growth and reaching for yield.

For one, profit growth in the health care sector depends far more on age demographics than global economic activity. The U.S. Centers for Medicare & Medicaid Services, for instance, reported that the percentage of the U.S. population taking at least one prescription treatment was 85 per cent for the 65-and-older age group, compared to 36 per cent for the 18-to-44 year old segment.

Demographics are far more predictable than economic growth, which bodes well for the health sector. To be sure, there are risks – new U.S. government regulation is a big one – but an aging population will provide a reliable growth driver for the sector no matter what happens with the global economy.

In addition, health care stocks, particularly the pharmaceutical sector, often provide significant dividend yield and this should make them attractive to yield-focused investors looking to take profits in real estate, utilities and corporate bonds.

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The predictable growth in the pharmaceutical sector suggests that dividend increases are likely in the years ahead.

Investors looking for vehicles in the health care sector have numerous options. The ETF possibilities include the Health Care Select Sector SPDR Fund, the Vanguard Health Care ETF and the more specialized iShares Dow Jones U.S. Medical Devices Index Fund.

Among individual stocks, Merck & Co. Inc. is the current favourite of the analyst community. Fully 71 per cent of the 24 analysts covering the stock rate it Buy. Trading Monday at $47.80, the average price target of $53.23 (according to Bloomberg data) implies double-digit returns for the next 12 months. The stock also provides a healthy yield of 3.6 per cent.

Admittedly, the last time demographics-related investment themes were popular (cough, Boomernomics, cough) things didn't end well. Investors, however, should remember market history. From the 19th century U.K. rail bubble to the dot-com craze of the late 1990s, there is often an investment boom-bust cycle in financial markets before the actual trend, and the corporate profit generation, takes place in the real world.

In 2000, investors in demographic themes were speculating on the future date when the boomers would retire. That future is now, making global health care stocks a compelling option for Canadians looking to adjust their portfolio for a new investment backdrop.

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Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .

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