Healthcare Stocks: No Longer a Sure Thing

Popular Posts: 5 Stocks to Sell in FebruaryThe 3 Charts That Matter Most Right NowWhat Traders Can Learn From Super Bowl Sunday Recent Posts: Healthcare Stocks: No Longer a Sure Thing The 3 Charts That Matter Most Right Now What Traders Can Learn From Super Bowl Sunday View All Posts

Healthcare stocks were one of the best areas of the market in 2013, and they have continued to outperform so far in 2014.

Source: Flickr

In the most recent phase of the market correction, however, healthcare has begun to show some cracks. So is this a sign of things to come?

Healthcare stocks: Healthy Growth, Defensive Attributes Provide Support

First, the good news. The Health Care SPDR (XLV) is flat in 2014 (a total return of -0.07%, to be exact) compared with a return of -5.4% for the S&P 500. This places healthcare second only to utilities — up 1.6% based on the Utilities SPDR (XLU) — in terms of year-to-date performance among the 10 major sectors. This comes on the heels of a year in which healthcare stocks outpaced the S&P 500 by more than 9 percentage points.

One reason for this outperformance is that healthcare continues to deliver the goods in terms of earnings. According to FactSet, a full 86% of healthcare companies had reported better-than-expected fourth-quarter earnings through Jan. 31, tops among all sectors. In terms of top-line revenues, the number was the same: 86% exceeded expectations, second only to the telecom sector.

Healthcare stocks also led the way in terms of the extent to which they beat top-line estimates, coming in at an aggregate 2.7 percentage points ahead of expectations. Not least, their revenue growth rate of 5.4% was the highest of the 10 major sectors.

At a time in which investors have grown nervous about broader economic conditions, this type of fundamental strength is a magnet for those looking for a safe haven.

Perhaps even more important, healthcare stocks are largely immune to the broader issues that have plagued the stock market in 2014. The non-discretionary nature of their products and services means they aren't as vulnerable to the concerns about slower global growth, emerging markets contagion and higher natural gas prices that have combined to weigh heavily on performance elsewhere in the U.S. stock market.

Biotech, Pharmaceutical Stocks Beginning to Diverge

Based on the factors above, healthcare continues to look good on the headline level. More recently, however, the biotechnology industry has lost its leadership role. The table below shows the shifting relationship between pharmaceuticals and biotech stocks since XLV peaked on Jan. 22:

Sector	ETF	2013	YTD	Since Jan. 22
Healthcare	SPDR Health Care (XLV)	41.4%	-0.1%	-3.5%
Pharmaceuticals	Market Vectors Pharmaceutical ETF (PPH)	32.4%	1.1%	-3.1%
Biotechnology	iShares Nasdaq Biotechnology ETF (IBB)	65.5%	6.1%	-5.0%
S&P 500	SPDR S&P 500 ETF (SPY)	32.3%	-5.0%	-4.8%

One reason for this is the "risk-off" environment in which institutional investors are forced to sell winners in order to raise liquidity. This puts fund-manager favorites (and big 2013 winners) such as Biogen Idec (BIIB), Amgen (AMGN) and Celgene (CELG) in the crosshairs. Further, Celgene's earnings miss last month has depressed performance across the entire biotech sector since the news hit the wires.

In contrast, pharmaceutical stocks have held up relatively well. Merck (MRK) has bucked the broader-market downtrend to post a return of 6.9% year-to-date, while Pfizer (PFE) and Eli Lilly (LLY) are up 2.6% and 4.1%, respectively, through Tuesday.

This shift highlights a potential headwind to healthcare as a whole: valuations. With expectations high and stocks having performed so well in recent years, the latitude for disappointment is high. FactSet reports that as of Jan. 31, healthcare stocks were trading with a price-to-earnings ratio of 16.6 on 2014 earnings estimates. This isn't just higher than the S&P 500's forward P/E of 14.7, it's also higher than historical levels. In the past five years, healthcare has traded at an average of 12.2 times forward earnings; on a 10-year basis, the average is 14.1. This puts healthcare stocks at a valuation that’s nearly 18% above its long-term average.

That would be fine if the sector could deliver above-average earnings growth. However, FactSet estimates earnings growth of 7.3% for healthcare in 2014, behind the 9.6% for the S&P 500 and ninth among the 10 major sectors. (Only utilities are lower.)

It’s true that the estimates for healthcare are probably more reliable than that 9.6% number for the broader market, which looks destined to fall before the year is out. Still, investors are clearly paying a premium for the defensive characteristics of healthcare stocks at this point. This puts a potential damper on returns, especially if the recent selloff is just a blip and economic growth is indeed as strong in 2014 as investors were expecting coming into the year.

The Bottom Line

Healthcare stocks have demonstrated the ability to outperform in both up and down markets in the past few years. However, with valuations far richer than they were a year ago, investors need to take care to be selective and not overpay for growth.

At this stage, healthcare investors can no longer count on the "rising tide" to fuel uniform outperformance throughout the sector. Manage your positioning accordingly.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.