Cheap Health Stocks Set to Outpace Other Sectors

Healthcare stocks are poised to outpace the broader market for the rest of the year after a rough start, as investors find the cheap valuations irresistible.

The Standard & Poor's Health Care Sector index had risen only 1.6 percent this year through Thursday, compared with an 8 percent climb for the broader S&P 500 index.

Strong dividends and balance sheets are enticing to investors, as are the basic demographics: an aging population that leads to greater demand for health services and products. Yet uncertainty over the fallout from the recently passed U.S. health overhaul may keep investor enthusiasm in check.

"There's very little downside risk in the stocks because they're low P/Es, high dividends, strong balance sheets," said Bill Smead, portfolio manager of the Smead Value Fund. At 27 percent, healthcare is the Smead fund's biggest weighting.

"The second half of the year is likely to be a lot better for these stocks," Smead said.

Healthcare, the third worst-performing sector this year behind telecommunications companies and utilities, showed its resiliency on Friday, as news of fraud charges against Goldman Sachs Group Inc. shook the market. The S&P 500 was down 1.5 percent in afternoon trading versus only a 0.5 percent decline for the healthcare index.

"Going forward, you don't have much downside risk," said Bernie McGinn, president of McGinn Investment Management. "They're not going to go anywhere because they haven't had the run-up."

Healthcare has been caught in a rotation out of defensive shares and into cyclical stocks as investors become more optimistic about an economic recovery. A reversal in sentiment over the economy could lead investors charging back to sectors like healthcare that are perceived to be steadier in uncertain times.

"I don't think that it's going to continue unabated," Michael Farr, chief investment officer at large-cap growth investors Farr, Miller & Washington, said of the bull market. "I think we will have setbacks ... Therefore I think the healthcare could outperform from this point forward for the year."

One factor deflating excitement for the stocks is concern over the impact of the U.S. health reform law on profits.

"Once the sands underneath these companies quit shifting as a result of government intervention, investors will have better information and visibility upon which they can invest," Farr said. "When Wall Street doesn't know, Wall Street doesn't spend."

That lack of clarity stemming from the overhaul has David Katz, chief investment officer with Matrix Asset Advisors, wary about potential pricing pressure for drug makers and keeps him from diving into health insurer stocks.

"They're statistically very cheap, but we haven't been able to figure out the impact of the healthcare reform bill," Katz said of the health insurers.

Healthcare companies are trading on average at about a 20 to 25 percent discount to the broader market. Pharmaceutical companies and health insurers are trading at particularly low price-to-earnings ratios.

Overall, healthcare is "not a table-pounding buy group," Katz said. "The valuations are good, but there are more uncertainties."

The performance of healthcare companies will take center stage next week when many of the sector's titans report quarterly results.

Johnson & Johnson, Abbott Laboratories Inc. and Amgen Inc. are expected to report at least slightly higher profit, while Eli Lilly & Co. and UnitedHealth Group Inc. are projected to post lower earnings.

"My guess is their earnings growth will be a little less spectacular than more industrial or cyclical companies," said Bob Schaeffer, portfolio manager with Becker Capital Management. "I don't think there are going to be any Intels, if you will, in the healthcare patch this quarter."

Schaeffer likes healthcare in general but is largely avoiding pharmaceuticals, which face growth challenges due to patent expirations and few major new products. Schaeffer also is worried that the drug industry's low tax rates are not sustainable.

He prefers medical supply and product companies such as Becton Dickinson & Co. Katz also favors medical product companies, including St Jude Medical Inc., Medtronic Inc. and Zimmer Holdings Inc.

"We think they have favorable intermediate to long-term outlooks, don't have patent issues, and seem to have a manageable path with healthcare reform," Katz said.

Smead's fund is more bullish on drugmakers, holding Bristol-Myers Squibb Co., Merck & Co Inc. and Pfizer Inc. Among his favorites is Amgen, which is awaiting an expected July decision from the U.S. Food and Drug Administration on its osteoporosis drug Prolia, a potential blockbuster.

Drug approvals could prove to be a catalyst for further investment in the industry this year, Smead said, as would any hints of moderating economic growth that would hit other sectors of the market.

"The next time everybody decides to worry about something, it won't be these companies they worry about," Smead said.