Health Care Looks Healthy

09/02/2008 12:00 am EST

Focus: MARKETS

Tim Middleton, contributor to MSN Money, says health care is doing well, and he recommends a newly reopened fund.

The stealth success story of 2008 has been health care.

That sector's stocks have quietly outperformed all other equities this year, with the average health care mutual fund ahead 1.6% as of August 19th and up 6.4% in the past three months.

By contrast, the average large-core mutual fund is down 12.9% this year, and core foreign-stock funds have tumbled 20.1%.

Two big draws for investors right now:

  • Health care stocks are making money while the market loses ground. Standard & Poor's expects the [part] of the S&P 500 Index represented by health care to report a gain in operating earnings this year of 9.7%, compared with a decline of 2.1% for the index overall.
  • Health care is still a bargain. The sector's average price-earnings multiple of 15.11x is slightly less than the market average of 15.96x.

Health stocks are being buoyed by relatively constant demand for what these companies produce, along with massive cost cutting and share buybacks. When companies buy back shares, they spread their growing bottom line among fewer shareholders.

Earlier in this decade, health care was walloped as more and more blockbuster drugs lost their patent protection. Those patent losses have reduced sales growth industrywide to little more than 1% annually. But profit growth has remained substantial as drug companies slash expenses by closing unneeded plants and firing legions of salespeople. Innovation has occurred mostly in biotechnology, and that industry's stocks are on fire.

Health care is a perpetual political football, and in this decade that has put downward pressure on the sector, as governments have slashed billions in spending to rein in the group's constantly rising prices. Big Pharma, which accounts for 50% of the sector's market capitalization within the S&P 500, is the obvious target.

[So,] it can make sense to diversify within the group as much as possible; some changes disadvantage one industry while enriching another.

One signal that I have found correlates to a sector's success is the reopening of long-closed funds to new investors. That's because funds often close when managers can't find attractive investment prospects—and reopen when they spot opportunity.

We got such a signal from Vanguard Group on Aug. 7th, when it reopened Vanguard Health Care (VGHCX). This outstanding fund has seen its assets dwindle to $13.3 billion from $19.6 billion in 2004.

So far this year the fund is down 2.8%, but that loss is nearly ten percentage points less than that of the market.

Overall, health care is benefiting from its traditional status as a defensive sector and from profit growth wrung out of cost savings. A rallying dollar is a potential pothole, but it's more of a niggling doubt at the moment than a powerful negative.

The sector isn't likely to set the world on fire, but it is likely to outperform, and in today's market that's one commodity that's still valuable.

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