Trumpcare may be on the backburner, but segments of health care seem poised to outperform in the near term, while long-term trends offer major tailwinds.
Now that the U.S. House of Representatives has moved to shelve the American Health Care Act (AHCA), how should investors position themselves regarding U.S. health care stocks?
After years of strong performance, health care stocks suffered setbacks 2016, due to a combination of drug pricing uncertainty and a broader market rotation from growth to value sectors as the “old economy” recession ended and cyclical areas such as materials and industrials rebounded sharply.
In fact, last year health care underperformed every other sector, prompting investors to lighten up on their exposure. Health care mutual funds experienced record outflows as well, and institutional investors recently had their lowest weighting to the sector in five years.
Health Care Underperformed All Other Sectors in 2016
(S&P 500 Total Returns by Sector as of Dec. 30, 2016)
Yet, attractive valuations combined with long-term demographic trends suggest that investors should give health care a second look. Even after an early-2017 recovery—the sector was already up 8.5% last week before the AHCA was pulled and has been trending higher ever since—health care is still trading below its historic norm.
“Apart from the financial crisis, health care stocks haven't seen these kinds of valuations in five years," says Dan Skelly, head of Morgan Stanley Wealth Management's Equity Model Portfolio Team. “Investors need to be selective, but we are overweight this key sector in our U.S. model portfolio, which was recently 17% health care versus 14% for the S&P 500."
While the sector may still see its share of volatility post Trumpcare—and given lingering uncertainty over the direction of drug pricing—current valuations may offer investors a margin of “safety.”
Health Care Valuations Appear Attractive
(Next 12 Month's P/E Ratio as of Feb. 28, 2017)
Health care's turn for the worse began in late 2015 after Hillary Clinton commented on one drug maker's extreme price increase. “Price gouging like this in the specialty drug market is outrageous," she tweeted. “Tomorrow I'll lay out a plan to take it on."
“It was the first shot across the bow, but health care remained in the hot seat throughout 2016," says Skelly, adding that some of health care's decline was also due to a slowdown in earnings growth for biotech, as well as a pronounced rotation from growth to value. “Keep in mind that the sector was very crowded toward the end of 2015," he adds.
Even without a repeal of the Affordable Care Act, the prognosis has been improving for health care stocks. Demographic trends, including an aging population in most developed nations and a growing middle-class consumer in developing nations, bode well for long-term growth. “We’re also seeing improving earnings growth, and expect a rise in mergers and acquisitions as management teams invest for growth,” says Skelly.
Earnings Growth May Trough in 1Q17 as Drug Pricing Recovers
(S&P 500 Health Care Sector Index as of Mar. 2, 2017)
There are many ways for investors to tap into this diverse sector, but Skelly and his team have identified three themes for the next six-to-twelve months.
Despite near-term pricing risks, drug makers offer some of the most attractive valuations, with forward P/E ratios well below historic trends. Meanwhile, strong track records in research and development, combined with a high degree of intellectual capital, suggest that these entities will endure, regardless of any political fallout.
“Our view is that there is a very limited number of quality players that can specifically address the biggest health issues," says Skelly, adding that biotechnology's paramount role in the U.S. likely gives it some insulation in the face of pricing pressure. “The market cap of the U.S. biotech sector is 4.5x the combined size of all of the world’s biotech sectors combined. This industry is a U.S. competitive advantage and today a lot of these high-quality stocks are now trading at attractive valuations."
Biotech Next 12 Month's P/E Ratio
(As of Feb. 28, 2017)
Although this segment of health care wasn't punished to the same degree as drug makers, valuations are still below their historic norm. For investors interested in tapping into the growth potential of an aging population, equipment and supplies offer potential. The population is not only aging, notes Skelly, but older Americans are focusing more on improving their quality of life with everything from new knees to cardio implants.
Companies that make equipment to test and improve air and water quality represent just 5% of the health care sector, but this emerging area offers long-term opportunity to investors, says Skelly. Clean air and water are a growing health concern, particularly in developing nations, such as China. Developing nations continue to invest in these areas to help build a safety net as they transition to consumer-driven economies.
Morgan Stanley’s Wealth Management Investment Resources team has compiled a client presentation, “U.S. Health Care Under Trump,” which covers these and other insights in greater detail. If you’re a Morgan Stanley client, contact your Financial Advisor to obtain a copy. If you’re not currently a Morgan Stanley client, use the locator below to find a Financial Advisor near you.