I started the year with a cautious view on stocks generally, but noted that I expected Healthcare to potentially benefit from superior balance sheets relative to other sectors. Recently, I have been shifting into the sector, especially subsequent to the Obama drama in the first quarter, when the President revealed his reform plans and his intent to mandate massive Medicare cuts.
If a fan of the sector looks at the S&P 500 returns, he or she must be disappointed, as it has trailed the overall market badly. Almost 4 months into the year, its -10.6% price return is 6.5% behind the broad market and leads only Financials and Utilities. To keep things in perspective, it did weather the storm last year relatively well, second only to Consumer Staples in terms of sector performance as it beat the S&P 500 by about 14%. As you can see in the chart below, when discussing the sector, we are really talking about companies that make drugs, as 52% of the market cap is Pharma and almost 14% is Biotech:
When I look beneath the surface, I find that those two big fish are polluting the pond. The median YTD return for the sector is actually a much better -3.67%. In fact, 6 of the 10 sub-industry groups are down on average less than the overall market (including Pharma). Here is the the whole table, sorted by sub-industry and then by YTD return: Download Sector35 Detail
Here is the summary:
# of Stocks
YTD Return Technology
Looking at each of the sectors with significant market-cap contribution, we find that all of the Biotech stocks are down, with 5 of the six down double-digit. 5 of the 6 Health Insurance companies are down double-digit. The real problem is Big Pharma, though the performance among its members is as bifurcated as one could ever imagine. 5 names are up double-digit, while the other 8 are down double-digit. The problem is that the three largest names are in that latter group, representing over 1/2 of the sub-industry. If one were to exclude the impact ($70 billion of erased market value) from Abbott (ABT), Johnson & Johnson (JNJ) and Pfizer (PFE), the sector would be down 7.2% instead of 10.6%. In the large-cap space, clearly Pharma and Biotech are obscuring what is otherwise decent performance.
When one looks at Mid-Cap, some of the same trends are in place. S&P 400 Healthcare stocks are down 4.4%, lagging the broader index by a similar margin to their larger brethern, as the S&P 400 is actually up 2.2% on a price basis YTD. The sources of pain are generally similar. Biotech and Pharma are each about 10% of the sector. All three Biotech names are down, with two of them double-digit. 4 of the 5 Pharma names are down, 3 of them in excess of 20%. The real problem, though, is in the related area of Life Science Tools and Services, which includes the beleagured CROs. This sub-industry accounts for 14% of the sector, and while the tiniest member is up, the other 6 names are down, with 5 down double-digit. When I examine the other sub-industries, the larger ones are generally doing well. Equipment represents 1/3 of the sector, and it is down an average of just 0.8%, with 3 of the 12 up double-digit and 3 down. Health Facilities and the single Technology company are all up significantly. So, once again, the drug companies and those who directly support them are stinking up the joint.
Small-cap, as represented by the S&P 600, almost doesn't even matter. The total market value of $36 billion is smaller than the average Big Pharma company. In any event, it has been hammered, falling 14.5%, almost 10% behind the index. Pharmaceuticals have been hammered, but the 4 stocks, down an average of 17%, account for just 4% of the sector. Biotech represents about 8%, with all 5 negative and 3 down in excess of 30%. Again, the Tools and Service Providers have been slaughtered here too, with the six names down an average of 23%. The Equipment guys here aren't doing very well, with the 17% sub-industry down an average of 10%. 4 of the 18 names are up double-digit, but 11 are down double-digit and 7 of those by more than 25%. Healthcare Services are the largest sub-industry at about 25% of the sector, and this has been another source of pain. The 4 publicly-traded Home Health companies (which were really nailed potentially by the Obama administration's announced reimbursement cuts) are included in this group of 19 companies and are down 30-50%. There are 4 others down double-digit and only 1 that is up double-digit. In general, the cause of weakness in the small-caps mirrors that of the mid-caps and large-caps, but there are a few other issues as well.
It's not hard to see why investors don't like drug companies, even the biotechs. Patent expirations and declining innovation aren't new stories, but the sensitivity of the industry to the economy is. Scrip use has slowed dramatically. Higher co-pays and loss of insurance coverage are leading to fewer visits to the doctor and skipping or splitting medications. To the extent that expensive biotechs have co-pays, especially in other countries, we have seen shifts in consumption. Things are so drastic that the industry seems for the first time to be slowing R&D investments. The rest of the sector is impacted as well. Maybe the direction we are headed (towards universal coverage) will be a boon for hospitals, but the price rationing ahead will prove to be quite a challenge for almost any player in the sector. I continue to like the sector, but mainly in the context of a better place to be than most other stocks.
I began the year with only one name in the sector, Catalyst Health (CHSI), a small PBM, but I have added JNJ very recently and Zimmer Holdings (ZMH) in March. I had bought Intutive Surgical (ISRG) and Walgreens (WAG) (which isn't actually in the sector but rather Consumer Staples), but I took the money and ran recently. It seems like there could be some opportunities given the generally bad stuff that has been priced in. One area that interests me is the Home Health industry. In general, I believe that buying oversold names with low expectations will prove to be a better strategy than chasing momentum in the group.
Disclosure: Long CHSI, JNJ and ZMH