Health care’s statistical and fundamental risk has increased along with valuations. At the beginning of the recent five-year run, health care stocks posed very low betas. Since then, those betas have climbed at a fairly rapid pace.
Increased debt accounts for some of the increase in risk. As shown earlier, health care firms previously were more conservatively financed than the market. Low interest rates have spurred borrowing in the broad sector and specifically in biotechnology. While the increased debt levels may signal better financial management, they raise the required rate of return for health care stocks.
While the health care industry appears to be too richly valued for continued intermediate-term outperformance, two trends suggest giving the sector room to run in the short term.
First, the potential for acquisitions driving the sector seems attractive. The difference in corporate tax rates in the U.S. and elsewhere creates opportunity for mergers between U.S. and international firms that involve transferring the headquarters to the lower-tax country.
Second, biotechnology fundamentals are more attractive than broader industry fundamentals. The Food & Drug Administration’s willingness to approve expensive treatments provides additional hopes of profitability to a wider range of biotechnology firms.
While valuations in the biotech segment are high, fundamentals may allow more of those firms to do well. Letting the trend keep running may be the smart decision, but be wary.
Price momentum and mergers can sustain stocks for only so long.
At the time of writing, CLS Investments held a position in IYH, XLV and VHT. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.