Healthcare: Buying Opportunity or Trap? Taking Stock of Past Lessons
The strong recovery of the U.S. stock market in 2019 year to date has not treated all sectors equally (rallies rarely do). Healthcare has been a particularly noteworthy laggard in spite of fairly consistent earnings growth, having gone sideways while the market as a whole has moved higher. (It has recovered somewhat from its fourth quarter lows, but is still down nearly 6% from the high of early December.)
U.S. Healthcare Sector Performance vs S&P 500, 2019 Year-to-Date
Source: Bloomberg, LLP
Does this mean that some healthcare stocks may be starting to present buying opportunities? Investors should always be alert to circumstances in which market participants irrationality opens up the chance to buy high-quality, discount merchandise.
Whether it is wise to take that chance depends on the bigger context, as well as investors’ risk tolerance and investment horizon. This is where, inevitably, political considerations come into play. A stocks fundamentals cannot be considered in isolation from the political and regulatory environment, when those have a potentially significant impact on future earnings potential.
Lessons From History
The overhang for healthcare is political. Specifically, many of the candidates for the Democratic Party nomination in 2020 have adopted the platform of single-payer healthcare (that is, government-sponsored and guaranteed coverage) which was most recently promoted by Vermont senator Bernie Sanders during his 2016 Democratic primary campaign. Obviously, a move to a single-payer system would involve radical changes to the economics of U.S. healthcare delivery, and that would throw the profitability and survival of many healthcare-sector companies into question. There are many other proposed reforms being floated by the current administration and others — and even those that are modest in comparison with single payer could still be extremely disruptive. (An example is the administration’s proposals to investigate the indexing of U.S. pharmaceutical reimbursements to those of European countries — which would be in essence an indirect and partial adoption of European price controls.)
We can think of two other circumstances in which the U.S. healthcare system faced the possibility of radical change. One was the period of debate and initial implementation of President Barack Obamas Affordable Care Act between 2008 and 2010. That period is not very helpful to examine, because it also spanned the financial crisis, the Great Recession, and a major market crash — in short, a good deal of extraneous noise that makes its effects hard to evaluate.
More interesting is to consider the beginning of Bill Clintons first presidential term, between his election in November, 1992 and the final failure of his proposed Health Security Act in September, 1994 — a period during which his administration tried, and failed, to enact sweeping healthcare reform.
During that period, as during the present year, the healthcare sector drastically underperformed the broad stock market. It closed the period essentially flat, while the broad market was up nearly 11%. Healthcare also endured significant volatility as the controversy and infighting played out — at the worst, underperforming the broad market by more than 25%. By the end, it was recovering sharply as it became apparent that the Health Security Act would never make it into law.
U.S. Healthcare Sector Performance vs S&P 500, 1992-1993:
Would You Really Want to Own That Red Line?
Source: Bloomberg, LLP
While holding healthcare stocks during that period was not ultimately a catastrophe, it was certainly an unnerving and unrewarding exercise.
Then, as now, observers could point out that radical reform was unlikely ever to be implemented. (Of course, the political climate is different now; an Axios poll in February showed that almost 74% of Millennial and Gen Z voters agree with the statement that government should provide universal health care, and this cohort will make up 37% of eligible voters in 2020. They don’t seem to make it to the polls that much, however.)
Even if as we believe, the arrival of a single-payer system is really many years away in the United States (or may never occur), the 1992-1994 period gives investors some clear lessons. Healthcare stocks during that period were indeed cheap in relation to their anticipated earnings — but they were cheap for a reason.
Further, they are not now as cheap as they were then. On a forward price-to-earnings basis, healthcare stocks are trading at a discount of about 17% to the S&P 500, versus their long-term average of a 12% discount. Back in 1993, they traded at a discount of nearly 24%. In short, there is plenty of room for multiples to contract still further as the political pressure mounts between now and November, 2020.
An investor mulling a foray into healthcare at this juncture to take advantage of its discount should therefore ask herself a few questions.
First, “How do I evaluate the political risks? What is the likelihood that a reform as radical as single-payer might actually become law in the next few years? (We think the answer is Not high, but higher than it was in 1993.)
Second, Do I think the present opportunity is the best I’ll get, or is it likely that there will be further volatility and further declines? (We think the answer is, There will very likely be deeper declines, depending on how the Democratic nomination process proceeds.)
Third, Are there other investment areas that are better positioned? Is the opportunity cost too great to allocate funds to healthcare? (We think the answer is, Yes, there are better areas, and the opportunity cost of investing in healthcare would be high.)
And fourth, If I can handle the political risks, and I think this is a good opportunity, do I have a time horizon of at least 18 months, and can I psychologically endure a 25-30% or greater drawdown in the meantime? (This is a question that investors can only answer for themselves — and the more honest they can be with themselves, the better.)
Investment implications: We are advocates of active investing. We advocate concentrating attention in countries, sectors, and industries that are experiencing, or that our careful research leads us to believe will soon experience, tailwinds rather than headwinds. We do not believe that investors must hold stocks from all sectors and industries at any given time. At this juncture, we believe the political risks faced by the healthcare sector are substantial and rising. Even if those risks do not materialize, the volatility faced by the sector is unlikely to abate. The underperformance of healthcare stocks is likely to continue, and their discount to the broad market is likely to widen before it narrows again. Investors seeking an attractive entry point would be, we believe, well-served by further patience and by a careful monitoring of the ongoing political process in the leadup to the 2020 presidential election in the U.S. We believe that there will be better opportunities elsewhere in the meantime. If your analysis leads you to seek healthcare exposure now, we advise entering positions slowly.
