After more than a year hearing about ventilators, vaccines and booked up hospital beds, Canadians know a lot more about the healthcare industry than they ever thought they would.
The same goes for investors, who, before the pandemic, had likely never heard of companies like Moderna or BioNTech, vaccine makers that have seen their stock prices soar over the last 12 months, but investors are now much more aware of the companies in this space.
"While the pandemic has put a spotlight on healthcare, there’s a lot more to this sector than what’s being talked about in the news", says Tarik Aeta, a portfolio manager and vice-president with TD Asset Management Inc. (TDAM). From innovative drug trials to advances in hospital care to an aging population demanding better treatments, there will be plenty of opportunities for investors well after the current pandemic ends, he notes.
“Our personal health is our greatest asset as it allows us to enjoy life to its fullest,” says Aeta. “Governments, individuals and corporations recognize healthcare as a human right, and are increasingly spending more on it. Demand is consistently growing year-to-year and has a low sensitivity to the economic cycle. Combine all of that together and you have stronger expected growth than the broader stock market with historically lower earnings volatility than the overall market.”
Three buckets to consider
Despite all that’s happened in healthcare during the last year, now may be a good time for investors to consider this space. Over the last decade, the S&P 500 Health Care (Sector) Index has climbed by 244% compared to 214% for the S&P 500 Index. Though over the last 12 months it’s underperformed the S&P 500 by 20 percentage points – 41% to 21% – according to S&P Capital IQ. That’s because investors have moved more into cyclical stocks, such as industrials and consumer discretionary, as they usually do well in a recovering economy.
While company valuations in these other sectors have soared, healthcare’s price-to-earnings ratio is well below where the S&P 500 is at today. According to Aeta, the sector is trading at 17 times next 12-month earnings compared to 22 times for the S&P 500.
“A lot of areas of the market are expensive, but health care is very reasonable relative to history,” he says.
However, healthcare is not an easy sector for investors and advisors to jump into. It’s a global industry with many companies, all with varying growth profiles, explains Aeta. He categorizes the sector into three buckets: drug discovery, medical devices and life sciences tools, and healthcare services.
The first, which includes pharmaceutical and biotechnology companies, is on the whole fast growing, but is also the most volatile industry in the healthcare sector, says Aeta. The big drug companies are so large that they often have a hard time making enough discoveries to move the needle when it comes to growth, while the fortunes of the smaller ones depend on whether they successfully make it through clinical trials, but can see significant growth if successful.
The second group, medical devices and life sciences tools, includes companies that make pacemakers, heart valves, surgical robots and also the tools to make this sector run, such as DNA sequencing and the bioreactor tanks in which vaccines are produced. “This area is attractive,” says Aeta. “Demand for medical devices declined during the pandemic as surgeries and procedures were put on hold – but they’ll likely benefit as we work through the large backlog of elective surgeries as well as benefitting in the long term from an aging population."
“We like names in the second group because they take advantage of the same secular tailwinds, of demographics and innovation, that are supportive of growth in pharma and biotech, but without the drug discovery or patent risk you get in pharma and biotech,” he adds.
The last bucket, healthcare services, which includes health insurers, hospitals and diagnostic labs, gives investors less exposure to research and development risk and instead more exposure to overall industry demand growth.
“It’s really a play on the volume and growth of health care,” he says. “You’re going to need more clinics, hospitals and beds as people get older.”
Invest with a healthcare ETF
With so many companies to invest in, and the fact that most Canadians have no experience with for-profit healthcare operations and aren’t likely familiar with the companies in this space, buying individual stocks may be risky. These are also complicated businesses that only the most well-researched do-it-yourself investor might begin to understand.
Another option is to purchase a broad-based healthcare exchange traded fund (ETF), which gives investors an opportunity to own companies in all three buckets. Generally, ETFs can reduce volatility because when one name struggles the other stocks in the fund can continue performing well. That’s especially important in health care where, over the last decade, 26% of companies in the sector generated a negative return, but 15% returned more than 1,000%.
“While healthcare has been a fairly consistent performer and earnings volatility has been low, when you look under the hood there’s a big dispersion between the winners and losers,” says Aeta. “It is not uncommon to see a biotech name down 50% in one morning if they failed a clinical trial, while another can be up over 100% on successful trial results. So the diversification an ETF can provide is important.”
In April, TDAM launched the TD Global Healthcare Leaders Index ETF (TDOC) to provide investors with easy access to a diversified basket of international healthcare stocks. It differs from other healthcare ETFs because it has a global mandate and focuses on all parts of the healthcare sector. Other healthcare ETFs on the market tend to focus on the U.S. market and in a particular niche, like biotech. While TDOC has a 65% weighting to the U.S., it holds companies in the European Union, Japan and other Asian locales.
TDOC's investment mandate limits how much of the fund's assets can be allocated to a single company – no more than 2%, says Aeta. Otherwise, the ETF would be heavily weighted to the big pharma companies.
“Because this reduces the exposure to mega cap pharma companies, this weight gets redistributed to other areas, such as biotech, medical devices, life science tools and healthcare services,” he explains. “It’s more diversified and it’s reallocating to areas that are potentially faster growing.”
With the pandemic soon nearing its end, some Canadians may want to think about anything but health care. But with everyone knowing first-hand just how important the innovations in this sector are to people’s lives and loved ones, investors shouldn’t stop paying attention.
“There has been rotation into other areas of the market,” says Aeta, “but once the dust has settled, people will realize that there’s something here for the long term.”