Healthcare stocks have been hitting on all cylinders this year.
The combination of strong free cash flows, above-average dividends, stable businesses and earnings that aren’t tied to the fate of the global economy have made this group the top-performing market segment of 2013.
The Healthcare SPDR (NYSE:XLV) is up a whopping 20.7% year-to-date, more than 3 points above the next-best sector — consumer staples — and far ahead of the 12% gain for the SPDR S&P 500 ETF (NYSE:SPY). Biotechnology stocks have been especially strong, with a year-to-date gain of 23.3% for iShares NASDAQ Biotechnology Index Fund (NASDAQ:IBB).
What’s the attraction of healthcare stocks? It isn’t earnings, necessarily: According to Standard & Poor’s, large-cap healthcare stocks are on track for 5% earnings growth this year, behind the 7.4% analysts are forecasting for the S&P 500 Index.
And while healthcare naturally has no shortage of individual stocks putting up outstanding growth numbers, the large caps that are driving the sector’s gains are actually seeing earnings estimates slip somewhat. Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE) and Merck (NYSE:MRK) — which together make up nearly one-third of XLV — have all seen their 2013 earnings estimates decline in the past 90 days.
Instead, it’s all about stability. The strength in healthcare stocks should be viewed through the lens of the broader move into the defensive areas of the market. S&P calculates that the three least volatile sector over the past three years have been consumer staples, utilities and healthcare. The top three sectors performers so far in 2013? Healthcare, staples and utilities, in that order.
On the other end of the spectrum, the two most volatile sectors of the past three years — materials and energy — are worst and third-worst, respectively, in terms of their year-to-date performance.
Therein lies the beauty of healthcare. Not only is the sector seen as being a defensive group that provides shelter from the weakness in the global economy, but in the meantime it’s providing beta on the upside. No wonder investors are willing to pay an above-market multiple on 2013 earnings: 14.7x for large-cap healthcare stocks, compared with 14.0x for the S&P 500. In the mid- and small-cap spaces, a similar premium exists: 18.5x versus 17.4x and 19.7x versus 17.8x, respectively.
As with all things related to the financial markets, central bank policy is playing a key role in the sector’s strong performance. Simply put, the massive liquidity being pumped into the system by the world’s central banks needs somewhere to go. It isn’t flowing into the real economy, and bonds are no longer the attractive destination they used to be.
As a result, cash is flooding into “bond substitutes” — the areas most likely to provide stable returns and least likely to be dragged down by slow global growth.
This is reflected in the fact that the defensive sectors aren’t just outperforming in the United States, but they’re doing so on a global basis as well. For instance, the healthcare stocks in the MSCI Emerging Markets Index were up 4.4% in dollar terms year-to-date through April 12, compared with -3% for the index as a whole.
The story was the same in the MSCI All-Country World Index (which measures developed market performance, including the United States). Year-to-date, the healthcare sector has returned 17.7%, more than 8 percentage points above the index return of 9.5%.
This doesn’t mean that broader macro trends are the only factor driving healthcare. The aging developed-market population, rising demand for better medical care in the emerging world, and the minimal impact of the long-anticipated patent cliff are all factors providing long-term support.
At the same time, however, the macro factors have spurred so much interest in this group that dividend yields are now half of what they were four years ago. In addition, the long-term chart now has a parabolic look that’s rare for a defensive sector:
Can this trade keep running? Absolutely. As long as the combination of robust liquidity and weak economic growth perpetuates, healthcare stocks are likely to remain in high demand.
In the meantime, new investors to the group need to be aware of all of the factors underlying recent performance. This might seem obvious, but XLV has hauled in $894 billion in new assets so far this year — making it among the most popular sector ETFs in 2013. But a shift in investor preferences — when it eventually comes — is likely to bring healthcare’s run of outperformance to an abrupt halt.
It might be time for investors to temper their expectations.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.