When thinking about growth, many investors default to technology, noting companies like Amazon, Apple, Alphabet, and Facebook have changed the world by drastically altering how we live and work. In fact, in the two years ending June 30, 2020, Facebook, Apple, Amazon, Netflix, Microsoft, and Google accounted for 56% of the return in the S&P 500.1 However, fewer investors think of health care as a sector with similar potential to generate growth.
Health care presents the opportunity to invest in companies that are constantly innovating to improve quality of life and raise productivity. It is hard to put a value on vaccines, cancer drugs, joint replacements, and pacemakers. At the same time, health care names do not dominate the market like big tech. Johnson and Johnson (1.46%) and United Healthcare (1.07%) are the two largest health care firms in the S&P 500, but at a combined 2.53% they have less influence than Alphabet. (By way of comparison, Alphabet’s A and C shares account for 3.36% of the S&P 500.)
Despite its underrepresentation in the S&P 500 relative to technology, I believe health care continues to offer investors valuable long-term opportunity potential. Here are five reasons why.
The potential for strong earnings growth. In the five years through March 31, 2020, profit growth in the S&P 1500 health care sector rose at a compounded annual rate of 8.1%. This pace of earnings growth was nearly 3.5x faster than that of the entire S&P 1500 (2.4%), and the third-fastest sector growth rate behind information technology (9.9%) and financials (8.6%).2 Looking at growth potential from another angle, prescription drug spending rose at a 9.1% annualized rate between 2000 and 2018, underscoring the underlying demand for health care.
Health care is a play on demographics and an aging population. Since 2000, the US population over 65 years of age has grown 62%, which equates to a 2.5% annualized compounded rate.Over the next 10 years, the US Census Bureau projects the population over 65 rising another 30%, which equals a 2.6% annualized compounded rate.3 Older populations are likely to spend more on health care as their bodies mature, and medical care is needed to maintain their well-being.
The pandemic sheds light on the importance of health care to national security. COVID-19 highlights the potential of a virus to shut down economic activity, potentially contribute to social instability, and hinder national defense; after all, it’s hard to fight a war if the troops are sick. As a result, government policy is more likely to be friendly toward health care companies that have the resources and know how to innovate and combat the health care issues which threaten society. There is plenty of risk of policy change with an election around the corner, but it will be hard (or at least harder) for politicians to demonize and over-regulate companies that are contributing to national security, while working to solve the health care problems of the day.
Medtech offers the ability to blend technology with health care and drive future growth. Medtech has opened a new opportunity for health care beyond the traditional pharmacy, insurance, facility, and device industries present in the health care sector. Medtech improves the delivery and usage of health care products and services using concepts like artificial intelligence, digitization, robotics, monitoring devices, and 3D printing. It provides a new frontier for the health care sector and investors.
Health care earnings have the potential to hold up in economic downturns, while displaying less volatility. The S&P 500 health care sector has demonstrated earnings growth during periods where earnings for the S&P 500 have contracted. The following table displays the cyclical contraction in 12-month trailing earnings per share (EPS) for the S&P 500 and S&P 500 Health Care Index. 12-month trailing EPS for the S&P 500 declined by an average of 27.1% during the three pre-pandemic earnings recessions. In contrast, S&P 500 Health Care Index earnings rose by an average of 14.2% during the same time periods. The current earnings recession is ongoing, but data shows a similar pattern.
An option for harvesting growth. Investors looking to capture trends in the health care sector may want to examine the Invesco DWA Healthcare Momentum ETF (PTH). PTH uses relative strength to select the stocks demonstrating the strongest performance in the health care industry. Relative strength is the measurement of a security’s performance in a given universe over time as compared to the performance of all other securities in that universe. PTH is based on the Dorsey Wright® Healthcare Technical Leaders Index and can select stocks from across the market cap spectrum (small-, mid-, and large-cap), and rebalances and reconstitutes quarterly. The holdings are weighted by momentum so the stocks demonstrating the greatest strength receive the highest weight. A momentum-driven strategy has the potential to capture stocks which are demonstrating emerging strength and eliminate stocks that are showing relative weakness. PTH uses an objective non-emotional process and uses price, not fundamentals, in the selection process.
1 Source: Bloomberg, L.P. as of July 30, 2020
2 Source: S&P as of March 31, 2020
3 Source: US Census Bureau
All data via Bloomberg, L.P. as of July 27, 2020 unless otherwise noted.
Blog header image: Victor Torres / Stocksy
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The S&P Composite 1500® Health Care Index comprises those companies included in the S&P Composite 1500 that are classified as members of the Global Industry Classification Standard (GICS®) health care sector. The S&P Composite 1500® Index consists of those stocks included in the S&P 500® Index, the S&P MidCap 400® IndexTM, and the S&P SmallCap 600® Index.
The S&P 500® Health Care Index includes stocks in the S&P 500 Index classified as health care companies based on the Global Industry Classification Standard (GICS®) methodology. The index is market-cap weighted.
The Dorsey Wright Technical LeadersTM Index includes approximately 100 US companies from a broad mid- and large-capitalization universe. The index is constructed pursuant to Dorsey, Wright & Associates, LLC’s proprietary methodology, which takes into account, among other factors, the performance of each of the approximately 1,000 largest companies in the eligible universe as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors.
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Earnings per share (EPS) refers to a company’s total earnings divided by the number of outstanding shares.