This week, we’re diving deeper into the sector within a few key markets to explore why it has been underperforming and whether its current valuation reflects its potential.
🏥 Is Healthcare Poised for Outperformance?
From 2010 to 2020, the US Healthcare sector outpaced the S&P 500 index, returning 216% compared to the S&P’s 199%. This strong performance provided investors with a defensive sector for diversification, away from growth stocks.
However, since then, the sector has yet to catch up despite notable successes from a few companies. In 2020 and 2021, companies like Moderna and Pfizer reaped substantial profits, but their stock prices surged to unsustainable levels. In the past year, Eli Lilly and Novo Nordisk have profited from their GLP-1 weight loss and diabetes treatments. Yet, it remains uncertain if their current valuations are sustainable as competition increases.
Over the past 12 months, the sector has underperformed the broader market by 14% and 27% over the past five years. Despite this, the sector’s current P/E ratio of 96x seems relatively high, especially with earnings projected to grow by 21% annually in the coming years.
The pharmaceutical industry, which comprises nearly a third of the sector and has a P/E of 135x, is a significant contributor to the high P/E ratio. Other healthcare industries, excluding health services, are trading at much higher multiples than the broader market.
Why Has the Healthcare Sector Underperformed, and Is It Really as Expensive as It Seems?
Several healthcare companies saw strong performance during the pandemic, and others benefited from pent-up demand once it ended. This created a scenario where earnings grew, and valuations seemed justified through 2021. However, while revenues have risen, costs have increased at a much steeper pace. Revenue has grown by around 16% since early 2022, but earnings have dropped by over 55%.
As a result, the high P/E ratios reflect declining earnings rather than a surge in share prices. In fact, share prices have generally remained flat since the start of 2022.
For the past 18 months, analysts have been anticipating a recovery, but they’ve consistently had to lower their near-term expectations. Q2 EPS growth estimates have been reduced by another 1.5% in the past two months.
Much of this downward revision is due to shrinking profit margins. While the overall profit margin for the S&P 500 index increased slightly from 11.6% to 11.7% over the past year, healthcare margins fell sharply from 9.3% to 6.5%. To make matters worse, two major index players—Bristol-Myers and Gilead Sciences—reported 314% and 196% lower earnings, respectively, compared to the first quarter of 2023.
Despite these setbacks, analysts are still optimistic about a potential recovery in the second half of 2024 and into 2025, with earnings projected to increase by 18.5%.
Other Markets
A similar trend is emerging in various markets, though the outcomes aren’t uniform. In Germany, for example, the healthcare sector has seen a 21% increase in revenue over the past three years, but earnings have dropped by 4%. Companies like Merck (pharmaceuticals) and Bayer (life sciences) have significantly influenced this performance.
In other regions, strong results from one or two major pharmaceutical companies have led to divergent outcomes for the healthcare sector. In the UK, the healthcare sector has outpaced the broader market, primarily driven by the strong performances of AstraZeneca and GSK.
Similarly, in India, the sector has seen outperformance due to the contributions of pharmaceutical giants Sun Pharmaceuticals and Cipla.
💡The Insight: Performance Within The Healthcare Sector Is Less Correlated Than In Other Sectors
Companies within the healthcare sector have faced significant pressure from rising costs over recent years. However, global healthcare spending continues to grow yearly, and the industry remains resilient in the face of economic downturns. Should inflationary pressures ease, earnings should see a recovery. Moreover, the healthcare sector may attract more attention if the technology and communications sector’s momentum slows down.
Another key takeaway from recent performance is the considerable influence of the pharmaceutical and biotech industries on the healthcare sector. These industries, including some of the field’s largest companies, are also particularly vulnerable to earnings volatility.
The healthcare sector, in general, is composed of industries with diverse dynamics. These range from rapidly growing health tech companies to more stable healthcare service providers.
ETFs vs Individual Stocks in Healthcare
We often mention ETFs as a way to invest in specific sectors. However, when it comes to healthcare, ETFs require more caution. While they provide diversification but expose investors to companies with weak fundamentals. For this reason, the healthcare sector may be better suited for investors looking to pick individual stocks.
