- Healthcare spending is expected to grow at 5.8% per annum, or around 4% in recession time.
- The healthcare index is as equally valued as the S&P 500; global healthcare is cheaper.
- Government involvement and budget limits are the risks, but the risk reward ratio is one of the best in the market.
Yesterday we talked about how the market and the economy are sending mixed signals and look fragile which results in increased risks for low expected returns. One way to be defensive but still grasp the upside is to invest in healthcare stocks. In this article we are going to elaborate on the rationale for investing in healthcare and discuss diversified investing possibilities and risks.
Healthcare isn’t a sexy topic because inevitably, day by day, we are getting older. As we age, demand for healthcare increases. The speed at which the U.S. population is getting older will best be explained by the two charts below.
In the 1960s the baby boom is evident. The largest demographic group were children and the oldest group was 85+.
Figure 1: Age distribution in 1960. Source: AEI.
In the following 5 decades, things changed. Not only did life expectancy increase with the oldest group now being 100+, but the once children are sill the largest demographic group, only now they are 50 years older (red rectangle).
Figure 2: Age distribution in 2015. Source: AEI.
As the baby boomer generation will be retiring in the next decade, let’s be honest, their eating and lifestyle habits haven’t been the best and we can absolutely expect continuing increases in demand for healthcare.
The percentage of people above 65 has increased from 12.29% to the current 14.8% in just 10 years, and the trend will continue. It is expected that the number of people above age 65 in the U.S. will increase from the current 47 million to 58.6 million by 2022, an increase that is expected to increase demand for healthcare by 25%. This 25% increase in the next 6 years is a certainty, unlike many other economic forecasts. In total, U.S. healthcare spending is projected to grow 5.8% annually up to 2024. The Bureau of Labor Statistics expects that healthcare jobs have the fastest employment growth and will add the most jobs between 2014 and 2024, representing 1 in 4 new jobs.
The population is older in Europe where more than 18% of the population is over age 65, and is older still in Japan where 25.71% of the population is above 65. Therefore, global healthcare diversification may be a good idea.
Let us now look at the investment opportunities.
This aging trend and increasing demand for healthcare can be played in various ways. There are pharmaceutical and biotechnology companies, REITs specialized in healthcare, and companies that provide healthcare equipment or services. As this aging trend isn’t a new one, healthcare stocks are fairly valued, so it is necessary to do thorough research to identify the best investments.
If you’re looking for diversification without the headache, an ETF is a good option. The iShares Global Healthcare ETF (IXJ) has a PE ratio of 22.92 and the iShares U.S. Healthcare ETF (IYH) has a PE ratio of 25.26. With the S&P 500 PE ratio being at 25.21 and given the expected growth outlined above, both ETFs seem undervalued, with the global one being a little bit cheaper. It might look a little late to join the party now as healthcare stocks have had amazing returns in the last 7 years, but with the positive trends continuing there might be more upside.
Figure 3: iShares U.S. healthcare ETF performance last 10 years. Source: iShares.
Of course with an ETF, you buy a little bit of every company, never mind if the company is good or bad, and you will incur in some additional expenses. Therefore, by being willing to put more effort into it, you can pick the best companies and likely outperform the healthcare index. Low interest rates have enabled many participants to enter the market but they hold high debt levels, so to limit the downside you should look for companies that have a low PE ratio, low debt levels and good growth prospects. With the healthcare index still being below its 2015 high, there are plenty of opportunities to be found.
For more aggressive investors, a good idea might be to look at the biotechnology stocks which have double the volatility of the above mentioned ETFs because of the higher risks involved in developing new drugs. A good, diversified approach can be found in the iShares Nasdaq Biotechnology ETF (IBB), or you can also find great stocks to research in the iShares portfolio.
As with every other investment, investing in healthcare comes with its specific risks. The main risk for healthcare stocks is additional government involvement. As healthcare should be for the common good, the government will always try to at least lower margins if not regulate prices or similar other market influences. The latest concerns for the healthcare industry are the Affordable Care Act and talks of mandated government drug pricing.
In addition to the above mentioned political issues, budget limits could also prevent the growth rate from hitting the expected 5.8%. A recession would quickly limit spending to only the most necessary segments of healthcare, therefore and again, proper stock picking is essential. During the last recession (2009 – 2013), healthcare spending grew at less than 4% annually which is below average, and well below the expected 6% in better economic times, but it was still growth.
When looking at individual healthcare companies, we look at various specific risks that vary from government contracts to various medicaments being replaced by cheaper solutions.
Healthcare is one of the few trends that is certain to grow in the future due to inevitable demographic trends. However, this doesn’t mean that every investment related to healthcare is the best investment.
As the healthcare growth trend has been present for a while now, it is important to carefully analyze each investment and pick the best risk reward options. If a recession comes along, the healthcare index will probably do better than the S&P 500 as it did in 2009 with a 38% decline compared to 55% for the S&P 500.
If you are uncertain about future economic prospects, you might want to dig deeper into healthcare, it is the sector with the most certainties.