The health-care sector may be an underappreciated safe harbor for investors looking to shelter their portfolios from inflation and rising interest rates. Generally, the sector is cheaper than other defensive plays and has steady earnings growth. "Lower valuations make health-care stocks relatively less vulnerable to rising interest rates, while leaving the sector with ample room to re-rate if underlying relative earnings improve and policy concerns gradually recede, as we anticipate," wrote MRB Partners equity strategist Salvatore Ruscitti. Ruscitti also notes that total debt as a share of total equity is about 80% for the health-care sector, compared to 115% for the consumer staples sector and 150% for utilities stocks. "A stronger balance sheet should make health-care stocks more resilient to rising bond yields," he added. Health-care services Trivariate founder Adam Parker said he favors services and midcap biotechnology. Services are an inflation hedge because of their ability to pass along higher costs. "Health-care services is an area we like a lot," Parker said, noting he likes health maintenance organizations. HMOs offer services through a network of doctors. "Which businesses can consistently raise prices to offset costs? These companies can," he added. UnitedHealth Group is among Parker's top picks. Parker said UnitedHealth customers, such as small businesses, will pay their annual cost increases and stay with the system. "It's an inflation winner. It's a reopening winner. It has pricing power. It's a core holding for the next couple of years," he said. MRB's Ruscitti points out that the health-care sector trades at a forward price-earnings multiple of 16, while other defensive sectors are pricier. Consumer staples stocks have a forward price-earnings ratio of 21. For utilities, it is 20, Ruscitti found. "Health-care stocks offer stronger earnings growth at more attractive valuations," he wrote in a note. "Since 2005, the forward earnings of the health care sector have increased nearly fivefold, which is significantly better than the earnings expansion of the consumer staples sector and utilities," Ruscitti added. "There is nothing to suggest that the earnings growth advantage of the health care sector will diminish or materially change in the year ahead." He noted that the sector is expected to have earnings growth of about 8% this year, compared to 6% for consumer staples. Biotechnology names The riskiest part of the sector, biotechnology, has been beaten down significantly, and some investors are picking it over for opportunities. The iShares Biotechnology ETF and the VanEck Biotech ETF, for instance, are both down nearly 20% for 2022. Biotech has been slammed along with high-growth names. "Whenever you have growthier businesses, more of their value is farther out in the future. So the logic is if interest rates rise, that damages their value," Trivariate's Parker said. "That's why profitless tech and biotechs do badly." "Midcap biotech is down 50% in the last year," he added. "You look and say, 'Is that sensible? Or maybe they were too expensive to start out with, and maybe they've been reset.'" Parker said only 15% of biotech companies ever generate positive cumulative free cash flow. "Of the 15% that do, on average it takes them five years to do so. So we'll be in the next rate cycle by that point, so the logic that rising rates damages the cash flow of the biotech sector is probably not borne out by the realities of the biotech sector," he said. Parker also said he believes the market expectations for Federal Reserve interest rate hikes are too high. Economists expect as many as seven quarter-point hikes this year, starting in March. "I look at this and say this looks like an opportunity because I had the same sales potential I had a few months ago, and it's half the price, and if I get any directional dovishness coming, these things will moonshot higher," he said. Stocks that Trivariate has recommended in the sector include Seagen , Horizon Therapeutics , Neurocrine Biosciences , Natera , Kodiak Sciences, Travere Therapeutics and Avid Bioservices . Trivariate also recommends Coherus BioSciences, Enanta Pharmaceuticals , and Iovance Biotherapeutics. Pharmaceutical companies The health-care sector also has the benefit of more pricing power than other defensive sectors "given the inelastic demand for most medical services and products," says MRB's Ruscitti. As a result, health-care companies are more insulated from inflation and resulting margin pressures. Ruscitti said the pharmaceutical group stands out as an attractive purely defensive play. He said the group has underperformed, relative to its earnings, in part because of regulatory concerns. Drug price reforms that were included in the stalled Build Back Better Act could become part of a scaled-back bill, he noted. "Even if enacted, the drug pricing measures encompass only a small number of drugs and will have a much smaller impact on the pharmaceutical industry's profits than is currently discounted in valuations," Ruscitti wrote. The SPDR S & P Pharmaceuticals ETF is down more than 7% year-to-date, while the S & P 500 has lost about 10% in the same period. The pharmaceuticals ETF's biggest holdings are Eli Lilly, Pfizer, Atea Pharmaceuticals and Bristol Myers-Squibb. Parker said a risk with pharmaceuticals is that they have "patent cliffs," which means patented products that lose their protection will be at risk from cheaper generics. For investors looking at defensive sectors in general, he said consumer staples are the most expensive they've ever been relative to pharmaceuticals. But he'd rather be overweight on these drugmakers and underweight staples. Ruscitti sees promise for pharmaceutical names. "Relative valuations have discounted a worst-case outcome for relative earnings. However, the latter have proven resilient and should improve in the year ahead as the overall profit cycle decelerates, thus spurring a re-rating phase for the sub-group, especially once political concerns diminish," he wrote.
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The health-care sector may be an underappreciated safe harbor for investors looking to shelter their portfolios from inflation and rising interest rates.