Go Defensive With Healthcare ETFs as Congress Replaces Obamacare

Healthcare stocks and the corresponding exchange traded funds continue to spend time in the spotlight as the Republican-controlled Congress moves to replace the Affordable Care Act, also known as Obamacare. Even amid potential political controversy opportunity remains with the S&P 500’s third-largest sector allocation.

The iShares U.S. Healthcare ETF (NYSEArca: IYH) is up 11.1% year-to-date and could offer investors a defensive play with better appreciation potential and less interest rate risk than other defensive sectors.

The pharmaceutical and biotechnology sub-sectors may benefit under a Republican president and Congress as the industries are less at risk of price controls that Democrats vowed to impose. The iShares U.S. Pharmaceuticals ETF (NYSEArca: IHE) is up 6.7% year-to-date. IHE tracks the Dow Jones U.S. Select Pharmaceuticals Index and holds 40 stocks with a significant portion of ETF’s lineup devoted to blue-chip pharmaceuticals such as Pfizer (NYSE: PFE) and Merck (NYSE: MRK).

Healthcare stocks are also showing attractive valuations relative to other defensive sectors, which are richly valued.

“Since 1995, S&P 500 large-cap health care stocks have typically traded at a 10% premium to the market. Today they trade at nearly a 10% discount, close to a six-year low (see chart below). To some extent this drop in relative valuation is justified. Profitability is down from the glory years of the late 1990s when pharmaceutical companies were churning out a record number of blockbuster drugs. Currently the return on equity is roughly 18%, below the 22-year average of 20%. Still, profitability has been improving in recent years and is currently at the highest level since 2013,” according to BlackRock.

Industry observers argue that medical technology companies can tap into increased healthcare spending among emerging economies while the U.S. market has matured and could experience slower growth. Looking ahead, in the years through 2024, spending growth is projected to average 5.8% and peak at 6.3% in 2020.

For healthcare ETFs, the good news is that the U.S. economy moving into the late-cycle phase, overall growth may slow and signs of an economic slowdown could pop up. Consequently, investors may also turn to defensive sectors that are less economically sensitive, such as health care. The sector can also be resilient to rising interest rates.

“However, given lower financial leverage compared to other defensive industries, health care is less sensitive to rising rates. For example, since 2010 the level of the 10-year Treasury has explained roughly 20% of the relative value of the health care sector. However, during the same period the level of long-term rates has explained nearly 70% of the variation in the relative value of the consumer staples sector. Put another way, trading consumer staples has been overwhelmingly a play on interest rates,” according to BlackRock.

For more information on the healthcare sector, visit our healthcare category.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.