The all-weather sector – Healthcare

The information in this article is market commentary only and reflects Lincoln's views and beliefs at the time of preparation, which are subject to change without notice. To obtain up-to-date information, please contact us.

There is no denying it; markets are volatile. And notwithstanding the recent return to favour in shares, it would take a brave investor to suggest that the uncertainty is behind us, and it will be smooth sailing from here on in.

When asked by investors which is the best sector to ride out volatility, it is essential first to understand that volatility is a double-edged sword. Not only does it relate to downside risk, but it also provides the opportunity to outperform in the long-run. Cash is the ultimate insurance in volatile times; however, entrenches you in long-term underperformance as the best you can hope for is to stay marginally behind the rate of inflation.

Sectors such as utilities offer the stability of recurring revenue on essential services. Consumer staples covering the necessities of life and even Listed Property Trusts where a stable income stream can be achieved on illiquid non-tradable assets like industrial property, mean these sectors are prized for their earnings certainty during uncertain times.

One sector that many investors don’t consider is health care. The sector possesses many defensive qualities plus the bonus of strong underlying growth via global reach and innovation. This makes it an excellent sector not only to be exposed to when the bulls are running hard but also when things are uncertain.

The health care sector covers a wide range of services ranging from hospitals, auxiliary services like diagnostics and aged care, pharmaceuticals through to technology. To understand why it is considered a defensive sector, one need not look beyond the numbers to understand the current dynamic.

According to the website, spending on health services by Australians in 2016-17 was $181 billion, or 10 percent of all gross domestic product (GDP).  This amount is expected to increase, and it is not hard to see why. The Australian Institute of Health and Welfare tells us that though a record 15% or 3.8 million of our population is currently aged 65 or over, this figure is expected to balloon to 12.8 million or 25% by the end of this century. We share this phenomenon with others in our global village as the World Health Organisation predicts the number of people over 65 by 2050 will double to 2 billion, or 22% of the world’s population.

The positive, of course, is that we are all living longer and finding new ways to cure a widening list of ailments and diseases. From an investment perspective, there are other benefits such as patent protection, government subsidies, regulatory protection, global expansion potential, and of course, inelastic pricing of health goods and services. In other words, given how essential the service is, the supplier can often charge a hefty price for the product.

However, there are real risks that investors need to consider when investing in this space. The first may seem ironic, however, the health care sector is one of our market’s unhealthiest with over 80% of all companies on the Australian listed exchange exposed to unacceptable levels of financial risks. This is often the result of the binary nature of developing new and novel solutions to tackle our health issues. It often takes many years of high-risk product testing, capital raisings, and regulatory approvals before commercialisation, let alone any sign of positive cash flow, comes through for many of these businesses. In that time, the company will either have succeeded in its mission or failed – there is often no middle ground.

Source: Lincoln Indicators

Another factor to consider is health care’s role as a political football. Not just because of the number of voters who use these services and face the pressures of increased living costs, but also because the government contributes over 40% of the 10% GDP spent annually on health care. Given rising healthcare costs and the significant influential stakeholders involved, the government can undo these businesses with a simple stroke of a pen.

Due to the consistently high investment in R&D, the few companies that generate positive free cash flow do not pay much in the way of dividends, preferring to reinvest.  This makes them unfit for Income seeking investors. Relying on capital growth to pay ‘an income’ in this sector can be risky, given the volatile nature of share prices.

But these risks do not offset the investment thesis in our view.  If you aim to construct a diversified portfolio of stocks to help ride through the current volatility, then it is prudent to look at the high-quality stocks in the health care sector to help construct the perfect all-weather portfolio.

We continue to hold the following stocks from this all-weather sector in our Growth Fund. Many are now at different stages of their price journey and are being managed to provide the best balance between the objective of capital growth and defensive elements:

Code Company Financial Health Rating EPSG 1yr (%) ROE (%) Net Profit Margin (%) Rev Gth 1yr (%) Price Chg 1yr (%)
COH Cochlear Ltd Strong 9.37 39.78 18.27 4.62 8.11
CSL CSL Ltd Strong 19.42 42.07 22.47 13.97 26.91
FPH Fisher & Paykel Healthcare Corporation Ltd Strong 11.84 25.2 19.45 13.33 24.64
IDX Integral Diagnostics Ltd Satisfactory 20.17 21.28 10.05 21.96 16.16
NAN Nanosonics Ltd Strong 135.08 13.31 15.78 39.47 88.13
PME Pro Medicus Ltd Strong 50.12 40.28 37.86 39.49 172.98
RHC Ramsay Health Care Ltd Strong 0.65 21.55 5.09 26.01 20.99
RMD ResMed Inc. Strong 0.97 23.1 17.84 17.39 28.84