Market-Beating Wonks: Sub-Sector To Load Up On

Health care stocks in the S&P 500 have won the defensive-darling derby of late. A 27.3% year to date rise is the strongest sector move for 2013 managing to nose out the 26.6% rise for consumer cyclical stocks. Moreover, healthcare’s 16.3 forward PE ratio is more enticing than the 19.2 for the consumer cyclical group.

Despite the big run, the Leuthold Group, an institutional research and money management firm, remains bullish on health care, raising the sector’s allocation in its domestic stock portfolio from 14% a year ago to 20% currently. (The S&P 500 weight is 13%.)

In late July Leuthold initiated a 5.2% position in a sub-industry of the sector: health care distributors. Nearly three quarters of Leuthold’s investment in the sector is in McKesson (MCK), Cardinal Health (CAH), Amerisource-Bergen (ABC) and Henry Schein (HSIC).

As their industry name implies, health care distributors are in the business of taking products from manufacturers -- pharmaceuticals, devices -- and getting them efficiently delivered to their wholesale customers including hospitals and pharmacies.

In addition to the well-trod driver of an aging population, Leuthold notes that the growth of generic drugs amid pharma patent cliffs is another positive for this industry. While generic drugs cost less for consumers, Leuthold points out that they are sold at margins five times higher than that for branded drugs. The prospect of more insured Americans being prescribed more (generic) drugs should generate higher volumes for the distributors.

Using its favored 5-year normalized PE ratio calculation (4.5 years of actual earnings plus six months of forward estimates) Leuthold finds the 23 PE ratio right in line with the industry’s 10-year median. Though earlier in the year you could have scooped these up with normalized PE’s below 20.

On a price-to-sales basis, the industry’s overall average is 0.5. Three of Leuthold’s four big positions have price/sales valuations less than half the industry norm:

MCK Price / Sales Ratio TTM Chart

MCK Price / Sales Ratio TTM data by YCharts

Meanwhile, though the industry operates on thin margins, it still manages solid return on capital. The group’s current median return on equity of 17% is higher than its 14% median for the past 10 years.

MCK Return on Equity Chart

MCK Return on Equity data by YCharts

The group also scores strongly for its revenue stability, and can be observed in a revenue per share chart; demand for drugs and medical supplies is pretty sticky in an aging population.

Not surprisingly this fairly steady-eddie segment of the health care sector is decidedly less volatile than say biotech. The beta for all four companies that are the focus of Leuthold’s foray into the industry is well below 1.00.

MCK Beta Chart

MCK Beta data by YCharts

Leuthold said its overlay of technical momentum ultimately “sealed the deal” for its July move into health care distributors. “…this group’s weighted performance has held above its 200-day moving average on a price and relative strength (S&P500) basis since February 2012 and November 2012, respectively.”

Since Nov 2012:

MCK Chart

MCK data by YCharts

Of the four, McKesson and Cardinal Health have the lowest forward PE ratios. McKesson, the largest player in the field, recently raised its fiscal year EPS estimate from the $7.90-$8.20 range to $8.05-$8.35 range.

In addition to conducting your own investment research, McKesson is one stock with some extra-curricular concerns to be aware of. Never a boy-scout, McKesson has shelled out more than $1 billion in recent years to make peace with regulators and lawyers. Most recently it is getting added heat for what Morningstar, never one for florid descriptors, describes as “obscenely generous” executive compensation. That seems factually defensible given a recent Wall Street Journal report that CEO John Hammergren will be due a $159 million pension.

Last year alone Hammergren pocketed $131 million in compensation. Two institutional investors recently won support for the ability to claw back excessive compensation. YChart’s contributor Ed Silverman has more on McKesson’s latest governance problem.

So far, investors have shrugged off the latest McKesson dust-up; the stock continues to trade near its year-to-date high.

MCK Chart

MCK data by YCharts

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.

Read more articles about: Investing Ideas  healthcare   money managers   stocks that look cheap   

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