Identifying promising health care stocks

Many investors make mistakes because they have familiarity bias—the inclination to invest in companies or industries just because they know something about them.

Familiarity bias can also be negative. If a cardiac surgeon doesn’t like a certain kind of medical device, he or she might be soured on investing in the manufacturer, regardless of its growth prospects.

Naturally, the best way to approach stocks is without any bias. As health care is likely to be a fruitful sector this year and beyond, a disinclination to invest in it might mean missed opportunities.

Currently, healthcare is a split sector. Some companies are hitting new recent highs while others have descended to new recent lows, so discriminating between them is even more critical. This is a time for discerning stock picking rather than using funds or ETFs.

A surgeon’s potential bias against a supplier could be particularly disadvantageous these days because medical device and instrument companies are poised for growth as hospitals and surgery centers resume elective procedures suspended during the pandemic. This is happening as many baby boomers are entering their late 60s and need increasing care—a key factor driving growth.

The increase in surgeries comes at a time when healthcare is an undervalued sector according to its fair value—a measure of an asset’s estimated true or intrinsic worth. Fair value is different from market price, which could be much higher or lower. According to Morningstar, healthcare is among the stock sectors that, as of mid-February, had its lowest median price relative to fair value since the summer of 2020, when the world was in the throes of the pandemic shutdown. (Two others such sectors are industrials and, believe it or not, technology .)

The surgery surge bodes well for companies like Medtronic, a manufacturer of surgical/medical devices. Such supplier companies, which provide surgeons with the metaphorical picks and shovels of their profession, generally are poised for growth, as are some pharma and services companies.

Yet, investing in healthcare stocks is generally complicated by the sector’s current price bifurcation.

As of mid-February, some healthcare companies—including biotech company AbbVie, pharma company Bristol-Myers Squibb and nine care provision and services companies--were at three-month relative highs (AbbVie, at an all-time high). Among the nine were McKesson, Amerisource Bergen and Molina Healthcare.

Meanwhile, other healthcare firms—primarily in the life sciences tools and services subsector—were at three-month relative lows. Among these were instrumentation and reagent supplier Thermo Fisher Scientific, medical/industrial conglomerate Danaher and medical data science firm IQVIA Holdings.

The sector’s current bifurcation reflects likely investor confusion over its future amid an overall market atmosphere of uncertainty. Yet uncertainty often means opportunities for investors who can identify stocks with the potential to sail briskly without hindrance from the albatross of high risk.

My firm did an analysis designed to precisely achieve that. We started by selecting healthcare stocks with the lowest downside risk, according to our screens. From the resulting group, we selected those with 12-month trailing price/earnings (P/E) ratios below that of the S&P 500 (24.3) and relatively high projected annual earnings growth over five years, as determined by the average of various analysts’ projections. A low P/E reflects good earnings for the price investors must pay for a stock. This tends to attract investors and drive up price, as does projected high earnings growth. Such stocks can be lay-ups in the basketball game of investing.

The resulting list of lower-risk, low-P/E, high-projected-earnings stocks included Pfizer, Humana, HCA Healthcare, Anthem, Merck, Cigna and CVS Health Corp. Pfizer led the pack in projected average annual earnings growth with 15.88%, followed by Humana, 13.96%, and HCA Healthcare, 12.14%.

Some stocks in the initial, lower-risk group had even higher projected earnings growth—Danaher with 24% annually and biotech firm Vertex, 30%-- but both stocks have trailing 12-month P/Es above that of the S&P 500. So did Medtronic, but with lower projected annual earnings—9.62%. Yet with the resumption of elective surgeries, Medtronic’s earnings in the first year out of five might be significantly higher than in the next four. Also carrying a high trailing P/E is IQVIA Holdings---62--but that company has projected average annual earnings growth of 22.31%.

Even if these earnings projections are realized, this isn’t a guarantee of high price appreciation, but it’s a highly positive indicator. Other factors affecting price are harder to anticipate—for example, in pharma, a cutting-edge new drug or a clinical-trial disappointment can send values up or down in an instant.

Equity prices are subject to the impact of recessions, black swan events like the pandemic recession and, more typically, the vagaries of market sentiment. But the metrics used above are among the best available ways to project performance.

Of course, you can’t benefit from a stock’s long-term performance if you don’t keep your shares long term. Productive investing requires patience.

David S. Gilreath, a Certified Financial Planner™, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors LLC, a portfolio management company for individual investors, and Innovative Portfolios LLC, an institutional money management firm. Based in Indianapolis, the firms managed about $1.4 billion in assets nationwide as of Dec. 31, 2021.