The market's healthiest sector

By Tim Middleton

The stealth success story of 2008 has been health care.

That sector's stocks have quietly outperformed all other equities this year, with the average health care mutual fund ahead 1.6% as of Aug. 19 and up 6.4% in the past three months.

By contrast, the average large-core mutual fund is down 12.9% this year, and core foreign-stock funds have tumbled 20.1%.

"The group has come back (because) investors are really very nervous about the economy, and these stocks are seen as safe havens. And to a large extent, that is true," says Herman Saftlas, a Standard & Poor's equity analyst who tracks pharmaceuticals, the biggest industry within the group.

Two big draws for investors right now:

• Moneymakers. Health care stocks are making money while the market loses ground. Standard & Poor's expects the 13% of the S&P 500 Index ($INX) represented by health care to report a gain in operating earnings this year of 9.7%, compared with a decline of 2.1% for the index overall.

• Still cheap. Compare earnings to stock prices, and you will find that health care is still a bargain. The sector's average price-earnings multiple of 15.11 is slightly less than the market average of 15.96.

You'd expect such a hard-working sector instead to have a higher multiple than the market, because investors usually would be willing to pay more for the same earnings. And that's why this sector deserves your attention before the crowd catches on.

• Video: 2 picks in tech and biotech

Hot sector, cold reception

Investors' enthusiasm for health care actually has waned substantially and consistently over the past five years; average price-earnings ratios were 20.45 in 2004, when the market's average was 17.93.

But with the group's earnings potential as relatively stable as it is, things are going to turn. S&P expects the sector to enjoy a premium next year over average P/E's, albeit because multiples are expected to contract less -- to 13.22 for health care and 11.89 for the market.

Health stocks are being buoyed by relatively constant demand for what these companies produce, along with massive cost cutting and share buybacks. When companies buy back shares, they spread their growing bottom line among fewer shareholders.

Biotech has provided all the sizzle lately, both because of new blockbuster drugs and therapies and because big drug companies continue to absorb the most successful operators.

Funds find more to buy

One signal that I have found correlates to a sector's success is the reopening of long-closed funds to new investors. That's because funds often close when managers can't find attractive investment prospects -- and reopen when they spot opportunity.

We got such a signal from Vanguard Group on Aug. 7, when it reopened Vanguard Health Care (VGHCX, news, msgs). This outstanding fund has seen its assets dwindle to $13.3 billion from $19.6 billion in 2004.

The fund closed in 2005, a year in which it outperformed the S&P 500 by 10.5 percentage points. In 2006 and 2007, it trailed the average by 4.9 and 1.1 percentage points, respectively, and last year delivered a net loss of 9.3% to shareholders.

So far this year the fund is down 2.8%, but that loss is nearly 10 percentage points less than that of the market overall.

The pharmaceutical group does face one big hurdle, though: the suddenly popular U.S. dollar. Big Pharma collects 40% of its sales in foreign currencies, which are suddenly less valuable. In the past three months, among exchange-traded funds, SPDR S&P Pharmaceuticals (XPH, news, msgs) has spurted 6.3% higher, while HealthShares European Drugs (HRJ, news, msgs) has tumbled 7.1%.

Building on biotech

Earlier in this decade, health care was walloped as more and more blockbuster drugs lost their patent protection. In Big Pharma, a proprietary drug can bring billions in revenue -- such as the $12 billion that Lipitor, a cholesterol-control medication, brings in for Pfizer (PFE, news, msgs) each year. That patent expires in 2011.

Those patent losses have reduced sales growth industrywide to little more than 1% annually. But profit growth has remained substantial as drug companies slash expenses by closing unneeded plants and firing legions of salespeople.

Here where I live in New Jersey, the industry's capital, literally thousands of highly paid salesmen, scientists and technicians have been furloughed.

Continued: Innovation

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