How to invest in healthcare, a massive market sector that offers unparalleled diversification for portfolios
Walecia Konrad- Investments
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The size and diversity of the healthcare sector make it a key industry for investors building a diversified portfolio. Stocks are often economy-proof.
- The size and variety of the healthcare sector make it suitable for almost any investor building a diversified portfolio.
- Healthcare stocks fall into six categories: pharmaceuticals, biotechnology, medical equipment, sales, insurance, and facilities.
- While the healthcare industry has good growth prospects and is often economy-proof, it also carries some unique investment risks.
Investing in healthcare is enticing. After all, everyone needs medical care at some point in their lives; everyone uses health services of some kind. If you go by the adage "invest in what you know," then health stocks, which range from drug to insurance companies, certainly qualify.
They qualify for economic reasons too. For years now, healthcare costs have far outpaced the rate of inflation. National health spending, which accounts for 18% of total US GDP (gross domestic product), is projected to reach $6.2 trillion by 2028 .
Many healthcare stocks have exhibited robust earnings and share price growth - not only in the COVID 19-dominated year of 2020 but throughout the past decade - and many economists and analysts predict continued growth in the years to come.
Why invest in healthcare stocks?
Actually, the question might be why not invest in healthcare stocks. In fact, the healthcare industry is hard for investors to avoid.
- Health care is the second-largest sector (industry group) of the Standard & Poors 500
- Health care stocks represent over 10% of the Nasdaq Composite Index
- Of the 30 companies in the Dow Jones Industrial Average index, five are health-care related
So, you might be hard-pressed to build a diversified portfolio of any kind that doesn't include at least some healthcare stocks.
But it goes beyond ubiquity. Ranging from robotics to insurance companies, from century-old drug makers to fresh cannabis farms, the diversity of the health care sector also makes it an important place to invest. And because the sector includes both growth and value stocks, defensive stocks, aggressive small-cap plays and more conservative large-cap companies, you can achieve a lot of diversification within your portfolio via healthcare too.
We'll get into the hows of investing in healthcare. But first, let's examine how the healthcare industry is organized, the types of companies it includes, and their characteristics.
Types of healthcare stocks for investment
When you invest in the healthcare sector you're actually investing in a broad range of industries. Some are manufacturing/production, others are service-oriented.
Each element of the health care sector can act like its own mini-sector, with varying degrees of volatility and performance depending on demographics, government regulation, reimbursement patterns, scientific and technological breakthroughs.
There are six generally agreed-upon healthcare subsectors, each with its own characteristics:
Pharmaceuticals
Major pharmaceutical companies, aka "Big Pharma," manufacture and market prescription and over-the-counter drugs, creating a stable stream of revenue from continued sales. These firms also conduct research and development to create new drugs that undergo clinical trials in the hopes of ultimately being approved for use. Some of these efforts can result in "blockbuster" drugs such as cholesterol-lowering agents and diabetes drugs that generate profits for years.
The fortunes of these big drugmakers wane when patents expire and generic competition eats into sales or improved drug therapies are approved and take precedent over established brands.
Leading pharmaceutical companies include names such as Novartis AG, GlaxoSmithKline PLC, and Pfizer, the company that developed a COVID-19 vaccine with BioNTech.
Generic drug manufacturers are another important member of the pharmaceutical subsector. These companies manufacture look-alike drugs that are cheaper than brand-name pharmaceuticals once the patents for those brand-name drugs expire. Because of insurer and government incentives to use less-expensive generics, these companies can benefit from increased demand for lower-priced drug alternatives.
At the same time, because of the lower prices, generic drug makers experience thinner profit margins. In addition, many manufacturers have been under fire for faulty formulas and quality standards.
Biotechnology
Biotech firms also conduct research and development to create new drugs and therapies. However, they are often focused on one or two "breakthrough" products or treatments.
Biotech firms are sometimes classified as part of the pharmaceutical drug subsector, but they often behave differently than their Big Pharma counterparts. While the established drug-makers often offer steady returns and income, biotech firms are more akin to volatile growth stocks. Because their pipelines are concentrated and because it can take years to get FDA approval for a promising product, investors can wait years for a payoff.
Biotech firms include small startup companies and larger, more established drug makers such as Amgen and Biogen. BioNTech has become a well-known biotech name as Pfizer's partner in developing the COVID-19 vaccine.
Medical equipment
Medical equipment makers range from firms that make everything from commodity items such as bandages and gloves to expensive, high-tech equipment such as MRI machines and surgical robots.
In the right product categories, medical equipment stocks can offer long-term growth as the growth in healthcare consumption continues to increase. Investors need to consider product innovation, patents, government approval and reimbursements, and market demand when evaluating medical equipment stocks.
Large medical equipment companies include companies such as Johnson & Johnson and Medtronic PLC.
Sales and distribution
This sector includes pharmacies and retailers and wholesalers of healthcare products. Companies can be influenced by general retail trends, but are also subject to consumer demand for medical and health goods, and to regulations affecting the healthcare industry.
With more healthcare products and drugs being produced and used, growth in distribution networks has increased significantly in recent years, making healthcare distribution a growth industry with names such as McKesson and AmerisourceBergen.
Managed Healthcare
Managed healthcare is just another way of saying insurance companies. The field includes any company that provides health insurance policies, whether it be through employer-sponsored or private insurance, the Affordable Care Act exchanges, or socialized programs like Medicare and Medicaid.
Since health-care coverage is a staple of people's lives, managed-care companies' returns tend to be steady. It also helps that this sector in the US is dominated by a quintet of companies. The "Big Five" firms are:
- UnitedHealth Group Inc.
- Anthem Inc.
- Aetna Inc.
- Humana Inc.
- Cigna Corp.
Unlike the firms in other healthcare sectors, like biotech, the Big Five don't face many disruptors or new competitors. However, insurers' profits are tied to both consumer demand and government actions. The creation of new laws, or prospects of changes in laws, often causes ripples in the stocks, as the market tries to assess "what that'll mean for the insurance companies."
Healthcare facilities
Healthcare facilities firms operate hospitals, clinics, labs, physician offices, psychiatric facilities, and nursing homes. Major players include HCA Healthcare, which operates hospitals, and Laboratory Corp. of America.
Although the demographics are in its favor, this subsector has had problems with profitability in the past - making its business models work. It's also somewhat subject to real estate market trends.
It was particularly hard hit in 2020 by COVID-19, as consumers stayed away from routine doctor visits and hospitals wrestled with the demands of the pandemic.
The pros and cons of healthcare stocks
The number one advantage of investing in health care stocks? To participate in a sector that's expanding at a faster rate than the economy as a whole.
Healthcare stocks generally belong to an investment category of defensive stocks - that is, they provide consistent returns, regardless of how the stock market or economy is doing. But of course, some companies perform better than others. When investing in healthcare, look for companies that are best poised to take advantage of some underlying fundamentals that can fuel growth, including:
- An aging population
- Treatment advances in chronic diseases and conditions, including obesity and diabetes
- Technological advances such as telehealth and remote monitoring
Drawbacks of healthcare stocks
Despite their defensive reputation, healthcare stocks do offer risks - some typical of any investment, some more unique to this industry.
- Regulatory: Subsectors such as pharmaceuticals and managed care are highly regulated by the government. So FDA standards, new rules/changes in Medicare, Medicaid, and other programs, and cost controls can all play a role in how a stock performs.
- Political: No industry is immune to public opinion, but healthcare is a particularly hot button item. Consumer demand for lower costs and the ongoing debate for universal insurance programs and healthcare reform all can and do impact the prospect for healthcare corporate profits, and their stocks.
- Economic: Although the industry as a whole has good growth potential, many providers and facilities are experiencing dramatic competition - and consolidation trends. as consolidation continues pricing, and profits, could decline.
How to invest in healthcare
There are several ways to add healthcare stocks to your investments.
Individual stocks
All types of global healthcare stocks are available on the exchanges - not just US ones, but international companies as well, like Bayer AG ( BAYZF ). You'll need to determine which subsectors best fit with your portfolio and from there determine which companies offer the best potential for appreciation, income, or whatever your main investment goal.
Mutual funds and ETFs
There are numerous healthcare sector mutual funds and ETFs. Many are index funds. Some follow the sector as a whole via an index like the S&P 500 Health Care Index. There are also subsector indices such as the S&P Pharmaceuticals Select Industry Index or the Russell 2000 Biotechnology index.
Other funds are actively managed, with the manager choosing individual stocks within the healthcare sector based on corporate performance, outlook, and other factors.
Some examples of healthcare funds include:
REITs
Real estate investment trusts , publicly traded funds that hold a portfolio of properties, often specialize in healthcare facilities - the physical buildings that contain hospitals, medical offices, and senior housing. Though a more indirect play, these healthcare REITs can be a way to invest in real estate and healthcare at the same time.
The financial takeaway
Healthcare stocks offer an unusual bevy of choices and diversity. Growth, value, aggressive, and low-risk investors can all find choices within this expansive sector. Its sheer size, the growth in healthcare consumption makes this sector hard for any diversified investor to ignore.
Forecasts for healthcare consumption and spending suggest good growth prospects for this industry. As with any investment, though, healthcare has its downsides - and its own characteristic risks, such as its sensitivity to government regulation and political currents. That's why thorough research is an important part of healthcare investing.
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