Editors' Pick: Originally published Dec. 28.
With year-to-date average gains of 5.74%, according to Fidelity Investments, health care stocks are second on 2015's list of top sector gainers behind consumer discretionary (up 9.13%) -- both of which have outperformed the S&P 500 (SPX) (flat so far in 2015) and the Dow Jones Industrial Average (DJI) (down 1.5%).
Owing to an aging population that will rely on health care benefits spurred by the Affordable Care Act -- aka Obamacare -- health care stocks like UnitedHealth (UNH) - Get Report (up 17% in 2015) and Bristol-Myers Squibb (BMY) - Get Report (up 16% in 2015) entered 2015 as some of the hottest names to bet on. The 6% year-to-date rise in both the Vanguard Health Care ETF (VHT) - Get Report and in the Health Care Select Sector SPDR Fund (XLV) - Get Report would suggest these were wise bets.
But not all health care stocks were great investments. For instance, for every, say, Boston Scientific (BSX) - Get Report , which skyrocketed 41% in 2015, there was a Mallinckrodt (MNK) - Get Report (down 22% in 2015) or Tenet Healthcare (THC) - Get Report (down 35% in 2015), which struggled to deliver on their enormous growth expectations. In the case of Tenet, while the company has beaten its revenue and earnings estimates in three straight quarters, its P/E ratio of 184 remains roughly nines time the P/E of the S&P 500. So, through -- seemingly -- no fault of its own, given its streak of earnings beats, it would seem investors decided the P/E must come down.
Like Tenet, there are may be similar cases in 2016, where investors wakeup and realize valuation does matter. But overall, health care stocks should continue their upward trend, especially the ones that were left out of 2015's rally. Execution will still be the key ingredients to their success, however. It's also important to look for companies with a good combination of product positioning in the market that are also well diversified. It helps if they can offset the strengthening dollar that devalues their overseas sales. And it's an added bonus if they pay great dividend yields.
In that vein, Johnson & Johnson (JNJ) - Get Report (down 1.13% in 2015) comes to mind. At around $103 a share, the New Jersey-based company is priced at just 15 times consensus 2016 estimates of $6.42 a share, compared to a forward P/E of 17 for the S&P 500. Apply a 17 multiple to those estimates and JNJ stock would be priced today at around $110, or 8% higher. In terms of execution, JNJ has beaten Wall Street's earnings estimate in eighteen straight quarters. And it pays a 75-cent quarterly dividend, yielding 3.00% annually -- a full percentage point higher than the S&P 500.
Medtronic (MDT) - Get Report (up 7% in 2015) is another stock to watch in 2016. Unlike JNJ, shares of MDT -- at 17 times fiscal 2016 estimates of $4.37 a share -- don't scream bargain. At best, they trade in-line with the S&P 500. But few health care stocks are positioned as well to capitalize on the Affordable Care Act.
Take, for instance, its 2014 acquisition of Covidien, which gives Medtronic access to new markets like weight-loss surgery. Not only did the $43 billion deal open doors to new growth businesses to complement Medtronic's strength in areas like insulin pumps and spinal implants, Covidien turned Medtronic into a much better diversified company -- one that can better compete with both larger competitors like Johnson & Johnson and smaller rivals such as Boston Scientific.
Given these factors,Medtronic is projected to grow earnings at an annual rate of 7% in the next five years -- three percentage points faster than the average growth rate of the S&P 500. Based on fiscal 2017 consensus estimates of $4.84 a share, MDT is priced at just 15 times those estimates, suggesting despite its shares trading at near all-time highs, they may yet be cheap. Add in its 38-cent quarterly dividend that yields 2.02% annually, there's tons of reasons to favor MDT here.
Among other health care stocks to watch, Merck (MRK) - Get Report (down 6.73% in 2015) and GlaxoSmithKline (GSK) - Get Report (down 4% in 2015) -- are two names with plenty of cash, but short on growth and may consider the M&A route in 2016 to gains access to products and markets that would otherwise taken years to build. Not only do both stocks pay excellent yields, they trade at relatively cheap P/Es of 14 and 10, respectively.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.