To recession-proof your investments, try healthcare stocks

A big question for investors today is will the US economy enter a recession in the next 12 months? We believe the risks are skewed towards a recession, albeit starting only sometime in early 2024. Nonetheless, we see investors oscillating between the two narratives of ‘no-recession’ or a ‘deep recession’.

In this environment of uncertainty, we believe the defensive and high-quality healthcare equity sector, which is reasonably valued, can outperform the broader US market. Our US sector strategy takes a “barbell approach”, with healthcare on one side and the so-called ‘growth’ sectors, namely communication services and technology, on the other.

Defensive earnings

Healthcare, by its nature, remains in demand regardless of whether a recession happens or not. People continue to age and fall ill while accidents continue to happen, regardless of the economy. Economic activity levels would fall in a recession, which may correlate with less accidents and less infections, but relative to other sectors of the economy, demand for healthcare remains resilient. This is borne out in earnings trends historically, where healthcare earnings have lower volatility than the boom-and-bust cycle seen in the broader US market.

Healthcare earnings growth have remained positive even through a recession in the last two decades, unlike the broader market. Negative earnings growth in healthcare was only seen recently, when demand faded after the boom during COVID-19 due to surging demand for vaccines, test-kits, protective equipment and treatments.

The pandemic aside, we expect the healthcare sector to deliver steady and robust earnings growth through the economic cycle.

High quality earnings

Quality earnings can be a difficult trait to measure but a commonly used metric is return on equity (ROE). In the case of the US healthcare sector, the 12-month forward RoE is 23 per cent. What this means is that every dollar of profit reinvested in the healthcare sector is expected to generate a further 23 per cent of profit over the next 12 months.

This is attractive on an absolute basis, but also on a relative basis compared to the broader US market’s RoE of 20 per cent. The high ROE speaks to the healthcare sector’s efficiency in generating profits and often indicates good pricing power in a growing market.

Coupled with the historical consistency of earnings, this points to the high quality of the healthcare sector, a factor we believe will be sought after in the uncertain economic environment.

Reasonable valuation

To top it all, the healthcare sector is reasonably valued, in our view. The 12-month forward price-earnings (PE) ratio for US healthcare is at 18x, or 5 per cent below the PE for the broader US market. On average in the past two decades, the healthcare sector has traded at a 1 per cent discount to the broader US market.

Whilst the current discount of 5 per cent is not a significant undervaluation, we view it as attractive given it is a high quality and defensive sector. In an uncertain economic environment, one might even want to “pay up” for defensive exposure. Against this backdrop, investors can still enjoy defensive cover at a discount by investing in healthcare.

Regulations are a key risk to watch for when investing in the healthcare sector. On an individual company level, pharmaceutical company shares experience volatility on the back of drug trial results. On a sector level too, drug pricing regulations and health insurance rule changes can pose a risk. This is a particular risk, given the trend of rising healthcare costs in the US and the upcoming US presidential election in 2024. Healthcare may well become a political battleground between presidential candidates.

On balance, we believe the benefits outweigh the risks, leading to our overweight view of the US healthcare sector. We would combine it with a barbell approach in being overweight growth sectors, such as communication services and technology.