Healthcare Sector Overbought?

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– Healthcare sector has outperformed index in Australia ytd
– Brokers debate whether overvaluation is implied
– Potential for switch to "risk on"
– Stock preferences noted

By Greg Peel

Australia's large-cap healthcare sector has been able to deliver FY12 earnings growth, the recent reporting season confirmed, albeit in line with expectations, which has given investors two reasons to buy: said growth, and defensive qualities in the pervading “risk off” environment. The ASX200 healthcare index ((XHJ)) outperformed the ASX200 Industrials by 7% in August and the general index by 5%, and is up around 24% year to date.

This is not, typically, how a “defensive” is meant to work. Defensives are meant to outperform by not falling as much as high beta stocks in weak markets while offering stable but uninspiring growth in strong markets. The ASX200 index is net higher year to date but in a volatile market, yet healthcare has outperformed.

RBS Australia can see why the sector may continue to attract interest given the potential for further volatility on three fronts, being a lingering recession in Europe, sluggish growth in the US in the run-up to Washington's “fiscal cliff” and concern in the resource sector with regard to a slowing China and persistently strong Aussie dollar. However RBS also foresees an investor shift towards greater levels of risk as multiple rounds of quantitative easing play out around the globe. Correlation statistics are suggesting a fixation on the global economy is beginning to wane as investors focus more on individual corporate profits.

The large-cap healthcare sector is now showing a price/earnings ratio 16% above its three-year mean, RBS notes, and mean reversion would suggests 10% downside. The analysts are still keen on the sector on a longer term basis but see now as a good time to take profits in those stocks for which the market has already discounted earnings risk over the near term, being Ramsay Health Care ((RHC)), Primary Health Care ((PRY)) and Sonic Healthcare ((SHL)), over the medium term, being ResMed ((RMD)), Ansell ((ANN)) and Cochlear ((COH)), and over the long term, being CSL ((CSL)).

RBS has rolled forward its valuation model inputs which has led to target price increases for most of the healthcare stocks the broker covers, albeit no recommendation changes have followed. The broker maintains a Hold rating on all of the above mentioned stocks except Ramsay, for which the rating is Sell.

Note that while a “Hold” rating and a suggestion profits should be taken might sound contradictory, this is not the case. “Hold” or “Neutral” ratings imply those stocks should be weighted as per their index weighting in an index portfolio, which implies that if investors have been holding greater than market weighting then it's time to cut back positions.

Healthcare sector outperformance, says UBS, has “confounded our sector valuations and fundamental stock targets”. However this is not the first time in history such a premium has been afforded the sector. The XHJ outperformed by 1.7% in the FY09 GFC period and by 7% in FY01, the tech wreck period. In each case healthcare gained from earlier lows as investors abandoned risk and scarcity of opportunity allowed healthcare to stand out. Healthcare's premium is now at a 5-year average, UBS notes, but history shows there may yet remain another 15% upside on the weight of inflows.

UBS has set a year-end target for the ASX 200 of 4500, or 4% higher than current. Fundamentally the healthcare sector is suggesting resilient earnings growth of above 10% ahead compared to the overall market's more “realistic” expectations of 4-5%. This suggests to UBS that investors could pay up to a 60% premium compared to the current premium of 51% on one-year forward estimates.

If the market decides the Aussie dollar can ease back, key names including ResMed, CSL, Ansell, Sonic and Ramsay stand to benefit, UBS notes. However, if history is on the healthcare sector's side, it also speaks of the potential for an abrupt reversal if “risk on” is back in vogue. To this end, UBS joins RBS in assuming the potential for stimulus from China, Europe and the US as well as RBA rate cuts.

Put it all together, and UBS has Buy ratings on Primary and ResMed along with Sirtex Medical ((SRX)), and Neutral ratings on CSL and Sonic. All of Ansell, Australian Pharmaceutical ((API)), Cochlear, Ramsay and Sigma attract Sell ratings.

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