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Health Care Companies Showing Good Defensive Potential

- By James Li

Among U.S. companies, health care companies offer good defensive-investing opportunities. Such companies, including Johnson & Johnson (JNJ), Biogen Inc. (BIIB) and VCA Inc. (WOOF), generally had strong financial strength and gross margins.

Additionally, several health care companies made the Buffett-Munger Screener, one of two value screeners that generally outperform the stock market.


Brief discussion of sector

Like the consumer defensive sector, the health care sector also falls under the "defensive" super sector as health care products are generally essential to daily life. Even during an economic recession, consumers still need medical products to overcome illness and remain in good health. This market sector contains a diverse "basket" of industries including biotechnology, drug manufacturers and medical care. While the companies have dissimilar historical financial trends, the overall market sector generally outperformed the Standard & Poor's 500 index exchange-traded fund during the backtesting period from 2006 to 2016. Table 1 compares the backtesting results for health care companies to those of consumer defensive companies. The backtesting considers the largest 20 stocks based on market cap each year.

Year

SP 500 ETF

DJIA ETF

Consumer Defensive

Health Care

2006

13.74%

16.33%

15.40%

2.17%

2007

3.24%

6.54%

14.69%

5.93%

2008

-38.28%

-33.97%

-18.23%

-19.80%

2009

23.49%

18.91%

20.78%

13.65%

2010

12.84%

11.11%

9.05%

-0.31%

2011

-0.20%

5.38%

9.74%

9.33%

2012

13.47%

7.16%

16.08%

14.70%

2013

29.69%

26.72%

11.15%

38.28%

2014

11.29%

7.50%

8.39%

19.01%

2015

-0.81%

-2.19%

7.13%

4.26%

2016

10.74%

14.47%

3.34%

-7.19%

Overall

81.33%

86.22%

142.21%

96.39%



Table 1: Backtesting of consumer defensive versus health care sector. Screen date 200601, rebalanced every 12 months, ranked by market cap DESC, # of stocks = 20.

As illustrated in Table 1, both consumer defensive and health care stocks had a lower net loss during the 2008 financial crisis than the overall stock market did. This suggests that the consumer defensive and health care sectors have good defensive potential in a significantly overvalued stock market.

Biotechnology

Biotech companies, like Biogen and Gilead Sciences Inc. (GILD), manufacture medical products through genetically modified processes and technological advances. Such companies usually have strong gross margins as the biotech industry has high research and development costs and high barriers to entry. Figure 1 shows the historical trend of Biogen and Gilead's gross margin for the past 10 years.

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Figure 1

Even though Biogen's gross margins declined from 2006 to 2014, the margins sharply expanded about 10% during first-quarter 2014. Gilead's gross margins are less volatile; the California-based biotech company generally maintained a gross margin of 88% during 2007 to 2016, suggesting robust competitive advantages.

Likely due to strong gross margins, Gilead's profitability rank climbed from 5 to 8 during the nine-year period and occasionally reached 9 out of 10. The company reported third-quarter earnings per share of $2.49 and nine-month earnings per share of $7.59. Gilead's operating margin and return on equity both outperform over 97% of global biotech companies and reach near a 10-year high. Figure 2 summarizes the historical trend of financial strength and profitability ranks for Gilead.

Figure 2

Like Gilead, Biogen also has expanding operating margins and consistent per-share revenue growth. During the third quarter, Biogen reported $3 billion in revenues, a 6% increase from third-quarter 2015 revenues. Net income and EPS based on generally accepted accounting principles increased 7% and 13%. CEO George Scangos, Ph.D., praised the company's "solid performance" from its leading sclerosis business, which benefited a wide range of patients around the world. This likely contributed to a high profitability predictability rank. Currently, Biogen is one of about 100 companies with a five-star predictability rank. The company's financial strength and predictability rank trends are summarized in Figure 3.

Drug Manufacturers industry

Like the name suggests, the drug manufacturers industry contains companies that predominantly manufacture drug products. Such companies include Johnson & Johnson and Pfizer Inc. (PFE) with the former based in New Brunswick, New Jersey, and the latter based in New York.

Johnson & Johnson likely has stronger value potential as it has higher financial strength, profitability and business predictability than does Pfizer. The company has consistent operating margin growth as illustrated in Figure 4. Even though Johnson & Johnson 's gross margin slightly declined during 2006-2013, the margins seldom dropped below 68% during the 10-year period.

Figure 4

Johnson & Johnson reported operational sales growth of 4.3% from third-quarter 2015 to third-quarter 2016, reflecting success in the company's "new product launches and the strength of (our) core business," according to CEO Alex Gorsky. Likely due to its strong core business, Johnson & Johnson increased its 2016 full-year adjusted earnings guidance to about $6.705 ? 2.5 cents per share. With a strong core business and good earnings guidance, Johnson & Johnson maintained a profitability rank of 8 and a predictability rank of 3.5 stars. Figure 5 illustrates the historical financial strength, profitability and predictability rank for Johnson & Johnson.

Figure 5

Medical Care industry

Medical care companies provide services to their customers, which can range from elders to children. Such companies can also provide medical services to animals, like VCA, a California-based company that provides services to pets, especially dogs.

VCA reported robust third-quarter results, including double-digit revenue growth, gross profit growth and operating income growth from third-quarter 2015 to third-quarter 2016. VCA CEO Bob Antin further discussed the company's "outstanding" third quarter, which included a 16.2% increased in adjusted diluted EPS. The veterinary care company maintained healthy organic revenue and gross margin growth in both the Animal Hospital and Laboratory business segments. Likely due to strong revenue and margin growth, VCA had increasing profitability and business predictability during the past 10 years as illustrated in Figure 6. The company has a predictability rank of 4 stars.

Figure 6

See also

As health care companies offer good defensive potential, several predictable health care companies made the Buffett-Munger Screener, including VCA, Universal Health Services Inc. (UHS), Cigna Corp. (CI), Novo Nordisk A/S (NVO) and Parexel International Corp. (PRXL).

As of Dec. 22, the U.S. total market index is 126.8% greater than the country's gross domestic product. The "Buffett indicator" implies an average return of -0.4%, including dividends. Such market calls for defensive investing (i.e., investing in companies in the consumer defensive and health care sectors).

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Disclosure: The author has no position in the stocks mentioned in this article.

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This article first appeared on GuruFocus.