Wednesday, December 27, 2017

2017 Year-End Client Letter, Part 3: Sectors, Section 3: Healthcare, Utilities, Telecom, Consumer Staples and REITs

Link to Part 1
Link to Part 2
Link to Part 3, Section 1
Link to Part 3, Section 2

Here's a brief synopsis of what we view as today's fundamental aspects of the healthcare, utilities, telecom, consumer staples and reit sectors. We want to emphasize "brief", as we could easily offer up a lengthy research paper for each. 

Note, the following relates primarily to the prospects for sectors within the U.S. economy. Our targets are also influenced by our assessment of each sector within other countries -- as we maintain target allocations to foreign markets as well. A topic we'll tackle in Part 4.

The healthcare sector, at 8% of equities, remains a relative underweight in client portfolios. Essentially, while the sector offers much by way of diversity (pharmaceuticals, equipment, hospital and insurers), broadly-speaking we consider it an economically defensive play. While we think there's enough going on in the space to merit a high single-digit weighting, we feel that other more cyclical sectors offer better opportunities for the time being.

Here are some key fundamental drivers:

1. Age: An aging population requires ever increasing medical attention.

2. Longevity: Folks are living longer, even with chronic disease.

3. Sedentary lifestyles and poor eating habits: Obesity and diabetes are on the rise.

4. Technology: As in other sectors, technological advances in medicine are occurring at a rapid pace. The companies at the forefront make interesting investment prospects. 

5. Government: The more government intervenes into the healthcare space the greater the chasm separating the winners and losers. Think in terms of hospitals and insurance companies; the greater the number of folks who are covered the better off the service providers (of course reimbursement rates come into play), yet the more the utilization the higher the claims on insurers.

The utilities sector is considered your quintessential defensive play. It also sports some of the market's highest dividend payers. The following explains why we remain bearish (0% target) on the sector.

Key themes:

1. Economically defensive: Utilities are known for their defensive nature. I.e., folks gotta keep the lights, the air and the heat on. When the economy is in expansion mode, clearly, the cyclical sectors house the more compelling opportunities.

2. Interest rate sensitivity: Investors tend to buy utility stocks for their high dividend payouts. When interest rates rise, the sector faces stiff competition from the debt markets. I.e., while the utilities sector in the aggregate is paying a 3.34% dividend, yield-hungry, risk-averse investors will have zero qualms about exiting the space when treasuries yields are comparable. In addition, utility stocks tend to carry a great deal of debt on their balance sheets. Higher interest rates lead to hiring borrow costs, thus crimping their bottom lines.

3. Renewable energy: By some estimates, "by the year 2050, renewable energy could source approximately 80% of the world's energy." Thus threatening the future of traditional utility companies.

Telecom services is generally lumped in with utilities, healthcare and consumer staples as an economically-defensive industry. Which, despite the technical nature of the telecom business, has been how we've generally treated it of late in client portfolios. Thus our 0% target throughout 2017. 

That said, telecom is actually the one sector that we've allowed to move above the top end of its target range (0-2%) without stepping in to rotate out. For one, the two top positions in our core telecom ETF, AT&T and Verizon, happen to be the 6th and 10th largest holdings respectively in our core technology ETF. Plus, telecom is a key component within our emerging markets exposure, which is one place the sector performed quite well in 2017.

After an abysmal year for U.S. telecoms, their relative cheapness and a somewhat improving technical picture presently has our attention. I.e., we may find ourselves upping our allocation in the not too distant future.

Consumer staples: Save for the sectors we're avoiding entirely, consumer staples currently sports our lowest sector weighting -- at 6%. While there are no doubt some compelling individual stories within the space, they're defensive, and they pay high dividends. I.e., given our macro assessment, they lack timeliness and they're uniquely exposed to interest rate risk. That said, we don't see ourselves abandoning the space altogether (as we have with utilities, telecom [may soon change] and reits), as -- for the sake of prudence and diversification -- we believe some exposure to defensive industries is warranted at virtually all times. Today we're satisfying that objective primarily within the healthcare and staples sectors.

Real Estate Investment Trusts: While we counsel clients and often endorse their specific real estate investment ideas, such situations generally involve taking positions in opportunities within their respective communities. The way we buy real estate within client portfolios is through publicly traded REITs. 

While in the past we've maintained as high as a 10% target weighting to REITs, for now we remain at zero; for the simple reason that they, as a group, have been the definition of interest rate sensitivity. The quarterly correlation coefficient between REITs and the 10-yr treasury yield over the past 5 years has been -0.613. Over the past 12 months it's been -0.93. Meaning, when interest rates rise, REITs tend to fall in value (big time lately) -- and we believe that the risk to interest rates going forward is to the upside. 

Next up, Part 4: Global Investing

Link to Part 4

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