Sunday, January 6, 2019

2018 Year-End Letter, Part 3: Sectors: Healthcare and Consumer Staples


In last year's letter we expressed our view that, given our assessment of general conditions at the time, the healthcare sector -- with its defensive nature -- was likely to under-perform the more cyclical sectors in 2018. Although we nonetheless felt that the sector held sufficient prospects to justify a high single-digit weighting.

Comparing healthcare to the cyclicals, at the halfway mark it looked as though our thesis was about half right. Healthcare, at that juncture, had notably under-performed tech, consumer discretionary and energy, but it had notably out-performed financials, industrials and materials.

By year-end, however, healthcare had held up better than all other sectors, finishing the year (+3.5%) as one of only two sectors in the green. The other being utilities with a 1.4% gain. Not what we anticipated coming into the year!

Having acknowledged the sector's relatively strong showing, and its solid technical setup, we increased our target to 10% later in the year; which is where we sit today.

The key fundamental drivers that we cited last year are the same going forward. 

They are:

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.

Speaking of government intervention, we think Schwab does a nice job laying out the current landscape:
"Government actions and potential actions continue to be potential sources of volatility for the sector, but we believe this creates potential opportunities for investors and are currently rating the group at outperform. While large-scale changes to the existing system seem highly unlikely in the near term given the environment in Washington and the split Congress that resulted from the midterm elections, there are smaller changes being made administratively and proposed legislatively that will likely continue to result in ebbs and flows in the sector as investors try to gauge the impact on various areas of the sector. This is a story that will continue to develop, with health care continuing to be at the center of many political debates and the mix in Washington changing but remaining divided. This will likely keep the health care sector a bit more volatile than usual, but also create some opportunities for investors willing to ride the potential roller coaster."
While in our view odds currently favor economic expansion going forward, and that, in that event, cyclical sectors stand to out-perform the defensive sectors by a fair margin, we think it's prudent (despite Schwab's characterization ["more volatile than usual"]), given the still uncertain macro backdrop, to maintain our 10% healthcare target for the time being.

Consumer Staples:

Given our bullish view of general conditions we weren't inclined to heavily weight consumer staples coming into last year. Thus, we began with a modest 6% target. 

As the year unfolded, however, and conditions deteriorated, we incrementally increased our target exposure; finishing the year at 10%.

Interestingly, despite the sector's defensive nature, staples still finished the year off 10.2%. That speaks to the cause of the deterioration in conditions; the "trade war".

Yes, the U.S. consumer staples sector is dominated by huge multinational companies. Here are the sector's top 10 constituents, with the percent of their revenue generated in foreign markets next to the name:

Procter & Gamble: 58.1%
Coca-Cola: 58.4%
PepsiCo: 42.5%
Walmart: 23.9%
Costco: 27.2%
Altria: 0%
Mondelez: 73.8%
Walgreens Boots: 24.8%
Philip Morris: 100%
Colgate-Palmolive: 79.8%

Hence, staples was little help in cushioning last year's decline. This accentuates precisely why we find protectionism to be the most pernicious threat to the economy and to the financial markets!

We're maintaining our 10% target for now...

No comments:

Post a Comment