Healthcare, Industrials and Consumer Discretionary Investing Themes 2008: A Tale of Two Halves - Part 5

By: Hans_Wagner

The beginning of a new year is a good time to make a new assessment of the important investment drivers and themes for the year. If you want to beat the market it is important to understand what is driving the markets and where the best sectors are to find good opportunities. By identifying these factors you will have a solid framework to assess the impact market movements and news events on your investment strategy. This is the fourth of a five part series on the outlook for the 2008 markets. The first part discussed the key drivers ending with a mention of what sectors will benefit and those that will be hurt. This Part discusses the Materials and Utilities sectors. Part 2 discussed Energy and Financials, Part 3 reviewed Technology and Consumer Staples. Part 4 presented the Materials and Utilities sectors. 

For those interested in making money in this market you might want to read Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance) by Vitaliy Katsenelson. The core of Katsenelson's strategy is to break down into three key pieces what you need to look at when analyzing a company: Quality, Valuation, and Growth (QVG).

The chart below from StockCharts.com shows the performance for 2007 of the nine S&P 500 sectors. What is interesting is that seven of the sectors beat the S&P 500 for the year, with Financials and Consumer Discretionary being the laggards.

Healthcare Investing Themes

There are two important factors that drive the healthcare industry in 2008. The first is the perception that the aging baby boomers are requiring significantly more health related services and products. The other is the up coming Presidential election with healthcare being one of the major issues.

Healthcare has experienced difficult times and performed worse than many analysts have predicted. The basis for better performance in Healthcare is derived from the demand for more and better care from the aging population, especially what are know as the “baby boomers.” These are the people who were born soon after WWII and are now approaching retirement age. The oldest of these people will be 62 in 2008. This aging group of people represents about one third of the U.S. population. As a result many analysts expect them to spend more on drugs and health related services.

However, it will be several more years before we should see a dramatic jump in the demand for health related services from this group After all it will be 15 to 20 years before the leading edge of the boomers will reach the age where they will require extensive care. It is highly likely this group will live longer than their parents, which may cause them to consume higher expenditures of health services longer. However, we are not there in 2008. This is an issue that will become more important a number of years from now. So if you investing premise is based on the potential the baby boomers will generate in the healthcare sector, be prepared to wait for a number of years.

On the other hand the U.S. Presidential election is likely to make many investors avoid much of the healthcare sector. An all-inclusive health insurance program intended to cover the uninsured population is a primary focus. Such a program would likely include direct pricing negotiations between the federal government and drug manufacturers, adversely affecting the pharmaceutical firms. The winners would be the hospitals, because they have been negatively affected by rising levels of bad debt and the use of emergency rooms by uninsured individuals.

Another important election-year issue is generic biopharmaceuticals. The Democratic candidates have been vocal advocates for the removal of barriers blocking generic drugs and of creating a pathway toward biogeneric approvals at the Food & Drug Administration. However, there are numerous reasons why generic biopharmaceuticals are a distant threat to the U.S. biotech firms. First, these compounds are very difficult to manufacture. They are produced from human proteins, as opposed to raw chemical ingredients used to make traditional pharmaceuticals, so that plant validations alone would take years. Second, we don't think the FDA, as currently constructed, has the resources, not to mention risk tolerance, to take on a generic biopharmaceutical approval process. 

The generic drug manufactures are likely to benefit from the election as the government applies pressure to lower drug costs. Companies like Teva Pharmaceuticals (TEVA) and Barr Labatories (BRL) are likely to benefit.

The Health Care IT market may benefit from favorable political support with all candidates endorsing electronic medical records which require IT investment. As a result the large outsourcing firms such as Accenture (ACN) are likely to benefit. In addition electronic medical record companies such as Cerner ( CERN ), Quality Systems ( QSII ), and Allscripts ( MDRX ) should be of interest. 

And finally firms that can help lower the cost of drug development such as ICON Plc (ICLR) should benefit as the pharmaceuticals strive to lower their costs to develop drugs. As should firms that provide diagnostic testing, information and services.

Other than a few select firms, I do not expect the Healthcare to outperform the S&P 500 in 2008. 

Industrials Investing Themes

The industrial sector is comprised of companies that make and move products throughout the world. More than 40 percent of the revenues in this sector are from international operations, with many of the firms generating much more than that. Since various economists such as S&P Economics expect Asian and European economies to continue to do well, this bodes well for the sector overall. In addition an increasing share of revenues in this sector comes from higher-margin, aftermarket services which help to reduce cyclicality. The sector trades at a price earnings ration of 14.9 times projected 2009 earnings, vs. 13.9 for the overall market. Certainly earnings for these firms may decline which will raise the PE ratio, but the prospects look positive.

2008 election could be very significant for defense contractors, particularly if there are Democratic majorities in both houses of Congress and a Democratic President. If the prospect for this to take place looks more real, then it will tend to hurt the defense sector due to the projected reduction in defense spending. Possibly offsetting this situation would be demand for defense products from the rest of the world. 

Speaking of politics, it is likely that both parties will generally support spending on projects related to construction and engineering and industrial machinery, although the two parties might favor different types of projects in these areas. The Democrats are more likely to focus on environmental projects, including emissions control, water infrastructure, and alternative energy. A large potential positive impact from infrastructure upgrades for bridges, benefiting Lincoln Electric (LECO), Illinois Tool Works (ITW), and Kennametal (KMT); roads benefiting Astec Industries (ASTE), Terex (TEX), and Bucyrus International (BUCY); electric energy infrastructure likely aiding McDermott (MDT), Emerson Electric (EMR) and ABB (ABB)]; and greater efficiency in manufacturing benefiting ABB, Emerson, Rockwell Automation (ROK), and Roper Industries (ROP).

The high price of oil will drive investment in products and services to explore, produce and refine oil throughout the world. This will benefit companies that provide the support services such as Haliburton (HAL), Stumberger (SLB) and Baker Hughes (BHI). Many countries are designing and building plants and pipelines to move and process energy products. This will benefit the engineering companies such as Fluor Corporation (FLO) and Jacob Engineering (JEC) as well as the companies that provide key components such as pumps and valves like Flowserve Corporation (FLS).

Transporting goods and services such as grains, coal, manufactured products, exports and consumer goods continues to grow in demand throughout the United States. This benefits the rails such as Burlington Northern (BNI), or which Berkshire (Warren Buffett's company) owns 18%, Norfolk Southern (NSC), Union Pacific (UNP) and CSX Corp (CSX). 

The Industrials sector should outperform the S&P 500 in 2008 driven by the strength of the global economy and the eventual rebound of the U.S. 

Consumer Discretionary

Consumer Discretionary was the second worse performing sector of the S&P 500, beating only the meltdown by the Financials. Comprised of companies that depend on the consumers to spend their excess money, they took the brunt of the slow down in the U.S. economy during the later part of 2007. Since this slowdown is expected to continue for the first half of 2008, these companies will continue to encounter difficult times, especially as unemployment rises. Consumers are also controlling their spending due the problems in the credit markets and the negative wealth effect from declining home prices. On the other hand the strength of the global economies will be a positive for those companies that have substantial exposure to those countries such as McDonald's (MCD). 

Politics will have a positive impact on some parts of this sector. Regardless of which party gains the White House, advertisers will likely be the big winners, as spot TV advertising spending is projected to rise 9% to 10% in 2008, according to the Television Bureau of Advertising. This should benefit Disney (DIS), News Corp (NWS.A) and CBS Corp (CBS).

The economic stimulus package the federal government is planning is supposed to help stimulate the economy through a $146 to $157 billion bill that would give tax credits and rebates to 117 million people. This money is expected to add 0.2% to the GDP in the quarter it is distributed. Not exactly a big boost to the economy. Also, the retailers will receive the money, though many of the goods that may be bought are likely to be made in other countries, meaning a certain portion of the stimulus package will go help stimulate the global economy. Such is the nature of our interconnected economies. Unfortunately it just increases our debt with very little benefit. But enough of my opinions.

This sector is likely to continue to under perform the S&P 500 until investors believe the U.S. economy is at or near a bottom. Then it will be a good sector to invest. The important indicators to watch will be consumer sentiment. When sentiment finds a base and/or begins to rise then it will be a good time to seek out companies in the Consumer discretionary sector.

I expect the consumer Discretionary sector to under perform the S&P 500 in the first half of 2008 and then out perform during the second half. 

The Bottom Line

Healthcare face a difficult year ahead as they respond to the changing healthcare system in the United States. As a result they will under perform the S&P 500 for the foreseeable future.

Industrials will beat the S&P 500 throughout 2008, especially the companies that have significant global exposure. 

The Consumer Discretionary sector will experience a difficult first half of 2008 and then return to its upward path as the prospects for the U.S. economy improve. Companies that have exposure to global economies or political advertising should hold up better than others..

Readers interested in learning more about Sector investing should read Sector Investing, 1996 , by Sam Stovell. It discusses how to use sector rotation in your investing endeavors. An expensive book, but worthwhile for those interested in using sector rotation strategies to improve the performance of their portfolios.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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