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Diagnosing Sector Opportunities

By Rayna Penelova

With the Dow Jones approaching 20,000 and the S&P 500’s P/E ratio currently 21% higher than the mean, it is no surprise that all sectors in the market look expensive. The traditional valuation method (comparisons to their historical averages) is simply not comprehensive enough in the current market environment, as the market as a whole is quite expensive. We don’t believe bailing on the market is ever a good idea, so what’s an investor to do in this environment?  Looking at out how the sectors of the S&P 500 stack up against each other, over time, is one way to determine where to put your money.

Anytime you look at valuations based on history you have to be concerned about a value trap.  A value trap is the term used when a stock or sector is undervalued, yet gets even more undervalued over time.   A value trap looks attractive to investors, based on price, but it turns out that there is a good reason for it to trade at a discount. This is why a comprehensive analysis should be done every time a security is selected. An undervalued stock/sector with opportunities for sales growth is one way to avoid value traps. Growth in a slow growth economic environment is quite scarce and therefore merits a premium. Any company or sector with a strong catalyst for growth is probably not going to end up as a value trap.

After looking at relative sector valuation, using the price-to-sales ratio (P/S), we found health care to be a bright spot.  Health care was unloved in 2016; the worst performer in fact.  As a result, health care is now the most undervalued sector, using this approach. The series of charts below show the P/S ratio relationship between the sectors over time.  Health care has historically traded at a premium relative to other sectors, which can be seen by the value of the yellow line in the charts below.  For example, in comparison against the consumer staples sector, the average value of approximately 1.6 means that the health care sector P/S is historically 60% higher than the P/S ratio of the consumer staples sector.   If the blue line is below the yellow line, it means health care is trading at a discount to its historical relationship.  The charts below paint a clear picture that, relative to history, health care is cheap versus its peers.

Is the sector a value trap?  We don’t believe so.  The health care sector ranks well on an estimated sales growth basis.  Sure, it’s not number one, but is respectfully in the middle of the pack.  In addition, many of the companies in the health care sector have less volatile earnings than the overall market, which adds to the quality of the stocks.  This is especially true in an economic slowdown where earnings predictability warrants a premium. Any pull back in the price of such companies should be interpreted as a buying opportunity.

Now, uncertainty around repealing and replacing the Affordable Care Act could keep health care stocks under pressure. However, I would argue that most of the costs involving the prospective changes are already priced in the market and are perhaps overdone. A policy solution is an opportunity, as it would clear uncertainty and provide a clearer outlook, which should let the sector loose to catch-up to the overall market.

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Charts Source: Bloomberg

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