Are Healthcare Stocks Still Defensive in the Current Environment?

Healthcare has long been considered one of the most reliable defensive sectors—an effective portfolio buffer when equity markets turn volatile. That’s because hospitals, drug makers, medical device firms and other companies across the healthcare sector benefit from steady consumer demand regardless of the economy’s strength.

After a difficult first half, healthcare’s defensive capabilities are coming into question, but it outperformed the broader markets on a relative basis. The MSCI World Healthcare Index fell by 10.3% through June 30, 2022, in US dollar terms, compared to a 20.5% decline for the MSCI World Index, extending its steady pattern of downside risk reduction. In fact, healthcare has outperformed the market in every year global equities have lost ground since 2000 (Display).

Today’s Healthcare Sector Combines Defensive with Opportunistic

Healthcare’s defensive ability hasn’t changed, but the nature of the companies that comprise the sector have. For example, pharmaceuticals made up 82% of the benchmark in 2000. By the end of 2021, however, that share was just 38%. The weighting of biotechnology and equipment & supplies, meanwhile, nearly tripled (Display). Healthcare’s evolution has substantially changed the way market forces can impact the sector’s short-term performance, but it has also grown the opportunity set for active investors.

For instance, recent market declines are being driven by sharp sell-offs in growth stocks. Small-cap biotech companies—now a major component of the healthcare benchmark—have been caught in the downdraft. That’s why it’s important to distinguish among individual companies in biotech, or within all healthcare segments for that matter. The goal is to separate those that have the strength to weather the storm from those that might not.

Biotech, with such a large influence on the sector, exemplifies why active stock selection is so important in healthcare investing. Biotech firms’ returns tend to be highly volatile, because many investors pin too much of these companies’ growth prospects on the clinical success of new drugs or treatments in their pipelines. Just half of all new pharmaceuticals make it the second phase of testing, and only 8% receive full regulatory approval, according to Biomedtracker. That risk calls for a more fundamentals-based approach in this space. On the other hand, biotech covers a diverse ecosystem, including companies that profit from supplying or equipping its many different industries, which are relatively stable business models. 

Success Hinges More on Fundamentals, Less on Medical Breakthroughs

We believe the key to long-term growth in healthcare investing is to focus on a company’s business model—not the science behind it. Better outcomes come from research and analysis, rather than prediction and conjecture. That means an emphasis on high-quality, sensibly priced healthcare—and healthcare-related—companies with high or improving returns on capital and strong reinvestment capabilities.

Inflation, rate hikes and recession fears will keep 2022 challenging for most equity investors. If markets remain volatile, downside protection is always helpful, and we think that includes healthcare stocks, which have historically been reliable defenders. The sector doesn’t look the same as it did 20 years ago, but its positive contribution does. We think the dynamic products and services that now dominate the healthcare space are the reason why select stocks have the wherewithal to withstand tough economic environments and deliver long-term returns.