The health care sector of the mutual fund industry has been on fire for the past five years and anyone buying one of the several health care funds as of the end of 2009 would have tripled their money by the end of last year. The 10-year average annual return has been about 15 percent. So now what?
Before we get all excited about jumping on an apparent bandwagon, it's instructive to take a look at how much volatility and risk a select industry fund like this can bring to the table. Between December 2013 and the end of February 2014, these funds had gained 18 percent. Then, by mid-April, they had lost 14 percent. From that low-water mark to the present, they then gained more than 40 percent.
The price/earnings ratio on health care funds is now about 28-1, which means that the price of the average stock is $28 for every dollar of earnings. The current PE ratio for large dividend-paying stocks in mundane industries is currently 17. The long-term average for stocks in general ranges between 15 and 16.
There's a lesson here in one of the fundamentals of stock performance and that is the fact that what people will pay for a dollar's worth of annual company earnings is a reflection of what they anticipate the earnings to be in the future -- not necessarily what the earnings are today. In what could be a "bubble" in one or more subsets of the business world, it's the invisible hand of "irrational exuberance" that prompts the public to overpay for today's earnings. The expectation is that earnings will increase in future years to more than compensate for today's comparatively high stock price.
A large portion of the holdings of a typical health care fund consists of pharmaceutical companies, biotech companies, medical device companies, health insurance companies and hospital chains. It doesn't take much imagination to see these industries all benefiting increasingly as post-World War II baby boomers move into the period where we need more and more health services. Speaking for myself at age 71, I'm part of that pig in the python.
So we're at a point where two schools of thought collide. On the one hand, there are investment advisers who are still bullish on health care and urge clients to continue to buy. Part of their rationale stems from the fact that overall, high PE ratios are fueled, in part, by low interest rates on fixed-income investments like cash and bonds. In other words, a PE of 17-1 (which means a 6 percent return) is lower than normal, but the alternative pays next to nothing. This fact alone has contributed to the rising tide of PE ratios overall. So, the bottom line from some advisers is to hold your nose and buy more health care or at least keep what you have. For the record, the PE ratio for the entire S&P 500 in June 2009 was 122-1, so by that standard, even today's health care PE is not off the charts.
Modern portfolio theory, on the other hand, would prompt an investor to rebalance -- take a few chips off the table and spread at least some of those health care earnings into some of today's relative losers -- like energy funds that have lost 30 percent, but that gained about 50 percent just a few years ago. Also, foreign companies, over time, have had periods when they outpaced U.S. companies -- like from 2002 to 2008 when they outperformed by roughly 10 percent per year.
In the end, there is no right answer. We never know which of these approaches works best until we have the benefit of hindsight. But either strategy would work for the long-term investor. What won't work is to bail out of health care entirely in a futile effort to time the market and avoid the next 15 percent or more downdraft in the sector. That practice, as a routine, tends to cost investors a fortune in opportunity costs. And on a final note, if you're not in health care stocks specifically, there's no reason to despair. Their inclusion to some extent has contributed a large portion of the success you've had with your 500 index fund and other large-company core holdings.