“Moderna Signals New Age of Health Stocks” with faded stock charts in the background and “Weekly Viewpoint” in the top left corner

Medical stocks are going through an identity crisis.

The pandemic has inspired a wave of medical innovation, and it’s resulted in the creation of groundbreaking COVID vaccines in historic time. Yet health care has been one of the worst-performing sectors of the market since the lows of March 2020. Health care stocks got lost in the midst of the market’s obsession with stay-at-home and reopening stocks.

The sector often lacks distinction: It can be considered a biotech and health care equipment growth play in good times, and a defensive sector in bad times. That’s been a disadvantage so far in this recovery, but health care’s shapeshifting could be appealing in an environment where there’s a lot of uncertainty and a lack of conviction.

Chart titled Health Care Gets Lost in the Recovery tracks S&P 500 sector performance since March 23, 2020. The top three are information technology (117.8%), materials (117.7%) and industrials (112.7%). The S&P 500 (97.9%) is eighth, while health care (76.5%) is tenth and in the bottom three. Source: Ally Invest, Bloomberg

Health Care for Growth

When you think of the biggest health care stocks, big pharma may come to mind. And for a long time, pharmaceutical stocks dominated the sector. In 2010, pharmaceutical companies made up about half of the S&P 500’s health care sector. Pfizer, Merck and Johnson & Johnson alone were about 35%.

But health care has come a long way since then, and the sector looks completely different today. The number of stocks in the sector has almost doubled, and now just 28% of the index is made up of pharmaceutical stocks.

Two pie charts titled Not Your Mama’s Medical Stocks show industries in the health care sector by market cap for January 1, 2010 and July 29, 2021. The January 1, 2010 pie chart is as follows: Pharmaceuticals (51.1%); Providers & Services (17.1%); Equipment & Supplies (15.8%); Biotech (12.4%); Life Sciences Tools & Services (3.3%); and Technology (0.3%). The July 28, 2021 pie chart is as follows: Pharmaceuticals (27.8%); Equipment & Supplies (27.6%); Providers & Services (19.9%); Biotech (14.4%); Life Sciences Tools & Services (9.8%); and Technology (0.5%). Source: Ally Invest, S&P Capital IQ

Plus, the sector is getting its fair share of newer, tech-like companies. About a fifth of the sector’s companies weren’t traded in public markets until the 21st century. Companies like Dexcom and Align Technology offer innovation in equipment and services using modern technology. Nine of the S&P 500 health care sector’s 64 stocks are biotechnology companies, which develop treatments based on genetic or protein engineering.

All three American COVID shot manufacturers are in the health care sector, too. Moderna, a COVID vaccine developer whose stock has tripled this year, just joined the S&P 500 last week.

Younger, more innovative companies could equal more risk, though that could be offset by the more established household names in the sector. After all, stocks like CVS and Eli Lilly have risen more than the S&P 500 this year.

But these newer companies could also provide some diversification benefits, like helping the sector weather big pharma policy speculation and other negative headlines. And with a renewed push into medical research and better technology, new companies and products could pop up.

Health Care for Defense

Traditionally, health care has been more of a defensive sector that investors have leaned on for stability and income instead of growth and innovation.

And that’s been more of the sector’s role lately: a crutch for down days instead of a shot in the arm. In the S&P 500’s 10 worst days this year, health care stocks have outperformed the index by an average of 0.6%. In fact, health care has been the second-strongest S&P 500 sector this month, behind communication services. Why? The market is now fixated on low-growth worries, and investors have turned to more middle-of-the-road stocks instead of taking a side in the growth vs. value debate.

Don’t overlook the dividends, either. Stable health care companies tend to pay out more cash to their shareholders, and that can add up over time. Health care stocks have handily beaten the S&P 500 over a 10-year timeframe when you include dividends.

Graph titled Dividends Can Add up Over Time tracks S&P 500 health care stocks vs. the S&P 500 (including dividends) from July 2011 to July 2021. S&P 500 health care stocks are consistently ahead of the S&P 500 when including dividends. As of July 2021, S&P 500 health care stocks are at +366% vs. the S&P 500 at +317%. Source: Ally Invest, Standard & Poor’s

The Prognosis

Still, the health care sector has struggled, and many Wall Street analysts have pointed to its lackluster numbers. Profits for S&P 500 health care companies are expected to grow an average of 4.8% year-over-year through the end of 2022, the second-lowest growth of any sector (according to S&P Capital IQ estimates).

Sure, the earnings prognosis doesn’t look as good as other sectors, but valuations still look attractive. The health care sector’s estimate for price-to-earnings ratio — a measure of how expensive shares are relative to profits — is 17.8x, the third-lowest of all sectors and much lower than the S&P 500’s 22.5x. In an environment where it’s tough to find growth at a reasonable price, unloved sectors like health care could get some attention. And as the sector morphs more into growth, it could support an even higher price-to-earnings ratio than the overall market.

There could be some encouraging developments that are hard to quantify in near-term estimates. For one, while the pandemic is still with us, a significant part of the U.S. population is vaccinated, which has eased COVID’s burden on medical providers and opened up time for more elective procedures. Plus, people are becoming more comfortable with going to the doctor, and they’re scheduling those appointments they ignored during the pandemic.

The Bottom Line

The health care sector is morphing more into a high-growth sector as time passes. With COVID sparking innovation and as pent-up demand is released, higher spending in the health care space should lead to improving earnings estimates.

For now, don’t rule out health care because of its middle-of-the-road returns. Health care could play a key role in portfolios, especially when markets start swinging. Over the long-term, the group has a steady track record for performance. And an average return over time may help you stay the course better than years of big gains and losses.

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Callie Cox, senior investment strategist, contributed to this article.

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Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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