Equity Strategy and Quantitative Research
US Portfolio Strategy: Low Vol Sector Bubble, Valuations Displaced, Growth Underpriced — Buy Healthcare, Sell Staples
Income-seeking and growth-agnostic investors have crowded certain styles and sectors of the market. In particular, Low Vol, Quality, and Sustainable Income (i.e., Staples, Telecom, and Utilities) are outright expensive relative to Value and Growth (i.e., Healthcare and Technology).Historically, Healthcare and C. Staples have seen a high level of cointegration due to similar inelastic demand and stable fundamentals (vs. Cyclicals). However, in recent quarters performance and valuation between the two sectors have decoupled. Staples has increasingly become tied to rich valuations of “Sustainable Income,” while its defensive-peer Healthcare has seen multiple compression even though it offers long-term “Sustainable Growth.” Similar to Low Vol (relative to Value), Staples appears to be in a bubble (relative to Healthcare) after outperforming by 20% in the past year and it trades at a record valuation spread of more than 5x turns on PE NTM.
We are upgrading Healthcare to overweight and downgrading Staples to underweight as a convergence sector trade.Our thesis is predicated on: (1) recoupling in valuations within defensive sectors; (2) style rotation to favor sustainable growth opportunities over low vol; (3) investors refocus on attractive long-term fundamentals with Healthcare offering stronger organic growth and structurally higher margins; and (4) during four prior periods of Staples outperformance since 1980, the relative valuation never became this stretched. Why now? As uncertainties around the US election are already largely priced-in and Fed expectations very dovish, a reversal in sector positioning would be a risk for Staples. In this scenario, fund flows would likely reverse, Momentum rotates away from Low Vol, and the interest rate peg (record negative correlation between 10yr bond yield and Staples performance) becomes detrimental to performance.
· Four other periods when Staples outperformed Healthcare by 20% or more. We believe Staples has become crowded during this cycle after a rotation triggered by the Fed turning more dovish, zero rates abroad, and stabilizing USD. This happened in an environment where investors were already skittish of holding Healthcare going into elections and piled into the only other defensive sector with ample liquidity (Staples market cap at 12% of S&P 500 compared to Telecom, Utilities, REITs all at only ~3% each). Since 1980, during each of the prior four rotations, Staples was supported by declining bond yields and the sector traded close to parity on valuation with Healthcare (unlike now with a wide valuation spread), Figure 6.
· Staples valuation richer than Healthcare (and all sectors) as well as Low Vol (and all style factors). In our recent notes on Low Volatility and Global Style Investing, we argued investorsshould hedge against the negative tail risk by reducing exposure to Low Volatility where valuations are not justified by fundamentals. With Staples trading at 22x on PE (NTM), its valuation is even richer than Low Vol (also Momentum, Quality, and Growth) and all sectors (especially with its defensive peer Healthcare 16.5x). Historically, Staples have traded at a discount given lower growth and weaker margins. Also worth noting, Staples trades at a premium to Healthcare in most markets outside of the US.
· Rising stock values have compressed shareholder yields for Staples to near lowest levels of this recovery. This despite more than 50% increase in dividends since 2007 — Staples will find it difficult to increase its shareholder yield higher with total payout ratio running near 100% in recent quarters. In other words, dividend growth will be capped at a rate equal to earnings growth unless companies significantly raise leverage. By comparison, Healthcare has a shareholder yield of 4.3% (Staples 4.1%) but has more flexibility with payout ratio near 70%.
· Healthcare offers stronger organic growth with positive demographics and new product cycle. Healthcare expenditures have risen to 17% of total personal consumption wallet (i.e., ~12% of US GDP) from 6% since the 1950s, while Food and Beverages has declined to 7% from 21%. While a reversal in this trend might be a long-term threat, we believe the strong organic growth is likely to continue for now. In fact, Healthcare has generated strongest revenue growth of all sectors during this recovery (8.8% CAGR vs. 4.1% for Staples) and long-term (11% CAGR since 1994 vs. 6.2% for Staples). Healthcare is expected to continue generating stronger organic growth (6.4% NTM sales growth vs. 3.8% for Staples) driven by expanding market and new product cycle.
· Healthcare enjoys structurally higher margins due to patent protection and higher barriers to entry (10% net income margin vs. 6% for Staples). The combination of stronger organic growth and insulated margins provides a structural advantage over Staples. Within S&P 500 Biotech/Pharma command some of the highest margins — even higher than scalable Software and Internet companies, see Figure 24. Even though Biotech ranks highest of all S&P 500 industries on pricing power (net income margin of ~40%), it ranks among the cheapest on valuation at only 13x PE. While Tobacco (Staples) enjoys high pricing power status (28% margin), we are uncomfortable with its long-term growth and valuation disconnect (22.7x PE).
· Technicals could become less supportive for Staples. Investors have already rotated into Staples with steady fund flows into the sector compared to outflows for Healthcare over the last year, see Figure 8.Also, the crowded positioning is quite obvious by looking at style factors. Momentum constituents are heavily weighted to Low Vol compared to one year ago (Staples market-cap weight increased to 19% from 6% and Utilities has risen to 11% from 0%) compared to Growth (Healthcare has seen a sharp reduction in weight to 8% from 32% and Technology to 13% from 24%), Figure 5. If Momentum investors were to reverse positioning – possibly back to Growth – this would be a risk for Staples and Low Vol.
· Election rhetoric and drug pricing headlines waning. Drug pricing headlines and political rhetoric have been drivers of Healthcare sector underperformance over the last year. While headline risk is likely to remain elevated at least through November, we see limited read-through to business fundamentals as successful reform would require considerable alignment in Washington. We recommend using any headline-related pullbacks to add Healthcare exposure.
We believe the initial rotation will be driven by technical drivers (investors look beyond elections and preference for bond proxies declines).Historically, Healthcare performance has been inversely tied to rates but recently it has shown little correlation while Staples is near record negative. This decoupling in correlation suggests that Staples’ outperformance will continue to be tied to lower bond yields, and less with fundamentals. Also, macro could be a risk if we get positive economic surprises relative to current depressed expectations, a tick-up in inflation, better than expected global growth, and/or consideration of new fiscal stimulus. Also, if interest rates move higher, this will have a negative effect on dividend growth, which has been funded by declining interest expense (a negative for bond proxies). In summary, we recommend investors overweight Healthcare and underweight Staples given the Low Vol bubble environment, displaced valuations, and underpriced sustainable growth.
Click here for the full Note and disclaimers.
Dubravko Lakos-Bujas
(1-212) 622-3601
dubravko.lakos-bujas@jpmorgan.com
Bhupinder Singh
(1-212) 622-9812
bhupinder.singh@jpmorgan.com
Narendra Singh
(1-212) 622-0087
narendra.2.singh@jpmorgan.com
Scott A Linstone
(1-212) 622-9970
scott.a.linstone@jpmorgan.com
Arun Jain
(1-212) 622-9454
arun.p.jain@jpmorgan.com
Marko Kolanovic, PhD
(1-212) 272-1438
marko.kolanovic@jpmorgan.com
Visit J.P. Morgan Markets for more market-leading research and financial solutions across the full trade and investment lifecycle.
If you no longer wish to receive these e-mails then click here to unsubscribe
www.jpmorganmarkets.com
Analyst certification: I certify that: (1) all of the views expressed in this research accurately reflect my personal views about any and all of the subject securities or issuers; and (2) no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed herein. Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan–covered companies by visiting https://jpmm.com/research/disclosures, calling 1-800-477-0406, or e-mailing research.disclosure.inquiries@jpmorgan.com with your request. J.P. Morgan’s Strategy, Technical, and Quantitative Research teams may screen companies not covered by J.P. Morgan. For important disclosures for these companies, please call 1-800-477-0406 or e-mail research.disclosure.inquiries@jpmorgan.com.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Confidentiality and Security Notice: This transmission may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable law. If you are not the intended recipient, you are hereby notified that any disclosure, copying, distribution, or use of the information contained herein (including any reliance thereon) is STRICTLY PROHIBITED. Although this transmission and any attachments are believed to be free of any virus or other defect that might affect any computer system into which it is received and opened, it is the responsibility of the recipient to ensure that it is virus free and no responsibility is accepted by JPMorgan Chase & Co., its subsidiaries and affiliates, as applicable, for any loss or damage arising in any way from its use. If you received this transmission in error, please immediately contact the sender and destroy the material in its entirety, whether in electronic or hard copy format.
