How To Find Undervalued Stocks In The Healthcare Sector

The healthcare sector is underperforming the market by a wide margin on a year to date basis. The Healthcare Select Sector ETF (XLV) has gained 5.2%, while the SPDR S&P 500 (SPY) is up by almost three times that, with a cumulative gain of 15.1% in the same period.

ChartData by YCharts

This underperformance is due to the regulatory uncertainty affecting healthcare stocks to a good degree. There is an imperious need to make the healthcare system more efficient and to reduce healthcare costs in the US. With the presidential elections approaching, chances are that healthcare reform will be a heavily debated topic in the coming months.

The stock market hates uncertainty. However, short term uncertainty can be a valuable source of opportunities for long-term investors with a strategic mindset. After all, many healthcare stocks are currently offering solid balance sheets, attractive valuations, and compelling dividend yields.

Besides, the industry will also benefit from booming demand due to an aging population, expanding insurance coverage, new drugs with promising potential, and increased prevalence of lifestyle-related diseases in the years and decades to come.

With this in mind, the following paragraphs will be proposing a quantitative strategy based on applying The Magic Formula to companies in the healthcare sector. This is a quantitative metric based on a combination of profitability and valuation with a solid track record of performance over the long term.

The main idea is not that investors should blindly buy a stock because it has strong metrics based on The Magic Formula, but rather consider the list of stocks as a source of potential ideas with strong quantitative metrics for further research.

What Is So Magic About The Magic Formula?

The Magic Formula is a quantitative strategy designed by Joel Greenblatt. The formula was outlined in Greenblatt's 2004 book "The Little Book that Beats the Market" and later updated in 2010 in another book entitled "The Little Book that Still Beats the Market."

The formula is based on a combination of two main factors: profitability and valuation. Profitability is measured through return on capital and valuation is measured through earnings yield. The equations below provide the details about how these metrics are calculated:

  • Return on capital = EBIT/(net fixed assets + working capital).
  • Earnings yield = EBIT/enterprise value.

The main logic behind The Magic Formula is quite smart and easy to understand. In Warren Buffett's words, "price is what you pay and value is what you get". At the end of the day, you want to buy high-quality businesses for an attractive valuation, and The Magic Formula provides a simple and effective indicator to identify those kinds of opportunities.

Importantly, academic research has proven that The Magic Formula tends to produce market-beating returns across different markets in the long term. For illustrative purposes, the chart below shows long-term returns for companies in different Magic Formula buckets.

Data from S&P Global via Portfolio123

It's easy to see that companies in the higher rankings produce superior returns than those in the lower rankings, which confirms that The Magic Formula is an effective and consistent return driver for stocks.

Backtested Strategy

The following backtest considers only companies with a market capitalization value above $250 million in the healthcare sector. The strategy picks the 25 stocks with the highest Magic Formula ranking among such a universe. The portfolio is rebalanced every 52 weeks, and trading expenses are assumed to be 0.2% per transaction. The benchmark is the Healthcare Select Sector ETF.

The strategy outperformed the benchmark by a wide margin over the long term. Since January of 1999, the portfolio of Magic Formula stocks in the healthcare sector gained 1470.62% versus a much smaller gain of 361.76% for the benchmark in the same period. Strategy alpha amounts to 9.29% per year.

Data from S&P Global via Portfolio123

But looking only at returns over the very long term can mask the fact that a quantitative strategy such as this one can also significantly lag the benchmark over considerably long periods. Without going too far, the strategy gained 30.38% in the past five years versus 63.14% for the benchmark in the same period.

Strategy Benchmark
Annualized 14.43% 7.78%
Five Year 30.38% 63.14%
Total 1,470.62% 361.76%
Sharpe Ratio 0.78 0.44
Sortino Ratio 1.04 0.59
Max Drawdown -53.53% -40.53%
Standard Deviation 17.42% 14.31%
Correlation 0.61 -
R-Squared 0.37 -
Beta 0.74 -
Alpha (annualized) 9.29%

This is to be expected. No quantitative strategy can outperform the market in each and every year, and the statistical evidence is conclusive, even the most effective strategies can go through long periods of underperformance.

Over a period of five years or less, returns are impossible to predict. Patience is not only a virtue, but even a necessity when it comes to investing.

Practical Considerations And Strategy Portfolio

A strategy such as this one can be more volatile than average. The Magic Formula combines quality and valuation characteristics, while high-quality stocks tend to be more stable, cheap companies tend to be more volatile. Depending on how each company ranks in terms of quality and valuation, it can certainly be riskier than other stocks in the sector.

While the strategy beats the benchmark in terms of risk-adjusted returns, it also has higher volatility and higher maximum drawdown than the benchmark. This goes beyond volatility at the individual stock level, because the strategy is far more concentrated than the benchmark, and it is also more inclined towards relatively smaller companies.

The numbers behind the strategy are based on currently reported figures for earnings and profitability. No matter how attractive those numbers, if earnings are not sustainable going forward, then relying on the quantitative metrics does not make any sense in that particular case. Investors should always take a deep look at the business behind the numbers in order to evaluate if financial performance is sustainable or not.

Without further prologue, the table shows the 25 names currently picked by the strategy. Data in the table also includes current market price, The Magic Formula ranking, and market capitalization - in millions - for the companies in the portfolio.

Ticker Name Price Rank MktCap
ABBV AbbVie Inc 77.43 96.29 $114,460
AMGN Amgen Inc 175.51 96.15 $107,833
AMEH Apollo Medical Holdings Inc 14.24 98.87 $491
ARNA Arena Pharmaceuticals Inc 56.7 99.89 $2,809
BIIB Biogen Inc 227.23 98.9 $44,058
CELG Celgene Corp 96.04 96.18 $67,689
CORT Corcept Therapeutics Inc 10.12 96.79 $1,163
EGRX Eagle Pharmaceuticals Inc 52.39 95.01 $730
EXEL Exelixis Inc 20.2 94.63 $6,091
GILD Gilead Sciences Inc 65.35 98.1 $83,256
CO Global Cord Blood Corp 6.74 99.44 $819
HUM Humana Inc. 248.87 98.24 $33,606
INVA Innoviva Inc 14 99.53 $1,417
JAZZ Jazz Pharmaceuticals Plc 130.97 96.7 $7,421
LGND Ligand Pharmaceuticals Inc 113.56 97.44 $2,233
OTCPK:MFCSF Medical Facilities Corp 9.15 97.23 $284
MD Mednax Inc 26.38 96.41 $2,279
MOH Molina Healthcare Inc. 153.73 99.15 $9,685
NKTR Nektar Therapeutics 33 99.29 $5,750
PINC Premier Inc 37.68 98.8 $2,313
PBH Prestige Consumer Healthcare Inc 30.14 96.43 $1,561
SIGA SIGA Technologies Inc 5.61 99.97 $454
SUPN Supernus Pharmaceuticals Inc 30.69 96.46 $1,607
TARO Taro Pharmaceutical Industries Ltd 90.84 97.43 $3,582
UTHR United Therapeutics Corp 81.98 99.36 $3,591

The evidence indicates that a wide group of companies with strong quantitative attributes tends to outperform the market over the long term. However, this does not say much about how a specific company will perform in a particular year. For this reason, it is of the utmost importance to evaluate each company in terms of its qualitative factors as opposed to simply buying because the numbers look good.

That being acknowledged, there are strong reasons to believe that the healthcare sector will be fertile ground for opportunities over the coming years, The Magic Formula makes a lot of sense from a theoretical point of view, and the data shows that companies with strong quantitative metrics tend to outperform the market over the long term.

Statistical research has proven that stocks and ETFs showing certain quantitative attributes tend to outperform the market over the long term. A subscription to The Data Driven Investor provides you access to profitable screeners and live portfolios based on these effective and time-proven return drivers. Forget about opinions and speculation, investing decisions based on cold hard quantitative data can provide you superior returns with lower risk. Click here to get your free trial now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.