It appears that concerns over drug pipelines, new regulations and where new profit sources will come from are weighing on investors' minds, and we're unwilling to fight that sentiment. We are keeping an eye on the group, and should investor attention return we'd likely be quick to reinstate our outperform rating due to the positive fundamental picture we see.
Certainly, the health-care reform legislation could crimp profitability in the sector, but we still have some time before the more-damaging provisions take effect. In fact, after the November midterm elections, it appears more likely that at least some of the most-damaging elements may be adjusted by the new Congress. We continue to watch the legal process play out as split decisions by federal courts regarding the constitutionality of certain provisions of the bill almost certainly mean a hearing before the US Supreme Court at some point.
The beating a lot of the group took leading up to passage of the bill has also led to valuations that, to us, remain quite attractive. However, investors don't believe they're attractive enough to compensate for the potential risks, leading us to hold our lowered rating for now.
Clients can see our top-rated stocks in the health-care sector.
Positive factors for the health-care sector:
- The aging population could provide a boon for the industry as an increasing number of Americans require more extensive drug treatments and medical care.
- Americans are increasingly obese, which results in a greater need for medical attention due to the myriad health issues that coincide with obesity.
- Balance sheets in the health-care sector remain flush with cash, boosting the possibility of higher dividend payments, share-enhancing stock buybacks, and mergers and acquisitions.
Negative factors for the health-care sector:
- Government regulation will likely continue to increase during the coming years as more seniors demand intervention in order to theoretically lower their out-of-pocket health-care costs.
- Growth in consumer spending on health insurance has been trending lower recently, potentially putting managed-care shares at risk.
- The new health-care law could dampen profitability in some areas of the sector, although there is still uncertainty regarding the full impact of the bill.
Economic growth continues, with manufacturing seeming to lead the way, as evidenced by a solid reading for the ISM manufacturing index in the United States, an increase in industrial production and positive PMI readings in several other countries. This helps reinforce our belief that US economic growth is accelerating and could surprise on the upside.
Tempering our view of the group and leading us to maintain a marketperform rating is the fact that fiscal austerity measures are being put into place, which could dampen growth in the industrials arena.
Additionally, the new orders/inventory ratio has shown signs of rolling over, typically a negative sign for the industrials group, and we're watching the path of that ratio carefully. Finally, China continues to tighten monetary policy in order to slow economic growth and attempt to forestall the growing inflation threat.
Having said that, we're not overly negative on the group, because we also believe that (as a result of tight purse strings in corporate offices during the past year) companies are at the point where they need to start replacing and updating equipment—potentially benefitting the industrials sector.
Positive factors for industrials:
- Corporate balance sheets remain relatively cash rich, which could help push management to invest in new, more-efficient equipment to help offset production losses due to layoffs.
- Lending standards, while still tight, have started to loosen, which should help boost capital spending.
- Business confidence among companies is improving, typically a good leading indicator of future equipment expenditures.
- Inventories in much of the manufacturing area are extremely low, leading to the possibility of a demand-inspired rebuilding phase.
- Government is still targeting infrastructure for increased spending, which could benefit the industrial sector.
- Small business confidence is improving, which could help to boost spending plans.
Negative factors for industrials:
- Access to credit remains limited in many cases—among smaller businesses, for example—which dampens spending plans.
- Rising input (commodity) costs could put pressure on profit margins.
- New orders appear to be rolling over while inventories are rising, which could hurt profitability in the group.
Information technology: Outperform
We continue to like the information technology space—even more so given that economic growth appears to be solidifying. There continue to be occasional blips in the sector due to a variety of unique issues. However, we believe these are largely temporary, one-off type issues that provide buying opportunities.
With large cash balances, increasing dividend payments, solid management and tight inventory controls, the tech sector is far more stable than it was in the late 1990s environment that so many still remember. We've been touting this stability as one of the reasons to stick with the group. We believe those who remain invested in tech will be rewarded with outperformance in the coming months.
