Despite all the changes in store for heath care companies resulting from the Affordable Care Act, the health care sector is expected to outperform the broad market in 2013, according to a recent report from S&P Capital IQ.

Reasonable valuations, dependable––and, in some cases, double-digit––earnings growth and the defensive characteristics of these stocks should all prove attractive to investors. As a result, S&P is recommending that investors overweight the health care sector in 2013. The sector currently comprises 11.9% of the S&P 500.

Health care stocks are coming off two years of strong performance. The stocks (as measured by the S&P 500 Health Care Sector index) gained 15.9% in 2012 versus 13.4% for the S&P 500, and were up 9.5% versus essentially flat returns for the broad market in 2011. The development of innovative therapies, mergers and acquisitions, and a more effective drug approval process at the FDA helped drive up health care stocks last year, says Jeffrey Loo, head of health care equity research at S&P Capital IQ in New York. 

Going forward, health care reform should be a net positive for the sector, Loo argues. Uncompensated care costs are expected to drop significantly as a result of the Affordable Care Act, which should benefit sub-industries such as managed care and health care facilities. In addition, the new law is expected to bring 26 to 28 million new customers into the health care system between 2014 and 2019. And even though fees and taxes are part of the new law, Loo believes the overall health care reform package “is potentially one of the greatest growth drivers the industry has seen in several decades.”

In addition, the sector looks attractive now. With a trailing 12-month P/E ratio at 13.4 times, the health care sector is trading at a 15% discount to its median relative P/E ratio since 1995. Granted, earnings for the sector are expected to be up just 5.4% this year, primarily because of slow earnings growth at pharmaceutical companies that account for about half the sector index. But seven of the 10 health care sub-industries––including biotechnology, managed care, and health care services––are expected to grow earnings at double-digit rates.

Health care stocks also remain attractive for their relatively low volatility. The sector has a beta of 0.67 versus the S&P 500 and the standard deviation of monthly returns is 15.5 percentage points versus 19 for the S&P 500.

Investors looking for low-cost, diversified ways to profit from the industry’s positive outlook have several top-rated health care ETFs to choose from. S&P awards overweight ratings to ETFs that rank in the top 25% of their asset category based on factors such as stock appreciation rankings, quality rankings and expense ratios.

According to Todd Rosenbluth, an S&P Capital IQ ETF analyst, the largest ETF focused on health care that earns an "overweight" rating is the Health Care Select Sector SPDR Fund (XLV), which tracks the HealthCare Select Sector index in the S&P 500. The fund has $5.67 billion in assets and a low expense ratio of 0.18%. Its largest industry exposure to pharmaceuticals (47%), but it also has 19% in health care equipment and 13% in biotech. Top holdings include Johnson & Johnson, Pfizer, and Merck, which all have “buy” ratings by S&P analysts.

With earnings comparisons improving, low volatility and attractive dividends, “we still like a lot of large cap pharmaceutical stocks,” says Rosenbluth. The fund has returned 5.77% versus 5.71% for the Healthcare Sector index year to date and 20.12% versus 20.59% for the index over the last 12 months. The fund yields 2% and has a standard deviation of 11.5 percentage points. “XLV is cheap, well diversified and very liquid,” Rosenbluth says.

Different Approaches
Investors looking for a top-rated ETF with slightly more exposure to small- and mid-cap companies (12% of total assets combined) can consider the Vanguard Health Care ETF (VHT). This ETF, which tracks the MSCI US Investable Market Health Care Index, has $1.1 billion in assets and an expense ratio of just 0.19%. Like with XLV, the top three holdings are J&J, Pfizer, and Merck.