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.

Year to date, the fund has returned 5.97% versus 5.71% for the Healthcare Sector Index and over the last 12 months 21.60% versus 20.59% for the index. Rosenbluth attributes its slight outperformance to its mid cap and small cap holdings. The fund yields 1.67% and has a standard deviation of 12.15. “We like both funds,” says Rosenbluth. “It just depends on how defensive you want to be.”

Investors interested in broadening their horizons may want to consider an international health care sector fund. “Not all the best health care companies are domiciled in the U.S.,” Rosenbluth says. S&P highly rates the SPDR S&P International Health Care Sector ETF (IRY), which tracks the S&P BMI World ex-US Health Care Sector index. The fund has $31.3 million in assets and an expense ratio of 0.50%. At 74%, pharmaceuticals dominate the fund’s sub industry allocation. The fund’s top three holdings are Novartis, Roche Holding and Sanofi. S&P has a buy rating on Roche and Sanofi.

IRY is up 2.85% versus 3.19% for MSCI EAFE YTD and up 20.52% versus 18.30% for the index over the last year. The fund’s 2.3% yield is slightly higher yield than its U.S.-focused peers, and it has a standard deviation of 13.35. “IRY has a big bet on pharmaceuticals, but it invests in high quality companies and volatility is low,” says Rosenbluth. “There are lots of reasons to consider it.”

Finally, investors looking to focus on the managed care industry––which S&P expects to benefit from industry consolidation as well as from health care reform––can consider the iShares Dow Jones US Healthcare Provider Index Fund (IHF). This ETF, which is rated overweight by S&P and tracks the DJ US Select Health Care Providers Index, has $230.8 million in assets and an expense ratio of 0.47%.

Top holdings are UnitedHealth Group, Express Scripts Holding Co., WellPoint and Cigna. All four stocks are rated a buy by S&P analysts. The fund has returned 4.97% versus 5.71% for the Healthcare Index YTD and 16.96% versus 20.59% for the index over the last 12 months.

The group has lagged the health care sector because of weak earnings. However, S&P expects double-digit EPS growth for the group in 2013 as a result of market exits by underperformers and market expansion by companies that remain and higher prices. As the economy recovers and the number of people covered by these companies rises, “we believe IHF will outperform the broad market in 2013,” says Rosenbluth.

Investors need to be careful when choosing health care sector ETFs because health care stocks cover several industries and some ETFs are less diversified than others. “You can’t just choose based on the best performance or even which is the cheapest,” says Rosenbluth. “You need to look inside.” Still, he believes that allocating at least a portion of one’s assets to this sector will be a healthy move for investors this year.