An energy boost and declining healthAdvantageVoice® Blog—
John Manley, CFA, Chief Equity Strategist and Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Perhaps the title overstates our views a bit. We are simply recommending to put health care stocks at a neutral weight rather than an overweight. We are also upgrading energy stocks to an overweight.
We put health care stocks at an overweight two years ago in the belief that investors were far too negative about the sector. In 2010, investors seemed to shun health care stocks after passage of the Affordable Care Act (or, Obamacare), assuming Obamacare would crush the profits of pharmaceutical companies and device manufacturers. Since then, investors have woken up to the reality that management of these companies are adept at adapting to their environment and the carnage didn’t ensue. Managers cut expenses and used copious quantities of cash flow to survive.
At the time we initiated our overweight recommendation, health care stocks were trading at a significant discount to the market, based on projected earnings. Now, those same stocks trade at a slight premium to the market. While not expensive, health care stocks just don’t look like they offer the best value, with the exception of some biotechnology stocks. Mid-cap biotechnology stocks, for example, still have interesting product pipelines and could be targets of larger companies looking to buy innovation rather than engage in the innovation themselves. However, this mid-cap segment is, by definition, a relatively smaller part of the sector’s total weight in a market-cap-weighted portfolio.
Changing one sector’s weight means changing other sectors’ weights as well. We decided to put energy at an overweight. Valuations on energy stocks look attractive to us. While the S&P 500 Index rose in valuation—based on forecasted earnings—by 3.15 in price/earnings units, energy has lagged, rising only 3.03. It’s not a huge difference, but we think it is unjustified given the prospects for many of the companies in the energy sector.
Many analysts expect the price of oil to fall. We agree. In fact, we may be more optimistic about the drop in oil prices than many. The recent nuclear talks with Iran went well, and there is a growing likelihood that the sanctions against Iran could be lifted, bringing a wave of oil into the market. There is also a lot of capacity in the oil extraction industry that should continue to put downward pressure on oil prices. Margins and volume, however, are the name of the game with integrated oil companies. Those companies involved with the extraction, refining, and distribution of oil and its products could see prices for the final product drop slower than prices for the raw inputs. That means fatter margins. Lower prices mean higher volumes. If you put the two together, you get a nice outlook for profits.
The energy sector isn’t limited to extracting oil. There are also other forms of energy, natural gas included. There are also service and distribution. The large-cap oil-service companies should benefit from the expansion of the energy infrastructure in the U.S. and abroad. It’s important to remember that much of the emerging world doesn’t have an aging infrastructure like we do in the U.S.—they have little to no infrastructure! The opening of foreign markets, like Mexico’s, to U.S. operators could result in significant growth opportunities. The size, quality, and cash-flow characteristics of energy stocks should be attractive to individuals planning their retirements in the years ahead.
The views expressed are as of 10-14-13 and are those of Chief Equity Strategist John Manley, CFA; Chief Portfolio Strategist Brian Jacobsen, Ph.D., CFA, CFP®; and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.