The following article appeared in the July edition of Valuentum’s Best Ideas Newsletter. Contact us to subscribe to our Best Ideas Newsletter.
Since the previous edition of our Best Ideas Newsletter released June 15, the markets have been on a bumpy ride. Still, the S&P 500 edged out a modest gain during this time period, and our portfolio continues to grow its outperformance gap. We’re now outpacing our benchmark, the S&P 500 SPDR (click ticker for report: SPY), by nearly 28 percentage points, the highest degree of outperformance ever.
Perhaps the biggest piece of news during the past few weeks was the US Supreme Court’s decision to uphold President Obama’s Patient Protection and Affordable Care Act (PPACA), which can arguably be considered the most sweeping change in America’s healthcare system during the past half–century. In a narrow 5–4 split ruling, the Supreme Court ruled as constitutional the so–called individual mandate — that Congress has the power to order most people to obtain health insurance starting in 2014 or pay a penalty (tax). Though we withhold judgment about whether this is good or bad policy, we instead remain focused on the long–term growth of healthcare spending and the favorable demographic conditions that support this expansion.
According to the Office of the Actuary in the Centers for Medicare & Medicaid Services, national healthcare spending is expected to grow at a 3–5% pace during 2012–2013 and then step up to a high–single–digit annual rate beginning in 2014 thanks in part to the PPACA (as tens of millions of currently uninsured people will then be insured at that time). Medicaid spending is expected to grow nearly 20% that year, while private health insurance and prescription drug spending will expand at a high–single digit pace. During the period of 2015–2021, healthcare spending is expected to advance at a pace north of 6% per annum (significantly above inflation), as general economic conditions improve and the population continues to age. Recent M&A activity supports this expected growth trajectory, as health benefits company WellPoint (WLP) recently announced plans to tie the knot with Amerigroup (AGP) in a deal that will give the combined entity an expanded Medicaid footprint in 19 states (was 13), including a presence in the four largest.
We admit there will inevitably be winners and losers in the healthcare sector as a result of the PPACA, but we’re big fans of the demographic trends that support the long–term secular growth in spending. And regardless of which administration is in office next year (or what happens to the PPACA as a result), we believe the Healthcare Select Sector SPDR ETF (click ticker for report: XLV) is the best way to gain aggregate exposure to this expanding sector in our Best Ideas portfolio. Plus, we think some of the ETF’s top holdings—Pfizer (click ticker for report: PFE), Medtronic (click ticker for report: MDT), and Johnson & Johnson (click ticker for report: JNJ)—are trading at deep discounts to their respective intrinsic values.
As the debate regarding the PPACA rages on among political interests, we continue to be encouraged with the performance of not only the domestic banking sector but also the US housing market. JP Morgan (click ticker for report: JPM) and Wells Fargo (click ticker for report: WFC) reported strong results last week, with each noting improved credit metrics across the board. Wells Fargo specifically noted that net charge–offs as a percentage of its loan portfolio have fallen to 1.15% in its most recently–reported quarter from 1.52% in the second quarter of 2011. And as it relates to the homebuilding sector, KB Home (click ticker for report: KBH) and Lennar (click ticker for report: LEN) each indicated in their respective quarterly results that backlogs continue to expand at a robust double–digit pace. Though the impressive growth rates are in part a result of depressed performance last year, we maintain that a recovery in the domestic mortgage/housing sector is well underway and that a bottom has finally formed. Such improving performance in the domestic banking/housing sector speaks to why the market largely ignored Moody’s credit–rating downgrade of five of the six biggest US banks in late June. The rating agencies have always been late to the game (and often wrong), and we continue to have conviction in our position in the Financial Select Sector SPDR (click ticker for report: XLF) in our Best Ideas portfolio.
While the domestic healthcare and financial sectors continue to be on sound footing, we remain pleased with order trends coming out of the aerospace sector, which comprises the largest weighting in our Best Ideas portfolio. In one of the most widely–anticipated events in the aerospace industry this year,