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March 3rd, 2011 by

Benefits of Diversification in the Health Care Sector

I am all for diversification of my portfolio to reduce risk and improve my portfolio returns. I also think the times are uncertain, both political and economic, and we need some safety and peace of mind.

I strongly believe that health sector is a good place to allocate to at this time. My reasons are, political, geopolitical and economic. Let me explain.

Political. the health care reform shenanigans are over, thankfully. It was a painful process to watch Washington politics in action and it was equally painful to see the sector being beat up so much. The XLV, which represses the entire health care sector, was the worst performing sector in 2010. It was up only 2.9% vs. S&P +12.8% and the average sector return of +15.5%.

As always in the stock market, it was the unknown that killed the performance of the health care sector last year. As investors we can always price news, good news or bad news, we have financial skills and savvy to do this with reasonable accuracy. So it is the “reform” of the industry (and emphasis on quotes in the reform), no matter how expensive, we would be able to price it in the sector valuation. But we could not. Why? Well ask the Washington folks, basically the health care reform was and is open ended. The “reform” does not allow either us (and more significantly) even the industry itself, to figure out how much is this thing going to cost them.

So the good news, if you have enough patience after last year’s performance to see it, is that fortunately the “reform” is over. Or in other words, it cannot get any more “reformed” in the near future.  What it means to us, the investors, is that basically the worst is over and we can now get down to basics and value the sector based on its fundamentals and not based on what the politicians had for breakfast that day.

Even the president has finally got the message, by saying to the States, that they will have some flexibility in implementing the “reform”, meaning that they do not have to implement it fully.

Geopolitical. Middle East upheavals bring uncertainty to the market. And because the upheaval is in the Middle East, oil goes up (but don’t short it, as I mentioned last week). So the health care is a defensive sector, it is safer than most of the things out there. It has even outperformed the S&P 500 for the past month.

Economic. Despite the fact that health care sector is unloved, there are many interesting things are in the pipeline of drugs for the big firms. Some patents are expiring and that is good news for the generics. Overall plenty to cheer about and worth considering on individual project basis.

So now that you are, hopefully, convinced that the healthcare is the place to be, you must be asking yourself, how do I gain exposure to the sector.

I will beat once again my drum of diversification. Look the chart below. If you pick any one of the major stocks, such as JNJ or MRK, you would significantly underperform the S&P 500 for the past two months. On the other hand, if you choose to invest wisely, with focus on diversification, the health care SPDR would be an excellent choice. You reduce individual company risk, while gaining the exposure to the entire sector and its benefits based on current political, geopolitical and economic views.

Happy diversification and some peace of mind!

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