Healthcare Investing Risks and How to Mitigate Them

Healthcare is constantly coming under the fire of political and media attention, and biotech companies are going boom or bust on FDA approvals that are out of their control. But healthcare is also an incredibly diverse sector -- so much so that if you thoughtfully diversify your investments within the healthcare part of your portfolio, you can see a lot of the sector's gains without too much of the risks.

In this Industry Focus: Healthcare clip, healthcare analysts explain some ways that investors can get diversified in healthcare, why the sector isn't going away anytime soon, what you need to know about the old "buy what you know" adage, and more.

A full transcript follows the video.

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This video was recorded on Oct. 25, 2017.

Kristine Harjes: You mention that healthcare is a fairly diverse field to begin with. That gives me a little segue to be able to admit something to you, which is that I am personally grossly overweight in healthcare. And that's because I get really excited about it. I love the industry. But the way I can justify this is, healthcare itself is a fairly diverse sector. You have different types of healthcare stocks. For example, you have small caps, you have large caps, you have mid-caps. That's, of course, the market cap of the company. In general, if you have a big established Goliath like a Johnson & Johnson (NYSE: JNJ), that in and of itself is a fairly diversified stock. They have all these different units within the company, they have an international business. As opposed to something like, I mentioned earlier, Ophthotech. I was a shareholder of Ophthotech. That was a very small-cap company that had a single point of failure. It obviously didn't go well.

So you have, within the industry itself, different market caps; you have different geographies. We talked on the show about Teva, for example. They're an Israeli company. They do a lot of business all over the world. But it's certainly possible to have shares of companies like, say, AstraZeneca or GlaxoSmithKline.

Todd Campbell: Roche.

Harjes: Yeah. Lots of drug makers are headquartered overseas. You also have non-drug maker healthcare stocks. Every once in a while, we'll get a listener write in in like, "Why don't you talk about any other areas of healthcare except for drug makers?" And the answer to that is just that it's the most exciting part of healthcare. At least, Todd, I think you'll agree with me there; there's always news about what drugs are getting approved and how trials are going. But there are other parts to healthcare. Hopefully we touch on them enough to keep you guys informed. You have your insurers and your retail pharmacies, your PBMs.

Campbell: Technology companies.

Harjes: Yeah, like Veeva. All this is to say, within a single sector, you can actually get pretty diversified. As important as it is to touch on different sectors, it's possible to be diversified within each one, and it's actually important to be diversified within each one, because you can fool yourself into thinking you're diversified because you have two financial stocks and two healthcare stocks and two consumer discretionary stocks. But if all of those are, say, micro-caps, then you're really not that diversified.

Campbell: You raised so many cool points there. One of the things that resonated with me, or jumped out to me, was Peter Lynch. Famous money manager for Fidelity for years. Wrote a wonderful book, Beating the Street. And he always advocated buying what you know. Invest in what you know. Well, the risk that you run when you invest in what you know, and we talk healthcare all the time, is that you get very heavily concentrated within that particular area that you know a lot about. If you work in retail, you end up owning a portfolio that's 80% in retail. If you work in healthcare, you own a portfolio that's 80% healthcare. There can be advantages to that, i.e., if you know the industry and they players really well, maybe that enhances your ability to pick the correct stock. Also, that concentration will allow you to outperform the S&P 500 Index during periods where the stocks that you own work.

Harjes: Yeah, when you're right.

You also brought up the point of being diversified within each individual sector. You're talking about healthcare, you look at your healthcare holdings. Owning an insurer and owning a big-cap pharmaceutical company and owning, let's face it, I happen to take on some risk in my portfolio, so sometimes I tend to own some small cap clinical-stage companies. And these companies are make it or break it companies. And as we already outlined, if their trials go wrong or they receive a rejection letter from the FDA, you could lose 80% of the value in a particular stock. So I always spread it around a little bit.

Just to throw out numbers, let's say I have $3,000 that I can do something with and I have three clinical-stage companies that I've done my homework on, I feel pretty good about, and I'm going to lean the odds in favor of victory for these companies. Maybe leaning the odds is 60-40 or something like that. Again, there's no such thing as a sure thing. So you say to yourself, I'll take that $3,000 and divide it between those three companies. Now, one may fall 80%, like Axovant Sciences or something recently with its Alzheimer's disease failure. But the other, Zogenix, may have a success in their epilepsy trial and triple. If you look at them as a whole, you ended up making money.

So I think the big thing to remember there is, keep everything in perspective relative to the portfolio and the risk that you're willing to take, obviously. Maybe that $3,000 is in a portfolio of $100,000, or something like that. If you lose $1,000 on a particular stock, it's really not going to move the needle that much for you.

But yeah, there's a lot of different ways that you can help insulate yourself against risk, and that always brings me to the thought of, how much do I really want to have in healthcare? In my portfolio, maybe I'm not as overweight as potentially you are, I have about 25% of my portfolio in healthcare stocks, but that is overweight relative to the S&P 500, which is, what?

Harjes: 14.5%.

Campbell: 14.5%. And overweighted as a percentage of GDP, because I think as a percent of GDP, healthcare spending is about 17.8%. So, there are different ways that you can look at, how much do I want to have exposure to. If I'm running a diversified portfolio of individual investments, how diversified do I want to be? Maybe you want to tie it to the GDP spending number. There are a lot of reasons that healthcare makes sense to have in your portfolio. We talk about them all the time on the show -- 10,000 baby boomers turning 65 every day. You have $8 trillion being spent globally on healthcare, and some estimates peg that number going to $18 trillion over the course of the next 15 to 20 years. This is a growth market, it's an interesting market, it's a fascinating market, it deserves a spot in portfolios. Don't be too afraid of going a little bit over what may seem prudent, in that 14%-15% S&P range.

Harjes: Another thing to point out about the healthcare industry is that these are necessary expenses. People are going to be paying insurance premiums and buying prescription drugs. These are not consumer discretionary purchases. They are medications that are life-saving, that people are going to be buying year-in and year-out regardless of what the rest of the economy is doing.

Campbell: And with big pharma, we've talked about this on the show with Johnson & Johnson, historically -- past performance doesn't guarantee future performance -- companies like Johnson & Johnson tend to do better during periods of stock market pullbacks because of that. And, you get the dividends.

Harjes: Yeah. Johnson & Johnson is a fantastic example of a company that has minimal downside risk when the rest of the market seems to be tanking. They've been able to weather the storm very well, and continue paying that dividend for over 50 years. It's really an incredible, I'm picturing a giant stable ship going through a bunch of storms. That's Johnson & Johnson for you.

Campbell: Right. And having that as a core holding in your portfolio, and then being able to have some fun with some of these clinical-stages, that's probably a lot wiser of a choice than trying to go out and saying, "I'm going all in MediGene!" [laughs]

Kristine Harjes owns shares of Johnson & Johnson. Todd Campbell has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Johnson & Johnson and Veeva Systems. The Motley Fool has a disclosure policy.