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Wednesday, December 31, 1969 - 18:00

The Only Health Care Stock You Need To Own

Tuesday, April 8, 2014 - 2:00pm

After two market crashes in less than two decades and the current bull market looking to take a breather, investors are rightly worried about their hard-earned gains. By investing in companies with wide economic moats and a history of total returns to shareholders, investors can reduce the pain of the market cycle and plan for the long term.

Not only do I overweight my portfolio with these long-term investments, but I like to look at stocks that are poised benefit from huge secular changes over the decades to come -- stocks benefiting from megatrends like the American energy revolution and aging demographics.

Combine shares of a company with a great long-term track record with one of these megatrends, and you've got something truly special.

Rich Valuations In Health Care
U.S. census data show nearly 80 million Americans were born between 1946 and 1964 -- the "baby boom" generation. More than 10,000 people reach the age of retirement every day in the United States, a pace that is expected through 2030.

The demand for health care could drive medical costs higher by 6.2% annually over the next decade, while general inflation and the economy may be stuck at annual rates around 2% over the period. Investment in health care-related stocks is a great way for investors and retirees to hedge against rising health care costs and to take advantage of the population shift.

Of course, none of this is new. Capital has been flowing into health care for years, and many of the companies at the razor's edge of this shift are trading at ridiculous prices.

Case in point: Health care software provider Castlight Health (NYSE: CSLT) took its shares public last month to huge fanfare and a huge multiple. Even after falling 46% since the IPO, CSLT still trades for 146 times trailing sales -- yet actual earnings are years away.

Even relatively mature companies are trading above their historical averages, with the Health Care Select Sector SPDR (NYSE: XLV) trading at an expensive 23.7 times trailing earnings.

While most in the space are trading at premiums, one company is coming off a huge discount and still trades well under fair value.

This company is a diversified play across health care and is trading near its five-year low. But that isn't even the best part: This company is also in one of my favorite sectors and pays a dividend yield above 5%.

A Standout Among REITs
Real estate investment trusts (REITs) are a favorite of mine and make up nearly 15% of my portfolio. Many investors understand the benefit of the high dividend yields they get from REITs, but there is an often overlooked advantage with sector-specific REITs: the ability to obtain exposure to growth across a business sector without the execution risk in a particular company.

REITs that own property leased by health care companies and facilities enjoy the demand and rental increases from a quickly growing market but are not exposed to the litigation or business risk of running a medical services company. The landlords just sit back and collect the rent, then pass it on to shareholders.

Granted, REITs are exposed to oversupply within their own property market and to interest-rate risk, but these cash-flow machines have consistently outperformed the broader index. The FTSE NAREIT Composite Index has risen by an annualized 10.1% over the past 20 years, well above the 7.4% total return on the S&P 500.

While each of the three mega-cap health care REITs has seen shares underperform over the past year, HCP Inc. (NYSE: HCP) has tumbled 22% on a management shake-up and fears related to rising rates and health care reform. While shares have rebounded off multi-year lows last month, they still trade well below long-term earnings multiples. Shares trade for 18.9 times trailing earnings, up from a multiple of 15.9 set last month and not seen since 2009.

Many investors assume that HCP is purely a play on senior housing, but the company is actually a diversified bet on health care with a unique investment model. HCP combines five investment strategies (including real estate ownership, joint ventures and debt investment) across five assets (such as senior housing, life sciences, hospitals and medical offices) to create an investment model that can withstand weakness in any one area.

Shares have generated an annual compound return of 17% since 1985, and funds available for distribution have increased at an 8.4% annual rate over the past three years. The company's debt of $8.6 billion is just 49% of its market cap, meaning there is plenty of room to fund growth by issuing debt rather than through a dilutive share issue.

HCP is the only REIT in the S&P 500 Dividend Aristocrats Index, increasing dividends for 29 consecutive years. The shares currently pay a 5.3% yield, and the company has room to increase payments at a faster rate over the next couple of years. HCP was paying out more than 90% of its funds from operations (FFO) as recently as 2010. The payout has since fallen to just 73%, but management will be under increasing pressure to return more cash to shareholders if the payout percentage drops further.

The shares are such a steal that one Bloomberg columnist recently wondered whether a record-setting merger of HCP and one of the other two mega-REITs might be in the making. HCP has made zero acquisitions since its 2012 joint venture with Blackstone Real Estate Partners to buy 133 communities for $1.7 billion. That is a long time for a REIT to be missing from the acquisition market, and it may be because HCP is shopping itself. According to Bloomberg, HCP was in talks with Ventas (NYSE: VTR) late last year before the departure of HCP's longtime CEO.

Whether a merger is in the cards or not, HCP has consistently provided investors with a strong cash yield, and I am looking at the recent weakness as a buying opportunity. The company is well positioned for strong gains in the health care market and should help protect investors from higher costs in health care.

Risks to Consider: There could still be some downward pressure on the stock around changes in health care reform. This would affect the entire industry, but HCP should do relatively well with its diversified business model.

Action to Take --> The shift in U.S. demographics, a unique business model and a strong yield makes HCP a REIT that you can truly hold forever. Shares have rebounded since a 52-week low last month but are still under my buy-under price of $42 per share. My one-year target of $45 represents 12% upside in addition to the solid 5.3% dividend yield.

P.S. Speaking of reliable dividend payers, have you seen this month's "High-Yield Stock Of The Month"? It's another REIT that provides unique access to a surging industry -- and pays a yield north of 6%. Click here to learn more about this special high-yield investment.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.