By Lewis Braham

If you're looking for growth on the cheap, you'd be hard-pressed to find a more attractive stock sector today than healthcare. For decades, it has been one of the U.S. economy's most important sectors, yet it has underperformed the S&P 500 index for two calendar years in a row.

"Over the past two years, we've had healthcare underperform by the largest amount that we have seen in more than three decades," says Andy Acker, manager of the Janus Henderson Global Life Sciences fund. "That's a very unusual situation."

The popular $38 billion Health Care Select Sector SPDR exchange-traded fund, which tracks the healthcare stocks in the S&P 500, gained just 2.1% in 2023 and 2.5% in 2024, while the broad index soared over 20% each year. Consequently, the S&P 500 has a high price/earnings ratio of 23 versus the ETF's 18, according to Morningstar. The growth-stock poster boy, the $76 billion Technology Select Sector SPDR ETF, has a nosebleed 28 P/E.

Traditionally, healthcare stocks trade at a premium to the S&P 500 because of the sector's consistent earnings growth. In good economic times and bad, people still need medical treatment.

But the sector has experienced numerous stumbling blocks. The most obvious, Acker says, is an inability to compete with artificial-intelligence stocks like Nvidia and Microsoft in the Magnificent Seven, which have soaked up the lion's share of investors' dollars. But there also have been healthcare industry-specific issues, such as excess inventory in the life-sciences tools industry and excess patient utilization among managed-care companies. There were also patent expirations for the largest pharmaceutical companies, and Biden-era regulators were capping drug prices for Medicare and blocking mergers. One of the most problematic issues was higher interest rates, as many biotech companies borrow debt to finance their operations in their research and drug-development stages.

Many of these problems have moderated or gone away in recent months. Acker's co-manager, Dan Lyons, points to life-sciences tools company Thermo Fisher Scientific, which makes scientific instruments and reagents, as an undervalued stock that the fund has increased its weighting in.

"We've gone through a period postpandemic where the [life-sciences tools] industry grew substantially below its long-term growth [rate]," Lyons says. "That was partly due to overbuying and too much inventory across bio process and basic research tools. With Thermo, their testing business was very large as Covid was peaking and is now very small. So they had to absorb [that inventory overhang], and we're coming through that now." He expects Thermo's growth rate to normalize going forward.

The healthcare sector is heterogeneous, with a wide dispersion in returns between the best- and worst-performing stocks. The performance difference between a company with a blockbuster drug and one that fails to get regulatory approval can be immense. For this reason, active fund management can pay off as managers with the expertise to determine in advance which drugs will be successful and which won't can beat their benchmarks. While the indexed low-cost healthcare SPDR ETF is perfectly suitable, supplementing one's exposure to it with an active fund can give investors an edge.

For instance, PGIM Jennison Health Sciences has produced a 9.9% annualized return in the past five years, besting the SPDR ETF's 8.6% and 99% of its Morningstar fund category peers. Manager Debra Netschert pays extra attention to small- and mid-cap biotech stocks, as they can be difficult to analyze yet have the potential for blockbuster drugs. She says higher borrowing costs have held back the biotech industry overall, but there are still many individual opportunities.

"Right now, we are overweight in biotech," Netschert says. "There's a lot of opportunities, but it's a stockpicker's market. One of the things that makes biotech so difficult is just the sheer number of companies and the amount of redundant products that are being developed. That has made it really difficult for people who aren't in the weeds in the sector to outperform."

One overlooked stock Netschert likes is Crinetics Pharmaceuticals, which focuses on endocrine-disorder drug treatments. "It's an area where there hasn't been a lot of innovation over the past 10 years," she says. "[Crinetics] will launch one [smaller product] within the next 12 to 18 months, but in their pipeline, they have several really exciting products that allow patients to get off injectable [treatments] that have major safety issues, and go on to oral [treatments] that are more convenient, more efficacious, and safer as well."

Of course, the big success story in healthcare lately has been Eli Lilly, with its weight-loss and diabetes drugs. Fidelity Select Pharmaceuticals has ridden this success into being a top-performing fund, with a 27% Lilly weighting recently. Yet manager Karim Suwwan de Felipe says there's still running room for the stock, as the obesity/diabetes problem is so vast. Still, he isn't just investing in Lilly. His top 10 holdings also include less-well-known companies that the biggest U.S.-focused index funds don't track, such as veterinary-drug maker Elanco Animal Health and Belgium drug company UCB.

It's in these undiscovered healthcare companies where the real excitement for bargain hunters lies.

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February 19, 2025 02:30 ET (07:30 GMT)

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