By Jacob Sonenshine

Healthcare stocks have jumped, but the easy money has already been made. Now, these companies have to offer strong profit outlooks to further boost their shares.

The Health Care Select Sector SPDR ETF, home to health insurers, drugmakers, and medical device makers, has gained just over 6% since hitting a multimonth low in late December. That compares with a gain of 1% in the S&P 500 over that period.

Driving the outperformance is that investors and traders have allocated more money to defensive sectors, where demand isn't badly hurt when the broader economy takes a hit. Demand for healthcare doesn't change much, regardless of how much money consumers have to spend.

Interest in defensive shares has grown as the market has become more volatile. Most S&P 500 stocks have stumbled in the past few weeks, partly because President Donald Trump's tariffs would reduce consumer and business demand. Semiconductors stocks have reeled from the tariff issue and because the Chinese artificial intelligence start-up DeepSeek's success in producing AI at lower cost could prompt tech companies to cut back on capital investments. That could reduce chip demand.

The resulting gain in the healthcare fund has pushed the share price to $147, roughly where sellers have consistently come in to knock it lower. Several times in the past year, the fund has gotten knocked down after rallying to the $147 to $150 range.

Headlines showing worsening trade tensions, or other downbeat economic news, could push the fund up to its record high of $157, which it touched in September. That wouldn't be a large gain, and the price didn't remain at a record for long. Sellers came in there, too, promptly knocking it lower.

These stocks, now more expensive, are vulnerable. If earnings don't beat expectations by enough, selling could emerge again. But if the results are satisfactory, the sector could see more gains.

Johnson's & Johnson's earnings in early April are hard to ignore. The company's market capitalization of $366 billion is almost 7% of the total for the entire sector. That gives Johnson & Johnson's stock a significant influence in the movements of the healthcare fund.

The stock has participated in the healthcare rally, so now the market wants to see that its diversified business -- just over 60% of revenue is in pharmaceuticals, with a little more than 30% from various medical devices -- is providing the stability and mild growth investors expect.

Another company to watch is UnitedHealth, the $504 billion insurer. Its stock has rebounded from its December low as the market has come to the view that bipartisan legislation proposed that month, calling for insurers to part from their pharmacy benefit management businesses, wouldn't hurt much. Analysts estimate that United's PBM business generates just a few hundred million dollars in annual operating profits, compared with the total of $38.4 billion the company is expected to bring in this year.

The stock is trading at 18 times the per-share earnings expected for the coming year, compared with the peak of 19 over the past decade and 22 times for the S&P 500. The discount was wider in December, and investors have historically rarely bid it up to par.

Now, with the valuation closer to the level for the S&P 500, the company must demonstrate that profits will keep rising rapidly for the stock to rise. In its January earnings release, management told investors to expect full-year sales to fall within a range with a midpoint of $452.5 billion. That implies growth of 13%, which would likely be driven mostly by the millions of new Medicare patients the company continues to sign up each year. The guidance was a few billion dollars above analyst's expectations.

Whether the company demonstrates that type of growth in April, when it next reports its financial results, will be key for the stock. If the company can also keep its medical cost ratio -- the percentage of premium revenue that it pays for claims -- at near the 86% analysts expect, it will help profit margins remain around where they were last year, supporting earnings growth.

The tax rate was unusually low in 2024, but is expected to go back up this year, keeping earnings from growing as fast as revenue.

But next year, with the tax rate remaining steady and other costs remaining in place, earnings per share should rise to $33.50 from $27.66 last year, FactSet estimates indicate, assuming sales rise to $487 billion. If the market expects EPS at that level at the end of this year, the stock would trade at just over $600, assuming it maintains its price/earnings ratio.

Critical to those expectations is whether sales growth and costs remain on track.

Also worth watching is Eli Lilly, a $769 billion pharmaceuticals gorilla that reports its earnings on Thursday. The stock has rallied recently, so the market needs to see robust growth in its obesity business for the shares to keep rising. Management reduced its forecast for sales in January.

Both Merck and Pfizer reported their earnings Tuesday. Merck stock fell as management released disappointing financial guidance. Pfizer's results were better then expected, helping the stock to rise just over 1% in afternoon trading.

For healthcare investors, identifying the companies that can deliver every quarter will be the key to success.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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February 04, 2025 14:11 ET (19:11 GMT)

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