By Paul Rickard

One of the standout features of the Australian sharemarket is that the healthcare sector goes from strength to strength. Already in 2017, the sector is up by 28.5%, with stocks such as CSL and Cochlear hitting 52-week highs this week. Over the five years to 31 October, the sector has returned 20.12% pa - outperforming the broader market as measured by the S&P/ASX 200 by an amazing 9.82% pa.

Over 10 years, a period which includes the peak of the market in 2007 and the full impact of the GFC, the broader sharemarket has returned (including dividends) a relatively unimpressive 3.20% pa. The healthcare sector, on the other hand, has returned 12.29% pa. To put this into perspective, $100,000 invested in the sharemarket at that time would now be worth (with dividends re-invested) $137, 024. The same $100,000 in the healthcare sector would be worth a staggering $318, 721!

So, why the strength in the healthcare sector?

Firstly, the same demographic and technology factors that are driving the demand for healthcare services globally (particularly in developed nations) are driving the demand for services in Australia. As the population ages, the demand for services increases, and expectations about what can be treated are raised. While some of the cost is met by the public directly, most is borne by government, and this expenditure has been growing at a rate well in excess of the inflation rate - closer to a rate of 3% to 4% over the inflation rate.

Secondly, we have some absolutely terrific healthcare companies. Our largest by market capitalisation, CSL, is the global leader in blood plasma products and number two in influenza vaccines. Resmed is the best at products to treat and manage sleep apnea, while Cochlear leads in the field of hearing implants. Ramsay Health Care is one of the leading private hospital operators, with operations in Australia, France and the UK.

Finally, the distortion of our local market caused by the overweight representation of banks and resources companies has meant that our local fund managers have been desperate to invest outside these sectors, and arguably, have paid way above the mark to invest in the healthcare sector. This problem has compounded over the last few years with so many of our large cap companies seeming to be “growthless”. The major banks, big insurers, retailers, Telstra and the big miners have struggled to grow earnings. Consequently, a huge premium is being paid for companies that can demonstrate consistent growth. The CSL's, Resmed's, Cochlear’s and Ramsay’s fit right into this category, and are arguably, super expensive.

The data below from FN Arena for the four largest healthcare companies paints the picture. On the major broker forecasts, CSL is currently trading on a multiple of 32.2 times forecast FY18 earnings and 28.0 times forecast FY19 earnings. Cochlear trades at an even more remarkable 41.7 times FY18 and 36.8 times forecast FY19 earnings!

It closed yesterday at $183.70, putting it 20.4% higher than the consensus broker target price of $146.26. Only Ramsay Health Care, which has recently been the target of short sellers and has been dragged down due to the lacklustre performance of Australian competitor Healthscope, is trading under the consensus broker target price.

How to play

Three longstanding investment adages are: 1. The trend is your friend; 2.You never go broke taking a profit; and 3. Let your profits run. Each is relevant here.

While Australian healthcare stocks are very expensive, not only compared to the broader Australian market but also compared to global healthcare sector peers, the trend to higher prices is clearly intact. As I noted earlier, I think it has been exacerbated by the underperformance of the large cap market stocks and until we start to see some rotation back into these stocks, healthcare stocks are likely to remain well bid.

Take a profit? Maybe with stocks such as Cochlear (the most obvious candidate) or CSL, but I could have argued exactly the same course of action when their share prices were $10 lower or even $15 lower. Let your profits run wins!

So, if you are long healthcare stocks, hang on for the ride. Maybe a little bit of profit taking to put some money into the bank, but not much more than that. If your portfolio is underweight, I think you may need to be very, very patient. Apart from perhaps Ramsay Health Care, I can’t advocate buying at these prices.