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  • Healthcare stocks tend to outperform in a recession.
  • Strong demand for pharmaceuticals offers upside for two large cap drug companies.
  • A tiny biotech with a fast-growing cancer drug could see its shares trade significantly higher.

Recessionary winds are blowing, creating all-sorts of volatility in stocks. The U.S. economy is shrinking, and globally, central banks remain behind the curve given runaway inflation, particularly in Europe. When inflation is rampant and economies are struggling, owning healthcare stocks can be wise. Demand for healthcare products and services is relatively inelastic to the economy, so they're somewhat insulated from the economic risks that can cause revenue, profit, and share prices to tumble. For this reason, healthcare is one of only a few groups that historically outperform during a recession.

If you’re underweight healthcare stocks, here are three stocks you can consider buying. I’ve included two large caps and one small-cap idea. Read on to learn if these stocks are right for your portfolio.

No. 1: Johnson & Johnson

One of the biggest healthcare companies in the world, Johnson & Johnson  (JNJ)  shares are under pressure over worries surrounding their exposure to lawsuits resulting from the use of talc in baby powder. In some instances, natural talc is contaminated with asbestos, which can cause cancer.

Although lawsuits  create uncertainty for the company, the recent drop puts shares close to support, providing investors with an intriguing risk/reward trade.

In “Johnson & Johnson Is On a Roll, and This Trade Has My Attention,” Real Money’s Stephen Guilfoyle writes, “My opinion is that JNJ presents as an income paying defensive type stock that can probably be bought into broader market weakness as we trek into a period of increased uncertainty.”

Guilfoyle’s interest in owning Johnson & Johnson stems from the fact the company delivered solid revenue and earnings growth last quarter, it possesses a strong balance sheet, and it plans to spin off its slow-growing consumer goods business to shareholders. In his opinion, those "pros" outweigh the risk of talc lawsuits, particularly given J&J's plan to segregate talc risk by creating a new company to house its talc-related liabilities, and then placing it into bankruptcy.

Back to Guilfoyle:

“The firm printed an adjusted EPS of $2.59 on revenue of $24.02B. These numbers beat expectations on both the top and bottom lines. The revenue print was good enough for year-over-year growth of 3%, or 8.1% on an adjusted operational sales basis…For the full year, JNJ maintained guidance of $97.3B to $98.3B for operational sales, which would work out to adjusted operational sales growth of 6.5% to 7.5%...As far as earnings, JNJ now sees an adjusted full-year EPS landing in between $10.65 and $10.75, which narrowed the range by a nickel on each end without impacting the midpoint.”

The revenue growth was driven by its pharmaceutical business, which accounted for $13.3 billion of its $24 billion global revenue last quarter. Pharmaceutical sales improved 6.7% year over year (12.4% ex-currency). Cancer drugs were particularly strong performers. For example, its multiple myeloma drug, Darzalex, saw revenue grow 39% to $2 billion from one year ago, contributing to total oncology sales rising 14% year over year. Sales of Erleada, a prostate cancer drug, were also up 50% to $450 million in the quarter, too.

J&J’s Medtech business consists of various products, such as those used in orthopedic and surgical procedures. Its revenue fell 1% (+3.4% operationally) year over year in the quarter. Meanwhile, sales in its soon-to-be spun-off Consumer health segment fell 1% (+2.3% operationally).

Back to Guilfoyle:

“Back in November of last year, Johnson & Johnson announced the intention to split off its consumer division within 18 to 24 months creating two companies. Without going into detail, the move would allow JNJ to focus more on the higher margin pharmaceutical business, while the slower growth consumer-focused business could focus on kick-starting products centered around wellness and personal health. Sound far off, but if the split is on schedule, it's now less than 9 to 15 months away.”

The planned spin-off allows investors to eventually own shares in two companies – the faster-growing drug and products business and the slow-and-steady consumer goods business. Today, the sum-of-parts valuation could be hamstrung because the steady-eddy consumer products are weighing down excitement over its higher-growth pharmaceutical business. Management plans to provide more insight into the new company later this year.

Johnson & Johnson generates plenty of cash that supports a healthy balance sheet and an above-market dividend yield.

Guilfoyle writes: 

"As of the end of that July quarter, JNJ had a net cash position of $32.568B, which was up from previous quarters, courtesy of free cash flow that reached $1.79 per share, which was a three-quarter high and the second highest per-share free cash flow print for the firm in six…the firm's current ratio at 1.42, which is healthy and up from 1.39 the quarter prior.”

The current ratio is a simple, effective way to ensure a company can access money quickly to pay off short-term obligations. The higher the ratio, the more likely the company’s balance sheet suggests the company is on solid ground. The fact that it's current ratio is nicely above 1 indicates its dividend should remain safe. Currently, J&J yields 2.55%, which is considerably better than the S&P 500's  (VOO)  1.5% yield. 

At $169, J&J's shares aren’t trading too far above support in the low to mid-$150’s that stretches back to early 2020, and shares aren't overly expensive. J&J is expected to deliver EPS of $10.58 in 2023, so its forward P/E is 16, which is about the mid-point of its 5-year P/E range of 12 to 21. Therefore, a buyer could pick up shares on weakness, and then protect via a stop loss below $150.

No. 2: McKesson & Co 

I recommended McKesson on May 17, writing “demand for prescription medicine should benefit sales and earnings because of aging demographics, and given uncertainty over its opioid settlement and overseas business exits are disappearing, McKesson could move higher, especially if investors embrace baskets that do best in a recession, including healthcare.”

I still like the company for those reasons, and I'm in good company. In Q1, Warren Buffett bought 2.9 million shares, and in Q2, he kept buying, adding another 276,369 shares. As of June 30, Buffett's Berkshire Hathway owns 3.2 million shares, making it McKesson's sixth largest shareholder.

Of course, there’s no telling if Buffett's still buying or how long he'll keep McKesson in Berkshire's portfolio. Nevertheless, the company’s still making progress on its opioid settlements and overseas divestitures, and growth elsewhere is expected  to largely offset lost revenue from the countries it's exiting. So far, McKesson says it's “completed or entered into divestiture agreements in 11 of the 12 countries,” and its inked agreements to settle opioid litigation in all 50 states, plus D.C.

On August 3, the company reported top and bottom line results that were better than analysts expected. 

Revenue grew 7.2% year-over-year to $67.2 billion, $2.4 billion better than estimates, while EPS clocked in at $5.83, $0.53 better than estimates. As a result, McKesson increased its full-year EPS outlook to $23.95-$24.65 from $22.90 to $23.60.

Its healthy profitability is allowing management to return a lot of money to investors. It recently increased its dividend by 15% to $0.54 per share per quarter, plus it repurchased $1 billion in shares last quarter, and it announced a new $4 billion share buyback program.

Although McKesson is up 48% year-to-date and 10% since my article in May, its shares are only trading 14 times next year’s $25.78 EPS estimate. So, there may still be room to run higher.

No. 3: AVEO Pharmaceuticals

This small-cap is arguably the riskiest of the three, but AVEO Pharmaceuticals'  (AVEO)  is riding a wave of sales growth following the approval of Fotivda in March 2021. 

Fotivda is a kinase inhibitor approved for third-line use in kidney cancer. In clinical trials, progression-free survival on Fotivda was 5.6 months versus 3.9 months for Bayer’s Nexavar, a commonly used late-line treatment option that produced over $750 million in sales in 2020 across multiple indications (liver, kidney, and thyroid cancers).

In “This Cancer Therapy Company Is Small but Its 'Options' Look Big,” Real Money Pro’s Bret Jensen writes, “The company should ring up net sales for Fotivda of just over $100 million this fiscal year. Given the stock's approximate market cap of $265 million, the shares are trading at just over two and a half times revenues. That's more than reasonable, given sales are projected to cross the $170 million mark in fiscal 2023 based on the current analyst consensus. AVEO Pharmaceuticals is also expected to become profitable for the first time next year.”

Last quarter, AVEO revenue grew 235% year-over-year to $25.3 million. This year, it's expected to see its loss per share shrink to -$0.76 from -$1.63 in 2021, and in 2023, additional sales growth is expected to result in EPS of $0.33, up from expectations for a loss of $0.07 30-days ago. The shift to profitability is supported by prescription volume growth of 18% year-over-year in Q2, 24% sequential quarterly revenue growth, and a $10-$20 million reduction in planned R&D spending.

The company expects sales to benefit from a recent decision by the National Comprehensive Cancer Network (NCCN helps dictate what doctors view as standard of care) to include Fotivda as the only "category 1" drug in the 3rd-line population.

Further out, a trial combining it with Bristol Myers’ Squibb’s multibillion Dollar blockbuster drug, Opdivo, is expected to be fully enrolled next year. If that trial succeeds, it could clear the way for its use in second-line kidney cancer patients, substantially increasing Fotivda's addressable market. For perspective, the third-line setting is valued at $480 million annually, while the second line is valued at $1.3 billion.

Back to Jensen: 

“AVEO fully owns the rights to Fotivda. This makes the company a logical and fairly cheap acquisition target for a larger player wanting to expand into this space. Oncology has been the hottest part of M&A across the industry for years. The company has some $75 million of cash on hand. The analyst community has been growing more sanguine around the company's story and growth. Since second quarter numbers posted just over two weeks ago, four analyst firms including Stifel Nicolaus have reissued Buy ratings on the stock with price targets ranging from $12 to $17 a share.”

The Smart Play

As I’ve highlighted, healthcare stocks tend to perform better than the market during a recession. Given that the U.S. economy has contracted for two consecutive quarters and the Federal Reserve continues to increase interest rates, further dampening activity, owning more healthcare stocks in portfolios could be smart if stocks' rocky performance continues.

If you’re interested in all buying all three stocks, consider spreading purchases across multiple tranches to take advantage of volatility. Furthermore, it may be wise to allocate more to the highly-liquid large-cap stocks than to AVEO, given it’s the highest-risk stock of the bunch.

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