Beware familiarity bias when choosing stocks

Many investors make mistakes because they have familiarity bias — the inclination to invest in companies or industries just because they know something about them.

Familiarity bias can also be negative. If a cardiac surgeon dislikes a certain kind of medical device, he or she might be soured on investing in the manufacturer, regardless of growth prospects.

Naturally, the best way to approach stocks is without any bias. Because health care is likely to be a fruitful sector this year and beyond, a disinclination to invest in it might mean missed opportunities.

Currently, health care is a split sector. Some companies have hit new recent highs whereas others have descended to new recent lows, so discriminating between them is even more critical. This is a time for discerning stock picking rather than using funds or exchange-traded funds.

A surgeon’s potential bias against a supplier could be particularly disadvantageous these days because medical device and instrument companies are poised for growth as hospitals and surgery centers resume elective procedures suspended during the COVID-19 pandemic. This is happening as many baby boomers are entering their late 60s and needing increasing care — a key factor driving growth.

The increase in surgeries comes at a time when health care is an undervalued sector according to its fair value — a measure of an asset’s estimated true or intrinsic worth. Fair value is different from market price, which could be much higher or lower. According to Morningstar, health care is among the stock sectors that, as of mid-February, had their lowest median price relative to fair value since summer 2020, when the world was in the throes of the pandemic shutdown. (Two other such sectors are industrials and, believe it or not, technology.)

The surgery surge bodes well for companies like Medtronic, a manufacturer of surgical/medical devices. Such supplier companies, which provide surgeons with the metaphorical picks and shovels of their profession, generally are poised for growth, as are some pharma and services companies.

Investing in health care stocks is generally complicated by the sector’s current price bifurcation. As of mid-February, some health care companies — including biotech company AbbVie, pharma company Bristol Myers Squibb and nine care provision and services companies — were at three-month relative highs (with AbbVie at an all-time high). Among the nine were McKesson, AmerisourceBergen and Molina Healthcare.

Meanwhile, other health care firms — primarily in the life sciences tools and services subsector — were at three-month relative lows. Among these were instrumentation and reagent supplier Thermo Fisher Scientific, medical/industrial conglomerate Danaher and medical data science firm IQVIA.

The sector’s current bifurcation reflects likely investor confusion over its future amid an overall market atmosphere of uncertainty. Uncertainty often means opportunities for investors who can identify stocks with the potential to sail briskly without high risk.

My firm did an analysis designed to precisely achieve that. We started by selecting health care stocks with the lowest downside risk, according to our screens. From the resulting group, we selected those with 12-month trailing price/earnings (P/E) ratios below that of the S&P 500 (24.3) and relatively high projected annual earnings growth over five years, as determined by the average of various analysts’ projections. A low P/E reflects good earnings for the price investors must pay for a stock. This tends to attract investors and drive up price, as does projected high earnings growth. Such stocks can be layups in the basketball game of investing.

The resulting list of lower-risk, low-P/E, high projected earnings stocks included Pfizer, Humana, HCA Healthcare, Anthem, Merck, Cigna and CVS Health. Pfizer led the pack in projected average annual earnings growth with 15.88%, followed by Humana at 13.96%, and HCA Healthcare at 12.14%.

Some stocks in the initial, lower-risk group had even higher projected earnings growth — Danaher with 24% annually and biotech firm Vertex with 30% — but both stocks have trailing 12-month P/Es above that of the S&P 500. So did Medtronic, but with lower projected annual earnings — 9.62%. With the resumption of elective surgeries, Medtronic’s earnings in the first year out of five might be significantly higher than in the next four. Also carrying a high trailing P/E is IQVIA Holdings (62%) but that company has projected average annual earnings growth of 22.31%.

Even if these earnings projections are realized, this is not a guarantee of high price appreciation but it is a highly positive indicator. Other factors affecting price are harder to anticipate — for example, in pharma, a cutting-edge new drug or a clinical trial disappointment can send values up or down in an instant.

Equity prices are subject to the impact of recessions, black swan events like the pandemic recession and, more typically, the vagaries of market sentiment. But the metrics used above are among the best available ways to project performance.

Of course, you cannot benefit from a stock’s long-term performance if you don’t keep your shares long term. Productive investing requires patience.

Dave S. Gilreath, CFP, is a 40-year veteran of the financial services industry. He is a partner, managing director, and chief investment officer of Sheaff Brock Investment Advisors, LLC, a portfolio management company for individual investors, and Innovative Portfolios, LLC, an institutional money management firm. Based in Indianapolis, the firms managed about $1.4 billion in assets nationwide as of Dec. 31, 2021.