Our May Market Perspective identifies and discusses the potential weaknesses in several traditional "safe" sectors within the equity markets-healthcare and utilities.

1. Market Perspectives – May 2015
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Overview: During market downturns, investors will often seek out defensive
areas of the market in search of “safety.” This month we investigate “safe”
sectors of the market which have been traditionally used for conservative
equity exposure: healthcare and utilities.
How safe is conservative equity?

2. Experience Insight Impact
Defensive Equity Allocation
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• It’s generally accepted that investors can improve their equity portfolio’s performance during down
markets by being defensive. Defensive actions during tumultuous times typically involve shifting
equity exposure toward less cyclical and less volatile (lower beta) sectors.
• Defensive sectors typically consist of firms that produce goods and services with relatively inelastic
demand curves. In other words, the demand of these goods is not impacted by price increases.
Economics professors use cigarettes as a prime example of inelasticity (people who smoke are still
going to smoke with relatively little regard for cost). In the stock market the least cyclical sectors have
been healthcare, water and electric utilities, food processors and other consumer staples.
• However, this relationship is not true during all periods. We believe some traditionally defensive areas
have greater risk in today’s market due to certain circumstances specific to the current environment.
• There are many reasons why a sector might perform differently from one bear market or recession to
the next. We examine why we believe the general utilities and healthcare sectors may not provide
the same defensive characteristics currently as in prior cycles.

3. Experience Insight Impact
Are Utilities Defensive in a Low Yield Environment?
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• Utility stocks are often considered the
ultimate risk-averse investment. They
boast reliable dividends, inelastic
demand, and regulated monopolies.
• This chart tracks utility dividend yields
over 25 years. While its dividend yield
is relatively attractive in today’s near
zero interest rate environment, global
demand for income has created a
price rally and pushed utilities’ yields
close to historical lows, limiting its
defensive characteristics.
• Perhaps as a precursor of what lies
ahead, utility stocks have traded
poorly during the brief interest rate
rallies we’ve seen over the past few
years.

4. Experience Insight Impact
Utilities – Defensive or Not?
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• Further limiting utility
sector’s safety is valuation.
This is a chart of S&P Utilities
Index earnings multiple, or
P/E ratio.
• At its peak, the P/E multiple
increased 62% off of its 2011
lows. At 17x earnings vs. its
long term historical average
of 14.8x, it’s difficult to
consider utilities defensive.
• Further, US utilities have
traded at an average
discount of roughly 25% to
the S&P 500. Even after the
sectors’ correction this year,
US utilities are only trading
at a 20% discount.

5. Experience Insight Impact
Is Healthcare Defensive?
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• Healthcare is a mainstay of defensive equity exposure. It’s inelasticity is evident – people continue to get sick no
matter what the economy does. However, the drivers of an industry can change dramatically over time. “Health
care” is in fact composed of many different segments with a variety of characteristics. While we do still find many
areas attractive based on growth and sustainability of earnings, the current investment landscape leads to the
conclusion that many areas of healthcare are no longer defensive.
• Today, healthcare indices are heavily influenced by major secular themes which are driving up valuations. It is no
longer dominated by big pharma trading at low earnings multiples and paying large dividends. Biotechnology
companies and interest rate driven merger activity have driven up valuations and substantially increased this
sector’s correlation to the broad equity market.
• For example, the S&P Healthcare Index is has a dividend yield of 1.41% and a P/E of 23.6x trailing earnings. This is a
substantial premium to the broader equity market. As of April 29th the S&P 500 has a dividend yield of 1.97% and is
trading for 18.43x.
• In addition, healthcare has been equally as volatile as the broad stock market. The sector’s beta – a measure of risk
which tracks correlation to the S&P 500 – is 0.97 over the last two years. Note: A beta of 1.0 is 100% correlated to
the S&P 500.

6. Experience Insight Impact
Healthcare Valuations
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• The chart represents the
earnings multiple of the S&P
Healthcare index. Over four
years, the P/E multiple has
increased by 131% or 26%
per year on average.
• The index moved from
trading at a discount to the
S&P 500 to a 28% premium
today.
• While there are attractive
and conservative individual
securities within the sector,
in aggregate we consider it
less defensive than it has
demonstrated historically.

7. Experience Insight Impact
Why is this Important for Clients?
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• Its important to constantly test rules of thumb for reasonability and validity. The security prices are
constantly changing due to changing market conditions and secular changes in sector dynamics.
• Individual stock selection and active management versus blind indexing can protect investors from
risky areas of the market by incorporating the impact of changing industry dynamics into the
investment thesis.
• The global search for yield and global central bank activities are affecting security prices for many
assets with income characteristics.
• When the US Federal Reserve changes its interest rate policy, it could result in increased volatility in
areas of the market where volatility has been historically lower.

8. Market Perspectives – May 2015
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Conclusion: “Defense” to some degree is an important part of the
investment process for the vast majority of investors. Regarding equities,
it is not sufficient to simply look at history. It is important to frame an
investment in the context of valuations, current economic and market
conditions and critical thought in order to achieve the desired risk
adjusted returns.
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9. Opinions expressed in this commentary may change as conditions warrant and is for informational
purposes only. Information contained herein is not intended to be personal investment advice for any
specific person for any particular purpose. We utilize information sources believed to be reliable, but
cannot guarantee the accuracy of those sources. Past performance is no guarantee of future
performance; investing involves risk and may result in loss of capital. Consider seeking advice from a
professional before implementing any investing strategy.
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Disclaimer
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