When thinking of high risk and high reward investments, the healthcare sector is one that immediately comes to mind.
It is home to a range of companies from extremely profitable global giants, such as biotherapeutics company CSL Limited (ASX: CSL) with a market capitalisation around $40 billion, down to micro cap minnows which may never turn a profit, like Prana Biotechnology Limited (ASX: PBT) which has a market cap of $70 million.
The potential for rapid growth in this defensive industry is enticing, but you must understand the risks and structure your portfolio accordingly.
The lower-risk approach
The easiest way to minimise risk in this sector is to invest only in companies that are already profitable with favourable outlooks. Companies like CSL, Cochlear Limited (ASX: COH) and ResMed Inc. (CHESS) (ASX: RMD) are excellent examples.
This approach might not be the most exciting strategy, but it can be extremely profitable. CSL, Cochlear and ResMed delivered an average 10-year total shareholder return of 24.1%, 11.5% and 11.8% respectively. An equally weighted portfolio (33% of each company) would have returned 15.8% compounded over the last 10 years!
A higher risk but higher potential reward portfolio
Investors chasing blue sky potential and quick returns are likely to buy into earlier stage biotech companies, hoping to find the next Sirtex Medical Limited (ASX: SRX) which has gained 250% during the past 3 years.
If this sounds like you, a quick way to reduce your risk is to build a structured healthcare/biotech portfolio that allocates between core, growth and speculative stocks. An example 5 stock portfolio could look like this:
Core stocks (portfolio allocation = 50% – 70%)
The core stocks should consist of large successful companies that will provide a solid base for long-term returns, while helping preserve capital during any market conditions.
1. Cochlear is a global biotech leader and pioneer of the bionic ear. The business provides a higher quality of life for people and demand for its hearing products will continue to grow in the future.
2. CSL is a global speciality biotherapeutics company that develops and delivers innovative biotherapies including blood plasma products and vaccines.
Growth stocks (portfolio allocation = 20% – 40%)
The growth stocks within the portfolio should be profitable businesses that are smaller and have the potential for higher growth compared to the core stocks.
3. Sirtex Medical is an emerging global leader in cancer treatment and its primary commercialised product is a targeted radioactive treatment for liver cancer called SIR-Spheres. The future looks bright with sales of SIR-Spheres increasing every year for more than a decade.
4. Medical Developments International (ASX: MVP) is a specialised healthcare company and the only global producer of Penthrox – an inhaler currently used to treat pain in emergency situations. Medical Developments is rapidly gaining approval to sell Penthrox around the globe and has a large growth runway in front of it.
Speculative stocks (portfolio allocation = 0% – 10%)
Speculative stocks are usually unprofitable but have significant potential if all of the stars align. They should make up a tiny fraction of your total portfolio as the chances for a total loss of capital are extremely high.
5. Avita Medical Ltd (ASX: AVH) develops and distributes innovative products in regenerative medicine. Its main product is ReCell, which uses a small sample of skin to create a suspension fluid that improves healing for burns and other serious skin wounds.
Foolish takeaway
It is tempting to include speculative companies in your portfolio due to their blue sky potential, but achieving market-beating returns over time is often more about minimising losses than picking the next big biotech company.
This can be achieved by avoiding the speculative sector entirely and instead focusing your money on the "core" and "growth" sections of your portfolio which should provide consistent returns.
Of course, buying these companies at attractive prices and holding over 5-10 years is critical to achieving good returns. With shares of many healthcare companies trading near record highs, investors must be patient to buy into companies when building a portfolio.
