Sherlock Holmes may be fiction's finest detective in human history. Sir Arthur Conon Doyle's protagonist boasts the keenest mind in investigation – but according to the loyal Doctor Watson, Holmes isn't the most well-rounded person. In the seminal A Study in Scarlet, it's revealed that Holmes is so caught up in studies that relate to investigation that he claims not to know the Earth revolves around the sun. Talk about a lack of diversity!
Yet, investors well-versed in specific fields -- such as the health care industry -- can make out with stellar returns. So which is it for health care investors: Should you focus in on the industry with a hawk's eye, getting to know the complete ins and outs of the FDA and drug discovery process, while paying only token attention to outside events? Or should you keep a broader perspective, taking note of how the economy, political situation, and society could affect the hottest health care stocks?
A case of medical devices
Sherlock and the medical device industry probably wouldn't get along too well. Out of the entire health care sector, perhaps no industry has been hit by outside forces recently as much as this one.
The medical device excise tax has been one of the most talked-about issues in the space. The 2.3% tax on certain types of revenues, which the recent fiscal cliff deal didn't correct, is poised to hit the entire industry to the tune of an estimated $30 billion over the next few years. While most companies will be negatively affected, the tax will slam small and young companies the most -- the exact businesses that can't afford to have an extra tax levied on them as they struggle to find profitability, such as in the case of robotic surgical maker MAKO Surgical (UNKNOWN:MAKO.DL).
If you hadn't been paying attention outside the health care sphere, however, falling victim to partisan politics would have been an awful investing misstep.
There's more: Europe's fiscal crisis and economic recession has pressured every industry -- but it's hit medical device companies especially hard, as many have reported declining revenues across the Atlantic. Sherlock Holmes, focusing solely on the ins-and-outs of the health care industry, would have missed the economic storm continuing to surge across the pond -- and probably wouldn't have seen the continued pressure on hospital budgets across the country. That financial tightening has put pressure on Intuitive Surgical (NASDAQ:ISRG), MAKO, and other producers of expensive devices to continue finding new markets and niches to tap into.
It's elementary, dear Watson: If you're looking to invest in the medical device industry, don't follow Holmes' example. Keep an eye on the movements outside of just health care... but that advice isn't limited to devices.
The pharmaceutical question
Holmes would have been better off in the high-stakes drugs arena, but he'd still face an uphill battle.
On one hand, the world's greatest detective probably could have done a good job investing in orphan drug makers like Alexion Pharmaceuticals (NASDAQ:ALXN). The company's drug Soliris, used to treat patients with atypical hemolytic-uremic syndrome (aHUS), gained FDA approval in 2011 and has sent Alexion's shares soaring ever since. The company's story, apart from its good management since the approval, is fairly simple.
Even with potential-filled drugs on pace for stardom today -- think Arena Pharmaceuticals' (NASDAQ:ARNA) Belviq, for example, and the 460%+ appreciation in Arena's shares over the past 52 weeks -- investors attuned solely to the health care field could do a good job making a decision. With Arena and many other small biotechs looking to capitalize on one or a few key drugs, it's more about reaching regulatory approval and having a market to sell to than many outside affairs. Sherlock Holmes would surely understand the obesity epidemic in Arena's case, even if he knew next to nothing about global economic trends or politics.
That's not enough for big pharma, particularly more diversified companies such as Merck (NYSE:MRK) or Johnson & Johnson (NYSE:JNJ). With Europe's sales under siege, investors in this space need to understand the alluring emerging markets and the importance of growing revenues around the world. Without understanding a broader view of investing, Holmes and other like-minded investors would never have seen China's slashing of drug prices coming, for instance, or that the second-largest economy is expected to become the third-largest pharmaceutical market in 2013, according to consulting firm McKinsey & Company.
While gaining regulatory approvals and meeting the needs of target markets is still just as important to big pharma as it is to small biotechs, these companies -- with their size and spread across the world -- need to pay attention to the bigger picture as well. Their investors should do the same.
The crooked portfolio
Overall, a health care-oriented Sherlock Holmes could potentially make decent returns by focusing in on medical stocks. However, he'd be paying a huge opportunity cost by not diversifying his portfolio across multiple sectors and industries.
It's true that health care has experienced the good times recently. The Health Care Select Sector SPDR (NYSEMKT:XLV) has been S&P's second-best sector ETF over the past 52 weeks, with gains of more than 17%. Among companies on the Dow, Merck has pulled in more than 10% over that same time frame, while Pfizer (NYSE:PFE) has seen gains of more than 20%.
But while we're cherry-picking Dow stocks, let's take a look at Bank of America (NYSE:BAC). Holmes, by sticking exclusively to health care stocks, has completely missed 2012's best Dow member. The financial staple has gained more than 72% over the past 52 weeks, and the rally in financials isn't limited to B of A in any way. S&P's Financial Select Sector SPDR (NYSEMKT:XLF) leads all the company's sector ETFs in gaining almost 24% over the past 52 weeks. Other sectors might not be as potent -- with tech gaining 13% and industrials 10%, for example -- but lack of diversity has certainly restricted Holmes's potential gains over the past year.
2012's been good for health care and sector investors no doubt, and the future still looks bright with an aging population across first-world economies. But big-picture hurdles from the European slowdown to continued growth in emerging markets will affect the sector heavily in 2013 and years to come -- and without a diverse portfolio spread across many sectors, investors following Sherlock Holmes' footsteps could find themselves blindsided by an unforeseen negative trend.
More evidence required
In A Study in Scarlet, Sherlock Holmes said, "There is nothing like first-hand evidence." We may not be on the trail like a detective, but the evidence is clear here: No matter the sector, investors should keep an eye on the big picture. It could make the difference between a successful portfolio and missing out on what could have been.
Fool contributor Dan Carroll has no position in any stocks mentioned. The Motley Fool recommends Intuitive Surgical, Johnson & Johnson, and MAKO Surgical. The Motley Fool owns shares of Bank of America, Intuitive Surgical, Johnson & Johnson, and MAKO Surgical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.