From the March 2009 issue of Wealth Manager Web • Subscribe!

To Your Health

During 2008, health funds lost 23.3%, according to Morningstar. While shareholders may have seen little reason to cheer, the group did outdo the S&P 500 by nearly 14 percentage points and ranked as the top-performing equity fund category.

Veteran advisors should not be surprised at the category's relative resilience; health funds have long proved defensive. Because consumers use drugs and medical devices in good times and bad, health shares often suffer little damage during market downturns. When the S&P 500 lost 3.2% in 1990, health funds returned 17.0%. The funds again outperformed the benchmark during the down years of 2000 and 2001.

To be sure, not all health funds performed identically. Funds with big stakes in biotechnology and pharmaceutical companies scored best in the past year, as consumers continued buying vital drugs. But funds with holdings in health insurers suffered. Many stocks in the sector were cut in half as investors dumped financial shares of all kinds.

Will health funds continue delivering competitive results? Probably. As the population ages, demand for health products should continue to increase. And if the Obama administration fulfills its pledge to expand health coverage, the upward trend could accelerate

To find the best choice in the category, Wealth Manager again turned to the eight-part screens developed by FI360, a consulting firm in Sewickley, Pa. FI360's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must surpass category medians. The expense ratio must fall below the top quartile, and at least 80% of the fund's holdings must be consistent with the category.

The screens reduced the field of 189 down to 35 finalists. A top finisher was BlackRock Health Sciences Opportunities, but we passed it over because it had been closed to new investors. The fund has now reopened. Other strong performers included Hartford Global Health and Jennison Health Sciences. We selected T. Rowe Price Health, which delivered strong returns as well as the highest alpha of any of the finalists that are open to new investors.

The T. Rowe Price fund ranks as one of the more aggressive choices in the category. Portfolio manager Kris Jenner emphasizes smaller companies, since they can achieve the highest growth rates. Currently, the fund has most of its assets in small- and mid-cap stocks. More than 40% of assets are in fast-growing biotechnology shares. In contrast, the average health fund has 60% of assets in large stocks and less than 30% in biotechnology.

Jenner figures that the recession will hurt some companies more than others. With consumers tightening their belts, there will be a decline in doctor visits and hospital stays for elective procedures. That will slow producers of hospital beds and other equipment that need not be purchased right away.

Meanwhile, sales should remain steady for essential drugs. To weather the hard times, Jenner is focusing on companies that produce life-saving medications. "The most valuable companies in healthcare will continue to be ones that can develop important therapies," says Jenner.

A favorite holding is Gilead Sciences, a biotechnology company that produces HIV medications. The company's earnings have been increasing at an annual rate of more than 25%. "Gilead's sales will not slow, because HIV patients understand the risks of not taking the medicines on a daily basis," says Jenner.

Another biotech holding is Amgen. The company is reporting only single-digit sales gains, but the development pipeline includes promising drugs that could keep earnings climbing for years. Jenner also likes Genentech. The biotechnology powerhouse has some promising drugs in development, and Roche Holding is likely to take over the company at a premium price soon.

Along with biotech stars and small stocks, Jenner also owns some major pharmaceutical companies that have strong product pipelines. The giants may never grow rapidly, but the cash-rich companies can deliver steady dividends and help to stabilize the portfolio in downturns, he says. A longtime holding is Merck. The stock has suffered in recent years as investors have worried that the company would lose sales as patents expired.

Jenner figures that the shares are cheap with a price-earnings ratio of 14 and a dividend yield of 4.90%. He believes that the company will deliver steady growth over the long term. "Merck has a longstanding record of scientific excellence, and they will eventually bring forth important new medicines," he says.

Jenner also owns Wyeth, a maker of prescription drugs as well as familiar over-the-counter products such as Advil and ChapStick. Revenues are only growing at a 4% annual rate, but the shares trade for a modest price-earnings ratio of 11 and provide a dividend yield of 3.10%. Jenner says that the company can enjoy some steady growth from key vaccines.

Jenner has 15% of assets in makers of vital equipment, including Henry Schein, which produces x-ray and surgical supplies used by doctors and dentists. Earnings are growing at a 14% annual rate. The company has warned that sales may moderate during the recession, but Jenner argues that the equipment maker is better financed than many competitors. "Henry Schein is in a position to make acquisitions and expand overseas," he says. "The company will come out of the recession with more market share than ever."

By sticking with Henry Schein and other outstanding health businesses, Jenner hopes to protect shareholders during the downturn and deliver solid results when the economy rebounds.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a regular contributor to Wealth Manager.

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