With an aging population, health care, especially the production of pharmaceuticals and medical devices, is a growth industry that we all know about. In fact, it’s perhaps the only major growth industry other than information technology. And while the constant innovation and brutal price competition in the information technology industry have meant narrowing margins and a huge downside for any firm caught just slightly behind the times, pharmaceuticals have, until now, cruised along without such difficulties. Only lately have many major pharmaceutical companies been feeling the sting of tough price competition from generic drugs and of manufacturing glitches that have led to under- or overstocked shelves.
One of the most appealing things about investing in health care is that health is probably the commodity for which demand is least quenchable. As families get richer, they move from owning no cars, to one car, to two or perhaps even three cars, but there is little desire to move much beyond one car per adult. In contrast, many people, particularly older individuals, can conceive of an essentially limitless desire for drugs to make them feel or perform better, as well as, of course, to cure debilitating and fatal disease. The average death rate remains 100%, of course, and that’s not a hindrance to medicine–it is its sustainer.
There are, of course, risks to health care investments. Looking at individual pharmaceutical firms that populate Merrill Lynch’s pharmaceuticals HOLDRS (PPH), an ugly downside can arise from FDA action and inaction on drug approvals, patent expirations, drugs taken off the market for adverse effects, drugs made obsolete by newer drugs, and liability for drugs that prove dangerous.
These generally company-specific risks can be reduced through diversification. But there are also industry-wide risks. Most notably, as boomers age, their dominance of politics may lead to increased pressure for socialized medicine, specifically “free” prescription drugs for seniors. This was made apparent in 1992 and 1993 as Hillarycare loomed, deflating high pharmaceutical stock prices, then itself deflating in the face of broad political opposition. Of course, there’s no guarantee that next time we won’t see European- or Canadian-style price controls.
Still, pharmaceuticals and other sectors of health care remain large, growing, and profitable areas in which to seek investments. There’s a good chance you or some of your clients will want to invest in health care, or pharmaceuticals in particular, but you probably won’t want to be tracking FDA approvals and analysts’ recommendations on a daily basis. An exchange-traded fund (ETF) can offer diversification relatively cheaply in even a relatively modest portfolio.
For other broad sectors, the S&P sector SPDR (Standard & Poor’s Depositary Receipt) is an obvious first choice. But, surprisingly, there isn’t a health care sector parsed from the overall SPDR. S&P’s SPDRs divide the market into just nine major sectors, yet they split health care up between two different funds: Pharmaceuticals are put into the consumer staples (XLP) sector fund (in fact, the XLP’s top 3 positions are Pfizer, Johnson & Johnson, and Merck), and medical services (e.g., United HealthGroup, HCA) are put in the consumer services (XLV) sector fund.
Fortunately, Merrill Lynch’s HOLDRS (short for HOLding Company Depository ReceiptS) include a pharmaceutical sector fund, PPH. HOLDRS are somewhat different than SPDRs, as noted below. Compared to most other ETF options and sector mutual funds, HOLDRs do have relatively small stock counts. There are currently 18 companies included in the PPH; enough to inject pretty much all of the benefits of diversification. Naturally, diversification is limited by the sector itself, and the PPH’s stock weightings (pretty close to market-cap weightings) reflects this: 91% of assets were recently in the fund’s top 8 stocks.
While my first choice for this area is the PPH, there are several other health care ETF options. You might choose one of them either because you want a somewhat different sector representation, or because of HOLDRS’ requirement that purchases be made in 100-share round lots (in this case recently selling for just under $10,000).
The ETF that comes closest in holdings to the PPH is Morgan Stanley’s Pharmaceutical BOXES (RXB), but there are several reasons to prefer the PPH. While BOXES (Basket Opportunity eXchangeablE Securities) are baskets of stocks that trade like other ETFs on the Amex, the Morgan Stanley ETF holds only 15 stocks, and unlike most other ETFs is not market-cap-weighted, having approximately equal weightings in each stock. The Morgan Stanley ETF is also much smaller than the PPH, with a recent market cap of $55 million and a much wider bid/ask spread. The other health care ETFs are either somewhat wider in scope or more aggressive and narrow.
The iShares Dow Jones U.S. Healthcare Sector Index Fund (IYH) and iShares S&P Global Healthcare Sector Index Fund (IXJ) each invest in the full range of health care stocks. The domestic IYH holds 187 stocks, with 62% in pharmaceuticals firms, 17% in medical products, 12% in biotechnology, and 9% in healthcare providers. And the global IXJ (29% foreign holdings) has fewer positions (66), and so is a bit more weighted in the largest companies, and thus in pharmaceuticals, with 72% in that sector.
On the biotechnology front, we covered the Merrill Lynch Biotechnology HOLDR (BBH) back in the January 2002 issue. But biotechnology stocks are suited to more aggressive investors than are the pharmaceuticals (arguably biotech and pharmaceuticals are the same industry, but in the same way that Ferrari and Ford both build cars). There’s also an iShares Nasdaq Biotechnology Index Fund (IBB); it’s much smaller ($7 million market cap versus $500 million for the BBH) but actually trades with pretty healthy volume and liquidity. And of course, if you want active management and aren’t averse to the tax consequences of turnover, the health care sector has numerous mutual funds to choose from. (See the next section for one I think complements the PPH well.)
As with most index investments, the PPH’s stocks were picked pretty much automatically due to their sector, market cap, and liquidity, and not any investigation of investment promise. That may sound haphazard, but index investing and market-cap weighting has a pretty good record against most stock-pickers. While the HOLDRS will not actively change their holdings, the number, names, and types of holdings will change with mergers, acquisitions, and other changes in the underlying stocks.
Finally, a termination of the HOLDR is possible, most likely if the number of stocks falls below nine, if 75% of the shares vote to terminate, or if the HOLDR is delisted from the Amex (but with over six million HOLDRS outstanding, with a market cap of $600 million, that seems unlikely for the foreseeable future). Shareholders would then receive the underlying stocks, but this would not be a taxable event. Prescription: For tax-efficient growth portfolios, the PPH could make you look smarter than the average single health care stock pick or actively managed health care fund. That should help you keep a healthy relationship with your clients for years to come.
A Dose of Reality
Forget bedside manner: Craig Callahan manages Icon Healthcare by the numbers
Icon Healthcare (ICHCX) is not your run-of-the-mill sector fund–not by a long shot. While most actively managed sector funds concentrate in major pharmaceuticals or biotechnology companies, you won’t find them here. And, while most ETFs that are worth more than a click follow the actively managed fund bias toward large-cap, major pharmaceuticals (or biotechs–see our review of Merrill Lynch’s Biotech HOLDRS in our January 2002 issue), manager Craig Callahan tilts in contrarian direction based on a proprietary valuation system. The fact that Callahan’s fund has a different tilt makes it a potential complement to the PPH, for example. True, his investment thesis meets its antithesis in the PPH–but we think a profitable synthesis of the two shouldn’t be ruled out.
Most health care sector funds concentrate in one industry (say, major pharmaceuticals), or one sub-industry (HMOs, or medical equipment). Your fund rotates from one to the other. What’s the trigger? We believe the U.S. market goes through themes. That is, certain industries and sectors lead for one- to two-year periods usually, and then that leadership ends, and then new leadership emerges. We use valuation to capture industry leadership. We sell stocks in industries that are overpriced and buy those that are underpriced in the belief that they’re on the springboard to be the next leaders. We do that for the whole U.S. market, and we populate our health care fund with the health care portion of our U.S. system, just like we populate our energy fund with the energy portion of our U.S. system. We’re not health care specialists, we’re running this one valuation system capturing industry themes and populating our sector funds with our favorite industries. So, in our health care fund you will get a real contrast to a health care index, and relative to many of the exchange-traded funds which do market cap index weighting. We will be tilted heavily toward our favorite industries within health care.
Do valuations matter? How do you compute them? On the valuation side, we compute value based on a methodology that most people overlook, even though its proponent, Benjamin Graham, is widely known. Most people think of Graham in terms of price-to-book, P/E ratio, and dividend yield. He realized the deficiencies of those techniques, and developed an intrinsic value equation that he published in 1962. He called it his “central value formula.” I’ve modified that, but that’s what we use. We don’t use P/E, price-to-book, or price-to-sales, or any of those value-type criteria. We never use them. We just use our valuation equation.
Here’s what goes into it: For a company, we take their average earnings and a forward looking growth rate in earnings. We consider beta, and the AAA bond yield. So it has all the fundamentals of finance. What do they earn? How will it grow? And then we discount those future earnings back to the present value considering risk and interest rates.