Hot Health Care ETFs Face Head Winds

September 24, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.

The health care sector has provided stellar investment opportunities in recent years.

Over the last five years, the iShares U.S. Healthcare ETF (IYH | A-94) has outperformed the broader Dow Jones U.S. Index by more than 8 percent. Health care has increased more than 22 percent per year while the broader U.S. market has increased at 16 percent per year.

Removing the annualized returns, IYH is up more than 177 percent in five years, while the Dow Jones U.S. Index has basically doubled. Both returns are very impressive. The question for health care investors is, will the outperformance continue?

More Upside Potential
The analysis below leads to the conclusion that health care stocks have potential for further upside, but most of the outperformance in the sector has already occurred.

Investors should watch price trends as well as merger-and-acquisition trends in the industry. If either slows down, investors should reduce their emphasis on health care in their portfolios.

While this analysis used the Dow Jones U.S. health care indexes, which are behind many of the subsector ETFs used in the industry, it applies to other broad health care ETFs like the Health Care Select Sector SPDR (XLV | A-93) and the Vanguard Healthcare (VHT | A-94). It also applies to the iShares Nasdaq Biotech (IBB | A-46) and other biotechnology ETFs.

Business Fundamentals
Health care’s performance has benefited from fundamental changes in the health care industry. New drug approvals are up 50 percent in the last four years compared with the previous four.

Some of these approvals have been for very-high-cost treatments that serve a narrow patient universe. The approval of applications in this area benefits many startups and increases the potential number of diseases that can be treated profitably.

The additional treatment opportunities are reflected in the business performance of biotechnology. The chart below shows biotech firms have superior historical earnings growth, wider margins and better return on equity (ROE).

The broader health stocks, which include strong biotechnology data, look more like the rest of the market. Of concern are the rapidly increasing debt loads of health care firms. Debt-to-capital ratios have risen from the high 20 percent to more than 40 percent for biotechnology and more than 35 percent for broader health care. Both are increasing more rapidly than the market.

Morningstar Direct_Health care data

Two major demographic trends also benefit health care stocks.

First, the developed world’s population is aging. Health care spending is expected to grow at about 6 percent annually in the U.S. through 2023.

Second, many emerging markets have substantial population groups moving into the middle class, which should increase the percentage of income devoted to health care. Combined, the two demographic trends are expected to push health care revenue 7.4 percent higher.

Valuations And Returns
The improving ROEs and demographic trends seem well-baked into the stock prices. Compared with the broader market, price-to-earnings ratios are higher, and have accelerated in recent years.

Price-to-sales ratios also show more rapid increases by health care stocks than the overall market, and outperformance per year of 6 percent for five years reflects a fair amount of improving fundamentals.


Morningstar Direct_Health care data

Risks

Health care’s statistical and fundamental risk has increased along with valuations. At the beginning of the recent five-year run, health care stocks posed very low betas. Since then, those betas have climbed at a fairly rapid pace.

Increased debt accounts for some of the increase in risk. As shown earlier, health care firms previously were more conservatively financed than the market. Low interest rates have spurred borrowing in the broad sector and specifically in biotechnology. While the increased debt levels may signal better financial management, they raise the required rate of return for health care stocks.

Conclusion

While the health care industry appears to be too richly valued for continued intermediate-term outperformance, two trends suggest giving the sector room to run in the short term.

First, the potential for acquisitions driving the sector seems attractive. The difference in corporate tax rates in the U.S. and elsewhere creates opportunity for mergers between U.S. and international firms that involve transferring the headquarters to the lower-tax country.

Second, biotechnology fundamentals are more attractive than broader industry fundamentals. The Food & Drug Administration’s willingness to approve expensive treatments provides additional hopes of profitability to a wider range of biotechnology firms.

While valuations in the biotech segment are high, fundamentals may allow more of those firms to do well. Letting the trend keep running may be the smart decision, but be wary.

Price momentum and mergers can sustain stocks for only so long.


At the time of writing, CLS Investments held a position in IYH, XLV and VHT. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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