A Healthy Discount on Big Drug Stocks

11/22/2010 11:17 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, Morningstar’s director of North American ETF research, and analyst Robert Goldsborough prescribe a top-heavy health-care fund for the portfolio.

Investors seeking a broad-based, health-care-oriented exchange-traded fund trading at a considerable discount to its holdings’ fair value should consider iShares Dow Jones US Healthcare (NYSEArca: IYH). With health-care reform now signed into law and unlikely to be repealed, we believe health-care stocks no longer are trading on fears and uncertainty around legislation.

IYH looks particularly attractive right now, [and] we believe [it] can be a great core holding for investors, particularly given the health-care industry’s defensiveness and the attractive demographic aspects that will benefit the space.

Historically, the health-care sector has been viewed as defensive and noncyclical, with growth driven by changing demographic trends as America ages. The defensive nature stems from relatively stable demand, because people get sick or injured and need treatment regardless of economic conditions. The secular-growth story is incredibly appealing, given that 78 million US baby boomers presumably will require increased levels of medical care.

Morningstar’s equity analysts believe [health-care] reform will weigh on the industry’s earnings by as much as 5% a year for the first few years, followed by earnings gains of about 2% a year afterward. By 2014, volumes created by increases in the number of patients insured will begin mitigating cost pressures. This outcome long ago was priced into big pharma’s shares, and we think the overhang on large pharma firms has mostly dissipated.

Many biotech companies are experiencing a lot of the same early effects from reform that Big Pharma is, including an industry tax and lower net prices for their drugs because of higher rebates for Medicaid patients. In addition, managed-care organizations and hospital operators both have been net losers in health-care reform, although the impact [on] MCOs appears much smaller than many had feared. And more broadly, hospitals will continue to see increased admissions growth as baby boomers age, because the 65-plus age segment historically has made up about one third of all hospital admissions.

Meanwhile, merger activity continues in pharma/biotech, as large firms seek to spruce up their drying pipelines by acquiring biotech firms with promising drugs and innovative research and development programs.

IYH holds 127 companies and tracks the health-care subset of the Dow Jones US Total Market Index, which is cap-weighted and, as a result, means heavy concentration among top holdings. Drug makers and large biotech firms dominate, accounting for almost 64% of assets. This ETF has a very high-quality portfolio, with more than 90% of the assets in IYH having sustainable competitive advantages, according to Morningstar’s equity analysts.

Although IYH does not own companies domiciled overseas, many of the firms in IYH have sales all over the globe. As such, investors still can enjoy plenty of foreign exposure through IYH. IYH’s top five holdings are Johnson & Johnson (NYSE: JNJ) (almost 13% of assets), Pfizer (NYSE: PFE) (10%), Merck (NYSE: MRK) (8%), Abbott Laboratories (NYSE: ABT) (6%), and Amgen (Nasdaq: AMGN) (4%). The top 10 holdings comprise more than 54% of IYH’s assets, making this fund very top-heavy.

The IYH charges a 0.48% expense ratio, which is reasonable, particularly by mutual fund standards.

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