Healthcare Sector Report

Sector Report by Christine Chan, 27 November 2020

S&P Health Care Select Sector (XLV

EXECUTIVE SUMMARY

Having a huge market capitalisation of nearly US$7 trillion and a market weight of over 13%, the healthcare sector is comprised of a number of industries, such as pharmaceuticals and biotechnology. It has historically seen exceptional performance and has consistently outperformed other sectors of the S&P 500. With the COVID-19 pandemic driving up demand for healthcare products and services, as well as many other factors pointing to long-term growth, including an increasing prevalence of chronic diseases, this suggests that the healthcare sector is an attractive one to invest in. This is further confirmed by a trailing P/E ratio (in the past 12 months) of 25.3 and a projected P/E ratio of 16.74 for the sector, as in the near future, the decreasing P/E ratios will likely arise from higher earnings per share of the sector overall.

Within the healthcare sector, I would recommend investing in the iShares S&P 500 Health Care Sector UCITS ETF (LSE:IHCU) due to its outstanding growth prospects and historical reliability in delivering profits to investors. At a large size with nearly US$1.5 billion in assets under management, it comprehensively covers the largest healthcare companies in a number of industries, including pharmaceuticals and healthcare insurance, making it an excellent low-risk long-term buy investment for the UCL Investment Fund.

OVERVIEW OF SECTOR

The healthcare sector is one of the largest sectors in developed economies, such as those in the UK and the US, where it accounts for nearly 20% of national GDP (gross domestic product). In a country like the UK, there is a high demand for the healthcare sector, due to its strong foundation for healthcare research and development (especially within higher education and industry) and also an ageing population.

Within the healthcare sector, there are a number of industries, including but not limited to pharmaceuticals, biotechnology, medical equipment, healthcare facilities, and managed healthcare. These industries discover new drugs, manufacture pharmaceuticals and medical equipment, provide medical services, or offer medical insurance.

The essential nature and high demand for healthcare products and services means that this sector is considered to be very price inelastic, as consumer behaviour generally remains the same despite changes in prices. There are many barriers of entry, namely government regulation, specialised expertise, high costs of research and development, as well as the need for professional licensing.

Since Q1’2020, the healthcare sector has been constantly thrust into the global spotlight due to the COVID-19 pandemic, where the ‘hot’ topics frequently include discussions of a potential COVID-19 vaccine or drug treatment. Most recently in early November, there has been quite a buzz surrounding Pfizer and BioNTech’s announcement of their vaccine candidate, which was found to be over 90% effective in preventing COVID-19 infections after analysis of their Phase III clinical trials with over 43000 participants. This had a huge impact and led to large fluctuations in the stock market, as investors became hopeful that an end to the pandemic would mean that normal commercial activity could be restored; this continues to cement the importance of the healthcare sector’s role in the global stock market. Shortly after, Moderna and AstraZeneca respectively reported a 95% and 70% efficacy for their vaccine candidates.

At the beginning of the pandemic in March 2020, share prices in the healthcare sector suffered, not unlike other sectors. However, it has also managed to recover from the steep drop much more quickly, with exchange-traded funds (ETFs) returning to their late-February values by mid-April. This is in stark contrast to the S&P 500 index, where recovery has been a lot slower and it only managed to recover to its pre-pandemic peak value by late-August.

FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS

As COVID-19 infection and death numbers continue to rise worldwide, the demand for healthcare systems follow a similar upward trajectory, which is good news for the healthcare sector. Even so, historically, the healthcare sector has performed extremely well, with the S&P 500 Healthcare Sector index consistently outperforming the S&P 500 for the past decade, often by a large margin. The top 5 players within the healthcare sector by market weight include the major pharmaceutical companies Johnson & Johnson, Pfizer, Merck, and Abbott Laboratories, as well as the healthcare products and insurance company UnitedHealth Group.

There are a number of trends to consider in the near future that contribute to a positive outlook for the healthcare sector. In developed economies or Western geographies, the sector will be mainly driven by ageing populations and technological advancement and integration. These factors mean that the demand for healthcare products and services will continue to grow, in both quantity and price, particularly with the development of personalised medicines. Another vital positive trend would be the increasing prevalence of chronic diseases, such as cardiovascular diseases, diabetes, cancer, psychiatric diseases, and obesity. Patients are required to take many long-term medicines or use healthcare services (usually for the rest of their lives) to preserve or improve their health and quality of life, thereby generating a consistent income stream for the healthcare sector for the foreseeable future. The global and comprehensive nature of illness and disease means that the healthcare sector will always remain an essential one, and as long as the economic and regulatory environment allows healthcare companies to profit sufficiently, the sector will remain as an incredibly attractive investment option.

However, it is also important to bear in mind the negative trends, which may include government regulation on costs, such as price controls on drugs and healthcare services. This may lead to the healthcare sector being less competitive if the financial incentive of developing new drugs and products decreases. This is more so the case in European countries, where healthcare is dominated by single-payer systems allowing for universal healthcare coverage. Despite this, it is increasingly important to consider uninsured American citizens as a negative trend, as research has shown that 10.9% of Americans did not have any health insurance, a value that has been growing every year since 2017, and will continue to grow due to the economic downturn caused by the COVID-19 pandemic. Uninsured individuals are therefore less likely to access healthcare products and services, meaning companies can only profit from a shrinking proportion of the population.

Overall, the strength of positive factors outweigh that of the negative factors for the sector, but it remains critical to thoroughly research the finer details, both financial and non-financial, for each stock before making an investment.

 FUNDAMENTAL QUANTITATIVE ANALYSIS

There are different metrics to conduct quantitative analysis on the healthcare sector. According to Fidelity Investments, to state a couple of figures, the market capitalisation of the healthcare sector is $6.93 trillion, with the market weight being 13.82%.

The price-to-earnings ratio (P/E ratio) is a ratio that measures a company’s current share price relative to its earnings per share (EPS). A high P/E ratio could mean that a company’s stock is overvalued, or that investors are expecting high future growth rates. Conversely, a low P/E ratio shows that the current share price is low relative to its earnings. Investors generally prefer buying shares in companies that have a lower P/E ratio, however, it is important to determine the reasons behind a company’s P/E ratio and understand why it may be higher or lower than an industry average.

The healthcare sector P/E ratio can be calculated from taking an average of the P/E ratios of the companies that fall within the healthcare sector, or a sub-sector/industry, such as biotechnology. Biotechnology companies tend to have very high P/E ratios as they tend to be smaller and newer companies that are yet to turn a profit, but may have very high potential for future growth. This is because drug discovery and manufacturing tends to be a very lengthy process and at least several years to decades are required for a potential drug to reach the mass market before they can make a profit, not to mention the expensive years taken for research and development (R&D), clinical trials, and regulatory approval.

Different sources have estimated the P/E ratio for the healthcare sector at different values. The S&P 500 Healthcare Index has a trailing P/E ratio of 25.3 and a projected P/E ratio of 16.74, whereas Fidelity Investments and other sources estimate the healthcare sector’s P/E ratio to be 40-70. This could be because the S&P 500 Healthcare Index only tracks the healthcare companies within the S&P 500, which are the top 500 publicly-listed companies in the US with the largest market capitalisations, meaning their P/E ratios could tend to be lower due to higher profit levels (and therefore higher EPS) and numbers of investors.

Other useful financial metrics to evaluate a stock or a sector may include the following:

MetricDefinitionValue for S&P 500 Healthcare
Price/Sales Ratio (P/S Ratio)The number of outstanding shares of a company multiplied by its share price (market capitalisation), divided by the company’s total sales (revenue) in the past 12 months. The lower the P/S ratio, the more attractive the investment.1.72
Price/Book Ratio (P/B Ratio)This is used to compare a company’s market capitalisation against its book value (tangible net asset value according to the balance sheet, i.e. total assets minus intangible assets) – share price divided by book value per share.4.25
Price/Cash Flow Ratio (P/CF Ratio)The ratio between a company’s share price and its operating cash flow per share. It measures the amount of cash a company generates relative to its share price, and is useful for stocks with positive cash flow but are yet to be profitable due to non-cash charges.17.65
Debt/Equity Ratio (D/E Ratio)The ratio between a company’s debt value (i.e. liabilities) and its shareholder equity value. This ratio allows us to determine how financially leveraged a company is.140.96
Dividend YieldThe percentage that a company pays out in dividends each year relative to its stock price – the stock’s annual dividend divided by the stock price.1.68%

MACRO OUTLOOK

Since the presence of the healthcare sector is heavily skewed towards the United States, it is most important to consider the economy there. For Q1 and Q2’2020, the US economy has been suffering due to the COVID-19 pandemic and was officially in a recession, as their GDP declined in two consecutive quarters. US Q2’2020 GDP dropped by 31.4%, which is the sharpest contraction since the second world war. Things looked a lot better for Q3’2020, as the GDP increased 7.4% compared to the previous quarter, and on an annualised rate, rose 33.1%.

This is not to say that the economy will recover in the near future, as the American holidays of Thanksgiving and Christmas combined with the ‘laissez-faire’ attitude of Americans will likely mean that COVID-19 case numbers will soar once again. The outcomes with regards to the economy of early 2021 will rely on how the new US president Joe Biden and his government handles the national budget and policies surrounding COVID-19 restrictions.

However, as indicated back in early November, the election of Biden was seen as a positive for the stock market, as stocks saw the largest post-election rally in over a century. These market gains were also partly attributed to a politically-divided Congress, as this may prevent Biden’s Democrat administration from tightening regulation on corporates, including those within healthcare and big pharma. Overall, the political situation and COVID-19 pandemic could have beneficial effects for the healthcare sector.

Currently, it will be interesting to see how governmental regulation with regards to a COVID-19 vaccine comes into play, as this will be the deciding factor of whether a vaccine candidate is able to make it onto market. This can have a huge effect on the wider economy, as a successful vaccine available to the general public would suggest that pre-pandemic economic activity could be restored sooner, leading to a more positive macroeconomic outlook. Again, due to this continuous healthcare crisis caused by COVID-19, the reliance on the healthcare sector for its products and services (and in the future, potential COVID-19 vaccines and treatments) will more than likely generate strong revenues for healthcare companies.

PRICE TARGETS

Currently, and for the foreseeable future, the healthcare sector is a very attractive sector to invest in. Two sector exchange-traded funds (ETFs) that I would recommend looking further into include:

Invesco Health Care S&P US Select Sector UCITS ETF (LSE:XLVP)

Entry PointTake ProfitTime Horizon
37500 p41250 pLong-term (e.g. 1 year+)

Based on a minimum historical annual growth rate of 10% for the past 5 years, and a previous peak of 39291p on Monday 9th November, I have set an ambitious price target of 41250p, which represents a 10% growth from today’s entry point of 37500p. I believe this will be achievable due to the continued significance of the healthcare sector when it comes to tackling the COVID-19 pandemic, may it be vaccine development, treatment, medical care services, medical equipment, or health insurance.

Because this ETF consists of the largest S&P500 companies belonging to many different industries within the healthcare sector, it is more diversified than some other industry-specific ETFs (for example, only biotechnology). This makes it a more desirable choice for a student-run investment fund as it is seen as relatively low-risk.

It is important to note that this ETF can be traded in two currencies, namely USD (XLVS) and GBP (XLVP). Since we are based in the UK and will be trading with GBP, but the underlying securities (or constituents) of the ETF are mostly (>95%) American healthcare companies that trade using USD on American stock exchanges, we must bear in mind the possibility of currency risk exposure, more specifically to the USD. Regardless of whether we choose XLVP or XLVS, we will be exposed to currency risk, particularly in the short term. For the purposes of the UCL Investment Fund, I have chosen the GBP-listed ETF, XLVP, as our initial capital is in GBP.

Size (AUM)Number of Holdings
$347.18 million62
Top 10 Exposures
SecurityWeight
Johnson & Johnson9.78%
UnitedHealth Group7.19%
Pfizer5.48%
Merck5.09%
Abbott Laboratories4.47%
AbbVie4.31%
Thermo Fisher Scientific4.07%
Amgen3.80%
Eli Lilly3.46%
Bristol-Myers Squibb3.40%

iShares S&P 500 Health Care Sector UCITS ETF (LSE:IHCU)

Entry PointTake ProfitTime Horizon
610 p670 pLong-term (e.g. 1 year+)

Based on a minimum historical annual growth rate of 10% for the past 5 years, and a previous peak of 638.75p on Monday 9th November, I have set an ambitious price target of 670p, which represents a 10% growth from today’s entry point of 610p.

The IHCU ETF has a very similar financial profile to the XLVP ETF, as they both have a similar number of holdings each at similar weighting. Therefore, my recommendations and rationale for investing in this ETF would be the same. However, since the AUM (assets under management) of this ETF is over 4 times larger than the XLVP ETF, I am more inclined to invest in this one, as a larger ETF tends to have higher trading volumes, therefore giving a lower and more attractive bid-offer spread. Also, the larger the AUM, the more desirable it is generally perceived to be, as it means more investors are willing to invest in it and expense ratios tend to be lower as well.

Size (AUM)Number of Holdings
$1496.41 million64
Top 10 Exposures
SecurityWeight
Johnson & Johnson9.85%
UnitedHealth Group7.44%
Merck5.19%
Pfizer4.82%
AbbVie4.60%
Abbott Laboratories4.30%
Thermo Fisher Scientific3.80%
Amgen3.69%
Eli Lilly3.68%
Bristol-Myers Squibb3.53%

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