Image Shown: The Health Care Select Sector SPDR ETF, a holding in both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios, has been on an upward tear over the past several years. Strong macro tailwinds combined with the ability for industries within the health care sector to generate meaningful shareholder value have been key to supporting strong capital appreciation of equities operating in the area of late.
By Callum Turcan
The Health Care Select Sector SPDR ETF (XLV) is a top holding in both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios. We like the exposure and diversification to health care equities that XLV provides. XLV yields ~1.5% as of this writing. State Street Corp (STT) acts as advisor to the fund through State Street Global Advisors, and annual fund operating expenses come out to just 13 basis points (we like the XLV ETF’s low gross expense ratio).
Five of the top ten holdings in the XLV ETF include Johnson & Johnson (JNJ) (another one of our favorite health care plays whose strong free cash flows are underpinned by its pharmaceutical, consumer products, and medical device operations), major health care insurance provider UnitedHealth Group Inc (UNH), pharmaceutical giant Merck & Co Inc (MRK), pharmaceutical giant Pfizer Inc (PFE), and medical device manufacturer Medtronic PLC (MDT). Most of the top ten holdings within the XLV ETF are represented by companies whose primary operations are oriented around pharmaceuticals, accompanied by companies that provide health insurance, manufacture medical devices, and sell consumer health care products.
Powerful Domestic Tailwinds
While these are global companies with operations all over the world, the US market remains one of the health care sector’s best profit drivers. In 2017, the US spent $3.5 trillion on health care expenditures, equal to 18% of US GDP at the time. Major health care programs as a percent of total federal expenditures (excluding interest expenses) grew from 5% in 1970 (shortly after President Lyndon B. Johnson signed into law the bill that created Medicare and Medicaid back in 1965, which created the Part A and Part B programs that cover hospital insurance and medical insurance, respectively) before climbing up to 20% in 2000 and 28% in 2017.
Medicare Part C came more formerly into being in the 1990s which eventually led to a name change (from Medicare+Choice previously) and creation of Medicare Advantage (fee-for-service insurance plans) by the 2000s. Medicare Part D, which covers outpatient prescription drugs, started fully coming into force at the start of 2006 after the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 was passed. Please note these federal programs helped play an essential role in boosting US health care expenditures on both a total and relative basis, as have demographic trends.
As the US gets older, demand for health care services will likely continue to grow substantially. By 2030, the US Census Bureau notes that “all baby boomers will be older than age 65. This will expand the size of the older population so that 1 in every 5 residents will be retirement age.” By 2040, the percent of US federal expenditures going towards health care could reach ~40% according to estimates provided by the Congressional Budget Office (these estimates will likely change over time, but the trend is clear). These are powerful macro tailwinds that support the long-term free cash flow growth trajectories of companies within the XLV ETF.
The passage of the Patient Protection and Affordable Care Act in 2010 has further enhanced this growth trajectory in part by expanding the guidelines for those that can be covered by Medicaid and by offering government subsidies for privately purchased health care plans to those that meet certain requirements. When taking a step back, it’s clear that the US federal government has increasingly become assertive in the health care sector over the past several decades, regardless of shifting political winds/power over time.
International Growth
Looking beyond the US, this third-party research provider sees global health care expenditures rising by 5.4% annually from 2017-2022, reaching over USD$10.0 trillion by the end of the forecast period. Trade wars, rising geopolitical tensions, and other factors will influence this trajectory, but ultimately the world is slowly but surely seeing sizable middle classes emerge all over the globe. Governments are increasingly being called upon to provide better health care services particularly in emerging and developing markets, which encourages greater health care expenditures.
Please note that foreign currency movements are a key risk, as a strong US dollar will depress the overseas performance of companies seeking to capitalize on this upside. Regulatory risks are also material given the inherent complexities of the health care sector, and patents will need to be enforced properly to ensure past R&D investments aren’t simply stolen. That isn’t always a given.
How We View the Space
Down below are segments from our 16-page Stock Reports covering the vast health care sector highlighting how we view each industry in the space. In particular, we like industries where companies that operate in the space are able to generate meaningful shareholder value. That’s seen by the firm(s) in question generating a return on invested capital, excluding goodwill, that consistently exceed their estimated weighted-average cost of capital. More importantly, we like industries where that trend is very likely to continue over the coming years and decades for numerous companies active in the space.
Here’s how we view the big pharmaceutical industry, which we view as an area that allows for material shareholder value creation:
The big pharma industry is primarily composed of makers of branded drugs. Intellectual property protection is vital to the successful commercialization of medicines and offers makers of branded drugs a unique competitive advantage via patents, which can extend for decades. When branded drugs lose market exclusivity, however, makers of generic pharmaceuticals can generate intense price competition, causing drastic revenue losses on unprotected therapies. Long-term success for branded pharma companies depends on a strong and diverse drug pipeline, which can be augmented by M&A activity. We generally like the group and expect continued industry consolidation.
Here’s how we view the pharmaceutical space for generic and other players, which we also view as an attractive area for shareholder value creation:
The pharma (generic/other) industry is composed of makers of both brand and generic drugs. Intellectual property protection remains vital to the successful commercialization of safe/effective medicines, avoidance of pricing pressures, and offers brand firms competitive advantages over the life of such patents. Firms in the biotechnology industry face no certain future. Drug development is complex, difficult, and risky, and failure rates are high. Competition can be fierce when biosimilar products exist, though patents are material competitive advantages. We like the group, but the timing of expiration of patents should be watched closely.
Here’s how we view the health care services industry, which we have a neutral opinion on as it relates to generating shareholder value:
The health care services industry consists of firms that operate traditional hospitals, inpatient rehabilitation hospitals, and other specialized health care facilities. Demand for the group’s services continues to increase as the US population ages and life expectancies rise. Inpatient rehabilitation care is growing at a 2%-3% annual rate, while the expansion of patients with end stage renal disease continues at a slightly faster pace. Improvement in clinical practices and pharmacology and reimbursement policies of third-party payors have also impacted hospital utilization/occupancy. We’re neutral on the group.
Here’s how we view the medical device industry, which we see as a quality place to operate in as it relates to shareholder value creation:
The medical devices industry is heavily regulated and characterized by rapid technological change. Firms have been forced to compete on price due to economically-motivated buyers, consolidation among health care providers, and declining reimbursement rates. Health care reform measures have put additional pressure on procedure rates and market sizes. Still, firms can gain advantages by developing products with differentiated clinical outcomes or by creating patent-protected technology. Since most constituents hold important patents or trade secrets, we tend to like the group.
Lastly, here’s how we view the household products industry, which is particularly relevant to Johnson & Johnson given its exposure across almost the entire health care space. We like the household products industry as it relates to shareholder value creation for these reasons:
Firms in the household products industry sell some of the most recognized branded consumer packaged goods in the world and often hold a significant market share position in a variety of product categories. Though the industry is characterized by stiff competition from retailers’ private-label brands, constituents tend to boast meaningful competitive advantages due to their brand strength/reputation and generate high returns on invested capital. Household products companies remain tied to the vicissitudes of consumer spending, but we tend to like the structure of the group.
Concluding Thoughts
There are a few recurring themes to keep in mind: 1) drug patents and the need for pharmaceutical companies to manage the expiration of their patents to ensure new drugs are coming online to replace the lost revenue streams, 2) trade/industry secrets (particularly for the medical device industry as these factors can determine whether medical devices are used in hospitals or not given the ability to differentiate medical device offerings by efficacy), and 3) powerful macro tailwinds (rising US health care expenditures supported by demographic trends and federal government health care programs, strong international growth in health care expenditures on the back of a growing global middle class).
We continue to like the XLV ETF in both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios and appreciate the ETF’s strong capital appreciation performance of late. Additionally, shares of JNJ are showing some life recently after bottoming out from August to October of this year, and the company is also included in both our Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Johnson & Johnson has beat internal estimates several times in 2019, which members can read more about here.
Medical Devices Industry – EW ISRG MDT VAR WAT ZBH
Health Care Services Industry – DVA EHC HCA UNH UHS
Pharmaceuticals (Big) Industry – ABT ABBV AMGN AZN BMY LLY GSK MRK NVS NVO PFE SNY
Pharmaceuticals (Biotech/Generic) Industry – ALXN AGN BHC BIIB BMRN GILD MYL REGN TEVA VRTX ZTS
Household Products Industry – CHD CLX CL ENR HELE JNJ KMB PG
Related: XLV, STT, MNK, ENDP, CAH, MCK, ABC, WMT, RAD, CVS
Tickerized for our healthcare and biotech ETF coverage.
—–
Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.
Callum Turcan does not own shares in any of the securities mentioned above. The Health Care Select Sector SPDR ETF (XLV) and Johnson & Johnson (JNJ) are both included in Valuentum’s simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.