For more than two years now, Invesco Perpetual's has been positive on the healthcare sector, gradually building his position in holdings such GlaxoSmithKline and AstraZeneca, advocating the undervaluation opportunities and strong fundamentals underpinning the sector. "There have only been a few occasions in my career where I have seen opportunities like the ones that I see now in the pharmaceutical sector," he said in an earlier interview this year. With pharmaceuticals enjoying a dramatic rally in the last few months, it seems that the UK's most famed fund manager's words might yet again turn out to be prophetic. But do specialist healthcare funds warrant a place in your broader investment portfolio?
Mounting concerns over volatility in the commodity market and debt issues in the Eurozone have seen a flight from risk, with investors rushing en mass into more defensive shares. This has pushed up pharmaceutical shares and propelled forward funds focused on the sector. In May, the MSCI World Index fell close to 4 per cent, in contrast to the 4.5 per cent rise in the MSCI World Healthcare Index. Meanwhile, the NYSE Arca Pharmaceutical Index, which is composed of the 14 largest global pharmaceutical companies, gained around 10 per cent over April and May.
Samuel Isaly, manager of the Worldwide Healthcare Trust, expects the sector's strong performance to continue throughout 2011, thanks to attractive valuations. "Low valuation measures should contribute to sound performance over the balance of the year, even after the 10 per cent or so gains year-to-date," he says.
Valuations across the healthcare sector have been on a downward trajectory for the past decade, with large cap pharma price-to-earnings (P/E) ratios falling 60 per cent since 2001. For biotech, the slump in valuations is even more marked - the tech bubble saw P/E ratios for the NYSE Arca Biotechnology Index reach over 120 times in 2000, falling to 100 times by 2001, then slipping to less than 20 times by early 2011.
"The case is one of valuation and sentiment," says Stephen Peters, investment company specialist expert at Charles Stanley. "The sector is unloved as few see any opportunities for big pharma to make money from big drugs, and many view the sector as ex growth. But no credit is given to any new discoveries, nor cost savings, or emerging market sales. It is a combination of all these that present opportunities."
BEYOND VALUATIONS
While uncertainty in the global economy together with historically low valuations are important short-term factors driving investors to the relative safety of healthcare shares, the long-term fundamentals underpinning the sector are even more compelling. These can be summarised as follows:
■ Emerging market growth
In the emerging world, there is a huge unmet demand for drugs that consumers cannot get access to from domestic manufacturers. Natalie Flury, co-manager of the recently launched Julius Baer Health Opportunities Fund, comments: "The global healthcare sector today already accounts for 10 per cent to 15 per cent of global GDP. Several powerful global drivers suggest that the sector should become one of the major growth markets in the decades to come, creating a compelling proposition for investors. The chief driver is emerging markets, which exhibit strong population growth and increasing wealth, which means more people can afford healthcare."
■ Ageing population
Rising life expectancy and falling fertility means the number of people over the age of 50 is increasing. This will have a huge impact on society, affecting consumer habits and demand, as well as many companies' activities and financial performances. An ageing population needs (and demands) more healthcare, which will inevitably lead to increased spending in the sector. Lombard Odier runs an unusual fund called 'Golden Age', which looks at investment opportunities linked to an ageing population around the globe. A Luxembourgh SICAV, the fund has around 67 holdings and requires a minimum investment of €3,000 (£2,600), available in euros and US dollars.
■ Innovation
Innovation in the healthcare sector is being driven by the need for companies to provide ever more targeted therapies for patients, while reducing overall costs.
■ US Healthcare reform
It is well documented that healthcare reform in the US will lead to more universal health insurance coverage and an expansion of healthcare infrastructure. Mr Isaly believes rich rewards are in store for investors who look beyond the well known names to niche areas of the healthcare universe. US health insurers have seen an even stronger rally than large cap pharma, while healthcare services and medical devices stocks are enjoying annual growth of 10 per cent or more.
BIOTECH VS PHARMA
The healthcare sector is diverse and ranges from large established pharmaceuticals companies at one end to small biotechnology firms at the other. There are funds focused on both these ends of the healthcare universe.
A biotechnology fund invests primarily in biotech companies that use biological processes in the development or manufacture of a product, while a healthcare or pharmaceutical fund will invest in companies that make a more diverse range of products than biotech companies.
Pharmaceutical companies tend to be large organisations with massive research and marketing capacity and multiple products ranging from consumer goods to prescription medication. These companies tend to be less sensitive to economic turbulence (people don't just stop taking their medication just because the economy is in a downturn) and are therefore viewed as strong defensive play for those worried about the speed of any economic recovery.
Meanwhile, biotechnology stocks are small and niche with the potential to benefit significantly from demographic changes, most notably the ageing population. "The success or failure of these stocks is usually dictated by the work of their research and development departments and, as a result, companies can potentially do spectacularly well or spectacularly badly," says Patrick Connolly of AWD Chase de Vere.
THE DETRACTORS
Not everyone is convinced that pharma and healthcare funds is a sound bet. Alan Dick of FortyTwo Wealth Management is one. "Why would you want to restrict your investment universe to just one or two sectors? If the answer is 'you wouldn't' and 'you would only buy pharma/biotech as well as other sectors, why bother?," he argues, adding that investors would be much better off buying a diversified fund such as a FTSE All-Share of FTSE World tracker, which will include pharma and biotech anyway.
Comparing the performance of the Franklin Templeton Biotechnology Fund, Axa Framlington Biotech Fund and Axa Framlington Healthcare Fund to the FTSE All-Share and S&P 500 (see graph below), Mr Dick points out that the performance has been "atrocious". "All three funds hold at least 75 per cent in US equities, so it isn't surprising that the returns are pretty close to the S&P 500 in the long run. The AXA Framlington Biotech fund holds 50 per cent of its assets in the shares of just 10 companies. Why take the extra risk when the market does just fine?"
