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Investment trust portfolios: Looking for healthier returns

John Baron explains why the portfolios’ healthcare exposure is being increased
Investment trust portfolios: Looking for healthier returns

With the healthcare sector having come to the world’s rescue at the behest of governments during the pandemic, one would be forgiven for thinking that it should now be a stock market darling – the industry’s response has certainly improved its image. Yet, despite having outperformed in recent years, the MSCI World Healthcare index is at another low relative to the MSCI All Country World index. Various factors account for this including a rotation in market leadership and regulatory concerns. However, while stock and subsector selection will as usual remain of key importance, various catalysts offer the prospect of a re-rating.

Sentiment and fundamentals

The Oxford AstraZeneca vaccine helped more people than any other, is the most widely accepted with around 120 governments recognising it, is approved by the World Health Organisation, and was priced at cost. And yet, over the last year, when the FTSE All-Share has risen over 20 per cent, the company’s share price has lagged far behind. Such performance reflects the malaise generally regarding the sector’s stock market plight – the index is trading at around a 15 per cent discount to broader equity indices.

Part of the problem is the threat of more restrictive regulation. President Biden’s team is questioning why the rest of the world on average pays almost half what the US does for its drugs. There are various nuances to the situation. However, the Democrat’s narrow majority in Congress, together with close examination of the administration’s proposed policies, suggest any legislation will be much diluted by the time it is enacted – assuming it gets that far. Narrow majorities tend not to result in controversial legislation. The political headwind will gradually recede.

In assessing sector prospects, it is important to recognise the long-term investment case remains intact. This includes ageing populations, the significant urbanisation and change in diet in the developing countries, and recognition by governments that more needs to be spent on health. The pandemic has highlighted the need for governments to provide efficient healthcare systems, together with the associated infrastructure – this is particularly true in some developing countries, where widespread shortages and rioting are causing a rethink by those in charge. The tailwind is still in place.

It is the shorter-term considerations which, in aggregate, are likely to spur a sector re-rating. The recent modest rotation in stock market leadership followed news of the vaccine efficacy rates last year which encouraged investors to believe the pandemic would end sooner than expected. Many stocks that had otherwise been laggards were suddenly in demand, and therefore outperformed the healthcare sector and market. In reality, once the euphoria subsides, market leadership is likely to be more broadly based. Such circumstances should be more favourable to those sectors offering a superior earnings outlook.

A further potential catalyst for a re-rating is likely to be a growing realisation of the unprecedented level and speed of innovation across the industry, which some respected investors are describing as an innovation revolution. As its sheer scale and reach becomes more evident, the market will come to question why a sector with better prospects than most is on a discount to the market. The sector spans many subsectors and tends to be defensive as it is resilient to economic downturns, but it is also home to many emerging and fast-growing subsectors including robotic surgery, diagnostics and radiotherapy.

Gene sequencing is enabling treatments to be developed more quickly. Advances in genomics and biotechnology mean that the number of disease states and treatable targets is at an all-time high, and this is being particularly helped by novel platform technologies which have enabled even more therapies to target diseases previously thought to be untreatable.

New diagnostic tools are helping to identify and treat diseases more easily and cheaply. AI and Big Data can now more than compete with the average medical profession when it comes to accurately diagnosing numerous diseases. There are exciting developments in cancer treatments which harness the body’s natural immune system to attack tumours – and, as it is far less intrusive and has fewer side-effects than radiation or chemotherapy, treatment costs are much reduced particularly as better technology is making for earlier diagnosis.

Opportunities abound across a range of these subsectors. But stock selection and maintaining the right balance between subsectors will be crucial. For example, the portfolios had profited by being early supporters of biotechnology. Yet, while the outlook for this subsector remains encouraging, exposure has been reduced in favour of more ‘general’ specialist trusts which enjoy greater latitude in capitalising on the ever-increasing number of subsectors which offer equally exciting prospects, if not more.

Likewise, questions are being asked of the less innovative and larger pharmaceutical companies. No company has a monopoly on gene sequencing, and so more competition for drugs is likely to reduce profit margins. In such cases, strong cash flow from existing operations may support an attractive dividend policy, but this can only delay the inevitable unless a healthy drug pipeline is developed – or bought. Indeed, continued M&A activity may further help to act as a catalyst for a re-rating.

There is a further short-term consideration. The wider market’s belief in a strong economic recovery is being reflected in those healthcare subsectors most impacted by the pandemic – these include hospitals, dental care, care providers and therapies. The prospect of a strong rebound continues to look encouraging, and may tempt investors to look more favourably upon the sector generally.

Favoured companies

Regular readers will know the two real portfolios covered in this column since 2009 are two of nine portfolios managed in real time on the website www.johnbaronportfolios.co.uk (where they are called Summer and Autumn), and these achieve a range of risk-adjusted strategies and income levels with yields of up to 5.1 per cent. When seeking exposure to a particular theme, in addition to the relevant specialist investment trusts, we also carefully monitor the ‘see-through’ exposure of the more ‘generalist’ trusts held by the various portfolios. This is an important discipline as shifting sands can catch the unwary.

Our two favoured specialist holdings are BB Healthcare Trust (BBH) and Worldwide Healthcare Trust (WWH). The larger holding is BBH, which invests in healthcare equities across the subsector spectrum – from early-stage companies with pre-clinical assets to fully integrated biopharmaceutical companies. It adopts a high conviction approach which, since the IPO in 2016, has delivered a net asset value (NAV) of 124.5 per cent compared with 80.8 per cent for the MSCI World Healthcare index.

And momentum is not slacking – over the year to June 2021, the NAV has risen 26.1 per cent compared with 10.9 per cent for the index. The company offers an annual redemption option while a dividend representing 3.5 per cent of NAV ensures a reasonable level of income given the growth bias. As an aside, the company’s monthly factsheet is usually worth a read.

WWH again covers the entire subsector spectrum of companies. OrbiMed, the portfolio manager, is the largest dedicated healthcare investment firm in the world. It has around $16bn under management, extensive expertise and contacts, and monitors around a thousand companies over three continents. Such scale and expertise has facilitated an excellent track record – recent figures suggesting the company has produced an annualised NAV total return of over 16 per cent since 1995 (the year WWH came to market) compared with 11 per cent for the index.

Looking forward, the managers believe demographics should ensure demand for healthcare will continue to rise, but suggest: "The key healthcare investment theme that the company has espoused has been centred on innovation. Innovation across new technologies, novel platforms, and therapeutic categories that have fostered increased drug discovery, development, and approval of new ground-breaking medicines around the globe with many of them now delivering cures". WWH can invest up to 10 per cent in unquoted securities.

Exposure to the sector is also evident on a ‘see-through’ basis in some of the more generalist trusts held by the website’s portfolios. For example, when it comes to trusts investing in larger companies globally, which are typically held in the smaller LISA and Spring portfolios, Monks Investment Trust (MNKS) has a 10 per cent exposure. Smaller company trust holdings tend to have larger healthcare weightings because of the opportunities on offer – for example, Edinburgh Worldwide (EWI) and Montanaro European Smaller Companies (MTE) have near-40 per cent and 20 per cent exposures, respectively.

Other specialist trusts should not be forgotten. The private equity holdings Standard Life Private Equity (SLPE) and HarbourVest Global Private Equity (HVPE) have exposure of around 17 per cent and 15 per cent. Meanwhile, exposure is not always equity-related. For example, BioPharma Credit Investments (BPCR) specialises in lending to the life sciences industry and produces a high income. Indeed, both BPCR and SLPE help the Winter and Dividend portfolios produce a high and sustainable income, which presently equates to a yield of 4.1 per cent and 5.1 per cent, respectively.

Portfolio performance
 GrowthIncome
1 Jan 2009 - 31 July 2021 
Portfolio (per cent)436.2292.9
Benchmark (per cent)*211.8157.4
Year to 31 July 2021
Portfolio (per cent)8.76.7
Benchmark (per cent)*   9.76.9
Yield (per cent)2.53.2
*The MSCI PIMFA Growth and Income benchmarks are cited (total return)