Investing in Pharmaceuticals Via ETF

I have been thinking about shifting some funds into pharmaceutical stocks for several reasons. Here’s my analysis to date:

• non-cyclical growth stocks like the pharmaceuticals can grow earnings and dividends through boom and bust – they are the kind of stocks one can put away for a decade and forget about
• because of concerns over legal issues, patent expirations, and product-pipelines in recent years, valuations are low -- BCA Research says that analyst earnings expectations for U.S. pharmaceuticals are at a historic low relative to S&P 500 earnings projections
• yet, a recent industry report by Standard & Poor says much of the shortfall from patent expirations will be offset by new drugs
• if economic growth slows down (of which there are signs), defensive stocks will gain favor over riskier plays in the market
• during the lackluster environment of recent years, U.S. pharma has responded by cutting costs -- while maintaining R&D and balance sheet strength (which also supports stock buybacks)
• pharmaceuticals in Europe and elsewhere have enjoyed good share gains in recent years, so U.S. peers have some catching up to do
• pharma is one of the strongest industries around: it has one of the highest returns on investment capital (35%) and best company survivorship rates.
• demographics (aging of baby boomers and rising middle class in emerging countries) are supportive

For North American investors, there appear to be four exchange traded funds (ETFs) and one HOLDRs covering pharmaceutical stocks:

Pharmaceutical HOLDRs (PPH)
iShares DJ US Pharmaceuticals (IHE)
PowerShares Dynamic Pharmaceuticals (PJP)
SPDR Pharmaceuticals (XPH)
iShares S&P Global Health Care (IXJ)

The HOLDRs does not track an index; it is an unadjusted basket of stocks that was selected by the fund’s founders to represent the U.S. pharmaceutical sector. The iShares Global Health Care fund includes some non-pharma health care companies but nevertheless retains a 75% exposure (and adds geographical diversification).

The Pharmaceutical HOLDRs stands out from the others in many ways:

• annual management cost much lower
• dividend yield much higher
• average daily trading volume way ahead
• option trading noticeably more liquid too.

Perhaps one negative of the HOLDRs for small investors is the requirement to buy in board lots only. With the current price at $75.50, that means there is a minimum purchase requirement of $7,500.

Another drawback might be the concentration of holdings: with no rebalancing or replacement of defunct companies over the six years since inception, the top ten stocks now claim 91% of the weights – with Johnson & Johnson and Pfizer at 21% each (other ETFs range around the 50% mark). This could make the HOLDRS more vulnerable to extreme moves by one or two stocks; volatility might be more of an issue.

Valuations for the North American pharmaceutical sector have ebbed because of concerns over lawsuits, patent expirations, and product-pipelines. Indeed, BCA Research notes that analyst earnings expectations are currently at a historic low relative to S&P 500 earnings projections. There is also a lot of catching up to do with the gains in the share prices of non-U.S. pharmaceuticals.

U.S. pharma has responded to the lackluster environment of recent years by cutting costs (while maintaining R&D and balance sheet strength). And a report by Standard & Poor says much of the shortfall from patent expirations will be offset by new drugs. Lastly, non-cyclical growth stocks like the pharma group should gain favor as global growth wanes.

There are four exchange traded funds (ETFs) and one HOLDR covering the sector. From the table below, it is apparent the Pharmaceutical HOLDR stands out in terms of cost, liquidity, and yield.

Perhaps one negative of the HOLDR is the requirement to buy in board lots. Another might be concentration in holdings: with no rebalancing or replacement of companies over the six years since inception, the top ten stocks now claim 91% of the weights – with Johnson & Johnson and Pfizer at 21% each.