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Summary

  • The Health Care sector is a high-risk sector, but has the potential for significant rewards.
  • An ETF pair trade can set investors up to capitalize on volatility in either direction in the sector.
  • Long XLV and short PTH has investors buying the highest-quality companies in the sector and shorting the riskiest ones.

The Healthcare sector comprises many different types of companies. From biotechs to pharmaceuticals to equipment manufacturers, it can be difficult to know in which portion of the sector an investor should place their money.

While industries within the Healthcare sector can be completely different, they each face volatility that investors can capitalize on. For instance, Intuitive Surgical, Inc. (NASDAQ:ISRG), a company specializing in medical robotics, saw its share price soar 23% over a four-day stretch in April 2014, only to fall 33% from the high by the end of the same month.

While ETFs do not usually experience price fluctuations this rapidly, their holdings can, and these fluctuations will affect the overall value of the ETF. As I've said before, a fund's performance is only as good as its holdings. iShares U.S. Medical Devices ETF (NYSEARCA:IHI), which allocates over 3% of its assets to ISRG, serves as a great example. Coinciding with ISRG's move, the value of IHI rose nearly 4% to begin April, and ended the month by declining 7% from the high.

Knowing the quality of a fund's holdings is key when determining investment opportunities. The movement of a few bad stocks held by IHI dramatically impacted investors in the fund.

The Healthcare sector overall is particularly dangerous for investors, as it ranks 7th out of 10 in my Sector Rankings for ETFs and Mutual Funds report. It receives my Dangerous rating, and as expected, investors must tread carefully. Bottom-up analysis of ETFs based on their holdings drives my predictive ratings on ETFs. These ratings allow investors to know more about the relative merits of ETFs.

We cover 22 Healthcare ETFs, which hold anywhere from 20 to 309 different stocks. This difference in holdings means that each fund's performance can be drastically different from the next.

A good way to navigate a Dangerous-rated sector such as Healthcare is through the use of an ETF pair trade (i.e. long/short strategy). The following ETF pair trade can be used to capitalize upon the volatility of the Healthcare sector for both upside or downside.

Long: Health Care Select Sector SPDR ETF (NYSEARCA:XLV)

Short: PowerShares DWA Healthcare Momentum Portfolio ETF (NYSEARCA:PTH)

XLV ranks second out of the 99 Heathcare ETFs and mutual funds I cover, and earns my Very Attractive rating. This ETF allocates 30% of its value to Attractive-or-better rated stocks, and also has very low Total Annual Costs of 0.20%. XLV holds high-quality stocks, while not charging investors too much to do so.

On the other hand, PTH receives my Dangerous rating, and is my second-worst rated Healthcare ETF. PTH allocates over 50% of its value to Dangerous-or-worse rated stocks, while allocating 0% to Attractive-or-better stocks. Despite this poor allocation, PTH charges investors 0.66% in Total Annual Costs. Why should someone want to pay a manager three times more to invest his or her money in worse holdings?

This pair trade gives investors exposure to one of the best Healthcare ETFs, while minimizing risk of loss by shorting one of the worst Healthcare ETFs.

Johnson & Johnson (NYSE:JNJ) is one of my favorite stocks in XLV, and earns my Attractive rating. As I wrote back in April, JNJ is a consistently growing company that remains undervalued. Over the past decade, JNJ has grown after-tax profits (NOPAT) by 8% compounded annually. The company currently earns a top-quintile return on invested capital (ROIC) of 15%. The best part about JNJ is its valuation: If JNJ is able to grow NOPAT by only 7% compounded annually for the next 15 years, the stock is worth ~$156/share today, a 51% increase from its current price of $103/share. With consistent history of profit growth, a diversified product line, and multiple expansion markets throughout the world, JNJ is in a great position to exceed even these expectations. While JNJ's price has increased since April, it still remains a strong value play with very little downside that will greatly benefit long-term investors.

The Spectranetics Corp. (NASDAQ:SPNC) is one of my least favorite stocks in PTH, and earns my Dangerous rating. Since 2010, SPNC's NOPAT has declined by 21% compounded annually. The company has a bottom-quintile ROIC of 1%. SPNC has also generated negative economic earnings in every one of the last 15 years. The stock fell over 8% earlier in the year, but despite this decline, still remains overvalued. To justify its current valuation of ~$23/share, ALKS would have to grow NOPAT by 20% compounded annually for the next 46 years. This expectation is highly unlikely for any company, especially one that has seen its profit decline and one that operates in a highly specialized industry. Investors should avoid SPNC and PTH.

Going long XLV allows investors to take advantage of the upside in the Healthcare sector and see consistent long-term growth from companies like JNJ. Being short PTH allows investors to hedge against companies like SPNC and other high-momentum stocks held by PTH. As I've said recently, momentum stocks will plunge from their highs at a moment's notice, and it's best for investors to buy quality companies whose prices will appreciate long term. This pair trade allows you to do just that: short the momentum stocks, and go long on those that will benefit over the long haul.

Kyle Guske II contributed to this report.

Disclosure: David Trainer owns JNJ. David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.

Source: An ETF Pair Trade For The Health Care Sector: XLV Vs. PTH