Morningstar Bullish On Big Pharma, Most Healthcare ETFs Undervalued

Sep.27.11 | About: Health Care (XLV)

By Patricia Oey

With 160 equity analysts covering more than 2,000 stocks, Morningstar is in a unique position to offer fundamental, stock-level research to help investors select exchange-traded funds. This complements our ETF research, which is more focused on explaining how to use ETFs in a diversified portfolio and providing analysis on the structure, costs, and risks of exchange-traded products.

Thursday at our ETF Invest conference, we invited Alex Morozov, director of global health-care research and Damien Conover, associate director of pharmaceuticals analysis from our Morningstar equity-research team to discuss their outlook for the health-care sector.

The health-care team is currently bullish on big pharma, which generally accounts for about 45% of popular health-care ETFs such as Health Care Select Sector SPDR (NYSEARCA:XLV) and Vanguard Health Care ETF (NYSEARCA:VHT). The group also has 5-star ratings for large caps such as Abbott Laboratories (NYSE:ABT), Pfizer (NYSE:PFE), and Novartis (NYSE:NVS). While expiring patents have been a major weight on big pharma's valuations, Conover expects cost cutting and new drug launches to offset some of the losses from expiring patents on high-margin drugs. New drugs are also likelier to be in more-niche areas, which should result in better reimbursements. He also sees emerging markets as an attractive growth area for the group.

As for valuations, pharmaceutical companies are trading at a price/earnings ratios of around 10 times, versus a mid-teen multiple in the past decade. While Conover does not expect valuations to return to those levels, he does expect to see some multiple expansion to around 12.5 times.

Medical devices, another significant subsector holding in health-care ETFs, are trading at attractive valuations, with several high-quality companies--including Medtronic (NYSE:MDT), Stryker (NYSE:SYK), Zimmer Holdings (ZMH), and St. Jude's Medical (NYSE:STJ)--trading at sizable discounts to our fair value estimates. However, a headwind in the near term is a weak economy, as medical-device companies have more exposure to elective procedures. In addition, the team thinks the health-care-reform bill will be slightly negative to the subsector, due to higher costs, with minimal volume upside.

In the biotech space, mergers and acquisitions continues to be the major theme. According to Morozov, firms in niche therapeutic areas represent attractive takeout targets. He also notes that after a huge sell-off in August, small-cap biotechs, on average, are trading at a discount to larger peers. To play the M&A theme, he recommends an equal-weight ETF such as First Trust NYSE Arca Biotech (NYSEARCA:FBT). The benefit of an equal-weight ETF is that it provides better exposure to small caps (companies likelier to take out candidates) relative to a market-cap weighted ETF. There is also another equal-weight biotech ETF--SPDR S&P Biotech (NYSEARCA:XBI)--but we prefer FBT given its higher exposure to 4- and 5-star stocks (which account for 45% of FBT's portfolio, and 23% of XBI's). However, small-cap biotech firms are certainly a more volatile segment of the health-care industry.

Finally, while valuations for the sector are attractive, the team cautions that health-care spending remains challenging in the near term, with weak patient demand, due to high unemployment and the expiration of Cobra subsidies, along with ongoing regulatory uncertainty.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.