Medical Devices Move Into Healthcare Leadership Position

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Includes: FSMEX, IHI, MDT, XHE
by: Matthew Sauer, Esq.

Summary

Medical devices have underperformed the healthcare sector due to punitive taxes under the Affordable Care Act.

Those taxes have been delayed for 2 years and stand a good chance of being repealed by a future president and Congress.

FSMEX is the best choice among mutual funds and ETFs for broad exposure.

This year started out with a chill in the air and many investors are looking for investments with lower volatility. Traditionally "defensive" sectors such as utilities and consumer staples held up well during the intense selling seen at the start of the year, and utilities are up in 2016. These sectors are unlikely to perform as well when the bulls return though. Sectors that have seen larger drops will experience large rebounds and outperform when the market turns. Among those sectors are energy, Internet and biotechnology sectors, to name a few. Those are high risk choices ahead of any bottom in the market however. Instead of chasing falling knives, it pays to look for sectors experiencing improved performance due to improving fundamentals. One such option is the strongest subsector within the healthcare industry: medical devices.

The medical device industry was just handed a gift by Congress and the President in the latest budget deal: a 2-year delay on the medical devices tax. The 2-year delay will almost assuredly turn into a repeal if a Republican wins the White House in November, but the tax may also die under a Democrat president forced to deal with Republicans in the Senate and possibly the House.

The benefit to companies in the industry is tangible. Medtronic (NYSE:MDT), one of the largest companies in the sector, expected to pay nearly $210 million in additional taxes in 2016, equivalent to almost 8 percent of 2015 earnings. They and other firms prepared for higher taxes by trimming costs, so the net gain to the firms will likely exceed the tax itself. Since the tax delay is not permanent, companies will not treat it as a recurring cash flow and investors will treat it as a one-time increase. However, of all the healthcare subsectors, this is the one sector that has the least amount of uncertainty because the benefit from the repeal of the Affordable Care Act can be calculated based on lower expected tax increase. Also, medical devices are the subsector that most underperformed the overall healthcare sector since the passage of the ACA.

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Fund Options

Investors have several fund options when it comes to medical devices. Fidelity offers the actively managed Select Medical Equipment & Systems Portfolio (MUTF:FSMEX), while iShares and SPDRs each offer a passively indexed fund: the iShares US Medical Devices ETF (NYSEARCA:IHI) and the SPDR S&P Healthcare Equipment ETF (NYSEARCA:XHE).

Fidelity Select Medical Equipment & Systems Portfolio

FSMEX has been managed by Edward Yoon since May 2007. The funds goal is capital appreciation and it typically has 80 percent of its assets invested in stocks in the medical equipment, devices and technology sector, both domestically and internationally. Analysts use a fundamental analysis approach including looking at a company's financial condition, their rank within the industry, the political landscape as well as overall market and economic conditions.

As of December 31, 2015 the fund had 54 holdings. The top holding in the portfolio is Medtronic at 23.6 percent. Medtronic is one of the largest medical device manufacturers in the world. They are located in Dublin, Ireland following a corporate inversion and have been in business since 1949. The company is known for their implantable cardiac re-synchronization therapy devices. It is widely used throughout the world. They manufacture many other life-saving devices and medical products. In addition to benefiting from the tax change, also benefited from the corporate inversion, which unlocked billions in capital for stock buybacks.

Boston Scientific (NYSE:BSX) is the second largest holding in the fund. They develop, manufacture and market medical devices for use in medical specialties worldwide. BSX represents 9.7 percent of the portfolio.

The next largest percentages in the fund include Abbot Labs (NYSE:ABT), Edwards Lifesciences (NYSE:EW), Stryker (NYSE:SYK), St. Jude Medical (NYSE:STJ), Zimmer Biomet Holdings (NYSE:ZBH), Wright Medical Group (NASDAQ:WMGI), Cooper Companies (NYSE:COO), and Resmed (NYSE:RMD). These 10 companies make up 65.5 percent of the holdings.

FSMEX has outperformed the MSCI U.S. IM Health Care Equipment & Supplies 25/50 Index since inception and over the past 3-, 5- and 10-year periods. The fund currently has $1.9 billion in assets. Morningstar gives the fund 3-stars.

The net expense ratio for FSMEX is 0.77 percent. There is a short-term trading fee of 0.75 percent on shares held less than 30 days. The minimum initial investment is $2,500.

iShares U.S. Medical Devices ETF

Launched in May 2006, IHI fully tracks the Dow Jones U.S. Select Medical Equipment Index, with all 50 holdings and their respective weightings in the index. The index is market capitalization weighted, with index rules mainly serve to exclude very small firms and to cap the weightings of the largest companies. The top holding in the fund is Medtronic at 15.2 percent of assets, followed by 9.0 percent in Abbot Laboratories . Key differences from the FSMEX portfolio include a much larger weighting in Intuitive Surgical (NASDAQ:ISRG) at 4.3 percent in IHI versus 1.5 percent in FSMEX. Thermo Fisher Scientific (NYSE:TMO) is a top holding in IHI at 8.5 percent of assets, but not a holding in FSMEX. IHI is not less concentrated than FSMEX, with 64.6 percent of assets in the top 10 holdings.

Historical Performance and Risk

As of January 31, IHI has outperformed FSMEX over the past 1 year, with a gain of 2.58 percent versus a loss of 1.47 percent for FSMEX. Over the past 5 years, IHI has outperformed as well, with an annualized return of 14.53 percent versus 14.32 percent. IHI trailed FSMEX over the past 3 years, gaining only 16.62 percent versus FSMEX's 17.61 percent annualized gain.

The chart below is a price ratio of FSMEX vs IHI. A rising line shows outperformance by FSMEX.

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The takeaway from the chart is the two funds perform similarly most of the time, but active management paid off during the financial crisis.

Fees and Expenses

IHI has an expense ratio of 0.44 percent, making it considerably cheaper than FSMEX.

SPDR S&P Healthcare Equipment ETF

XHE has low volume and therefore investors should avoid trading the fund unless they have experience with low liquidity funds. The bid and ask spread can be wide: at the moment of this writing, the bid is almost $4 lower than the ask, a spread of more than 10 percent. While liquidity argues against trading the fund, it is always worth checking to see if an unpopular ETF has been unfairly overlooked by the market.

XHE tracks the S&P Health Care Equipment Select Industry Index, which is a sub-index of the S&P Total Market Index. The index has 69 constituents, which are all included in XHE. The index is equal weighed and this creates a very different portfolio than FSMEX and IHI, with both have the bulk of their assets in the top 10 holdings.

As the price ratio of XHE to IHI bears out, the equal weighting method hasn't paid off since the fund's inception in 2011.

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Much of this under performance may be due to the under performance of small cap stocks since 2014. The black line on the chart shows the price ratio of the Russell 2000 to the S&P 500 Index. Large caps have been beating small caps since early 2014 and they are likely to do so until the market makes a significant multi-year low.

XHE is the cheapest option with a 0.35 percent expense ratio.

Conclusion

FSMEX is the best option for investors in the current market environment. The similarities between IHI and FSMEX are considerable and manager Yoon has done well in tough markets. There has only been one major bear market under his tenure, but the strong performance of FSMEX during the crisis is the tiebreaker in what would otherwise be a near draw between these two funds. FSMEX lost 23 percent that year, versus a 37 percent drop in IHI.

XHE is a good fund that suffers from low liquidity, a result of coming to market much later than IHI. XHE should outperform when small caps outperform large caps and if the medical device sector does well at the same time. Hopefully for investors, the fund will see increased inflows and volume to make it a viable option. If liquidity weren't an issue, XHE would be on par with IHI and FSMEX as a solid choice, and would be the go to fund when small caps are leading the market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.