Two ETFs for the Boom in Big Pharma

Includes: BMY, IYH, LLY, MRK, PFE, RXL
by: Charles Lewis Sizemore, CFA
It has been a long time coming, but the time is finally right to buy Big Pharma. The last few years have been rough for the sector; looming patent expirations and jitters over the potential effects of ObamaCare have caused investors to dump large-cap pharmaceutical stocks like discarded medical waste. Health care was the worst performing sector in 2010, eking out less than 1% in a year when the S&P 500 returned nearly 13% (see chart). Only the utilities sector, which was hammered by rising interest rates, came close. All other sectors returned in excess of 9%, while some were well in excess of 20%. Outside of the financial sector — which was utterly decimated in the 2008 meltdown — health care was the worst-performing sector over the past five years as well, actually losing money over the period.

(Click to enlarge)

Perhaps not surprisingly, in a recent Barron’s poll, fully half of the strategists and institutional investors interviewed had a bearish view of the sector, and only one out of 12 was bullish. Investors — even professionals — have given up on the sector.

But as contrarian investors, these are exactly the kinds of opportunities we look for. When investors abandon a sector en masse, there is truth in the old trader’s cliché that “there is no one left to sell.” The downside is often limited, while the upside is enormous. This is what I see in the health care sector today. Many of the biggest names — such as Merck (NYSE:MRK), Pfizer (NYSE:PFE), Bristol Myers Squibb (NYSE:BMY), and Ely Lilly (NYSE:LLY) — sport forward P/E ratios in the high single digits and handsome (and safe) dividend yields.

Patent expirations will hurt the industry’s growth rates in the years ahead, but at current prices investors have already priced in zero growth. In the worst case scenario, investors in the sector will enjoy a steady stream of dividends while waiting for the sector to recover. And should the industry do even marginally better than the Street is currently forecasting, investors could see their shares explode to the upside.

The trade: Aggressive investors can buy shares of the ProShares Ultra Health Care ETF (NYSEARCA:RXL), which is a 2x leveraged fund on the Dow Jones U.S. Health Care Index. More conservative investors can buy shares of the iShares Dow Jones US Healthcare ETF (NYSEARCA:IYH), which is a straight, unleveraged fund based on the same index. As this article is going to press, U.S. stocks are looking somewhat extended, and I see a correction in the next month as being highly likely.

Aggressive investors choosing the leveraged RXL should wait for a pullback before buying shares, preferably near the recent lows of $48. Plan to hold for the remainder of 2011 or for a return of 50%. Once invested, use a stop loss near the 2010 lows around $41. Conservative investors opting to use the straight IYH can buy now, at market. Given the attractiveness of the valuations and the negative sentiment surrounding the sector, I consider the risk sufficiently low. Plan to hold for the remainder of 2011 or for a return of 25%.

Disclosure: I am long IYH, BMY, PFE.