HQH: A Solid Way To Play Biotech

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About: Tekla Healthcare Investors (HQH), Includes: JNJ, THQ, THW, UNH
by: Power Hedge
Summary

Healthcare is likely to be a good investment over the next few decades.

One fund that helps investors take advantage of the capital gains potential of this industry is HQH.

The fund is heavily invested in biotechnology, which accounts for more than 60% of the portfolio.

HQH boasts a relatively hefty 8.35% distribution yield but this will vary depending on the capital gains generated by the fund.

The fund is trading at nearly a 10% discount to net asset value so the current price is an attractive entry opportunity.

Over the past few weeks, I discussed two of Tekla Capital Management's healthcare-focused closed-end funds, the Tekla Healthcare Opportunities Fund (THQ) and the Tekla World Healthcare Fund (THW). You can read my discussion of these two funds here and here. In this article, we will take a look at one of Tekla's other healthcare funds, Tekla Healthcare Investors (HQH). This is a fund that has delivered quite a handsome return to investors over the years and cemented Tekla's reputation as a top-notch manager of healthcare investments. In addition, the fund is likely to benefit from some of the strong demographic trends that are likely to drive profits in healthcare-related companies up over the coming years and decades.

Demographic Trends

First, let us take a moment to discuss the trends that are likely to benefit the healthcare industry in the years ago.

The first of these trends is the aging of the massive Baby Boomer generation. As I discussed in a previous article, the members of the Baby Boomer generation are 53-72 years old today. Therefore, not only will the members of this generation be retiring over the next ten years (which is one of the factors threatening Social Security) but they will also be entering the terminal years of their lives. As a general rule, individuals start to consume rapidly increasing amounts of healthcare products and services once they surpass approximately eighty years. The oldest members of this generation will hit that age in eight years, with the remainder hitting it over the following twenty. According to the US Census Bureau, there are between 72 and 74 million members of this generation living in the United States today, which represents 20% of the United States population and greatly outnumbers any generation that came before them. We can thus conclude that the demand for medical services will greatly increase as these individuals begin to reach their twilight years.

The second trend that seems likely to drive healthcare consumption upward is a surge in the obesity rate. According to a recent study, 39% of the American population is currently obese. This figure is expected to increase to 55% by 2045 due largely to the American diet and an increasingly sedentary lifestyle. There are a number of chronic health conditions linked with obesity such as hypertension, heart disease, high blood pressure, osteoarthritis, type-II diabetes, and several others. We can conclude that these conditions will become more common as the obesity rate increases. As all of these are chronic conditions, we can also see that a patient that contracts one of them will constantly need to consume healthcare resources to treat it. This will naturally result in growing revenues for healthcare companies.

About The Fund

Now, let us take a look at how HQH can help an investor play and profit from these trends. First of all, the fund describes itself as a non-diversified closed-end fund that invests primarily in the healthcare industry (including biotechnology, medical devices, and pharmaceuticals). The fund's primary goal is to deliver long-term capital appreciation, which is in stark contract to THQ and THW that aim to provide a high level of current income to investors. The fund also allocates up to 40% of its assets to investments in restricted securities of both public and private companies. This ability to invest in private companies is something that most retail investors do not have, so this could provide some fairly unique opportunities to profit off of the potentially high returns that these securities can provide.

The Portfolio

As one might expect from the description, HQH has a vastly different portfolio than most healthcare funds. Here are the top ten holdings in the fund:

Source: Tekla Capital Management

As we can see here, American giant Johnson & Johnson (JNJ), usually the largest holding in healthcare funds, only has a small position here and UnitedHealth Group (UNH), usually another large holding, is nowhere to be found. Instead, we see several companies that are in more exotic healthcare fields such as biotechnology. Biotechnology has a reputation of being somewhat high risk and high potential reward but fortunately most of these are very well established companies so this helps to mitigate the risk somewhat.

While we do not see any heavily outsized positions, we do have four companies here that each account for more than 5% of the portfolio, all of which are biotechnology firms. As a general rule, I get concerned when I see any single position account for more than 5% of the fund since it exposes the entire portfolio to significant losses in the event that something goes wrong with that company. Fortunately, none of these positions are substantially above 5% of the portfolio but this is something that potential investors should be aware of.

As might be expected by looking at the top ten positions, HQH has a heavy weighting towards biotechnology:

Source: Tekla Capital Management

I must admit that the 62.9% weighting to biotechnology reminded me a lot of THW's outsized weighting to traditional pharmaceuticals. However, pharmaceutical companies are generally considered to be somewhat safer plays than biotechnology. Thus, the fund is very much skewed towards high-risk high-reward plays. However, while any single biotechnology company may have some risks, there are a number of different ones in the fund so this helps to diversify the risk away. Of course, anything that affects the biotechnology industry will have a major effect on the fund but it is difficult to see what this might be outside of government intervention.

Distributions

One of the major reasons why people invest in closed-end funds is to derive income. While HQH is not an income fund per se, it actually does boast a relatively solid 8.37% distribution yield. However, it is important to note that all of the fund's quarterly distributions come directly from the fund's capital gains and as such tend to vary significantly from quarter to quarter:

Source: Tekla Capital Management

As such, it is not really a good idea to depend on these in the way that we might a dividend-paying stock or a fixed income fund. The fact that HQH has been able to consistently make relatively solid quarterly capital gains distributions is a sign that the fund is able to consistently generate a positive return for its investors. In fact, this is the case, as shown here:

Source: Tekla Capital Management

As shown here, HQH has delivered an average annual return of 12.11% on net asset value over the past ten years. As is sometimes the case with closed-end funds though, the share price does not always track the performance of the underlying portfolio.

Valuation

As investors, it is always important for us to ensure that we do not overpay for any asset in our portfolios. This is because overpaying for an asset greatly decreases the potential future returns that we will make off of that asset. In the case of a closed-end fund, the most typical way to value it is to take a look at the fund's net asset value, which is the market value of everything owned by the fund minus any outstanding debt. Ideally, we want to buy a fund at a price below its net asset value as this means that we are essentially getting the assets of the fund for less than they are actually worth. As of August 30, 2018, the latest date for which data was available, HQH had a net asset value of $25.59 per share. Thus, the fund trades at a 9.38% discount to net asset value, which is a fairly appealing price.

Conclusion

In conclusion, HQH looks to be an appealing way to play the promising next few decades of healthcare growth. The fund itself is heavily invested in biotechnology, which is typically a high-risk and high-return play, but it is well-diversified, which helps to reduce the risk. The fund has overall been a fairly solid performer as far as healthcare funds go and is currently trading at a fairly attractive discount to net asset value. It could be worth considering including in your portfolio.

Disclosure: I am/we are long THW. 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.