Currently, I rate iShares U.S. Pharmaceuticals (NYSEARCA:IHE) a hold. My most significant concerns about this ETF, and the pharmaceutical industry in general, are the high degree of regulation and the time it takes to develop drugs.
The iShares U.S. Pharmaceuticals ETF tracks the performance of the Dow Jones U.S. Select Pharmaceuticals Index. That index aims to provide exposure to a basket of drug companies that cover one or more of three functional areas: product research, product development, and manufacturing.
This ETF is entirely U.S.-focused. Precisely 100% of the holdings are traded in the United States. One distinguishing feature of IHE vs. most ETFs is its concentration at the top of the holdings list. Only two companies - Johnson & Johnson (JNJ) and Eli Lilly & Co (LLY) - make up around 40% of IHE's assets.
Looking deeper into the current holdings, the top 10 make up nearly three-fourths of assets. This is on the very high side for any ETF, even focusing on one industry or theme as IHE does. Furthermore, almost half of this ETF is invested in giant-cap companies (48%), though a decent mix of large caps, midcaps, and small caps provide a certain degree of balance.
Figure 1: Top 10 Holdings of iShares U.S. Pharmaceuticals ETF
Source: IHE Holdings
IHE has a low beta of 0.63, which makes it less risky than the market. When markets are going down, and while the S&P 500 was 8% down last year, IHE was only down 2%. IHE has been a market leader in challenging markets, but that period of outperformance is fading. In the long run, where S&P is expected to grow multifold, IHE will underperform because of low beta.
The pharmaceutical industry is also benefiting from the trend toward increased healthcare spending. As governments and individuals continue to spend more of their budgets on healthcare, the demand for pharmaceutical products is likely to increase. This can provide a tailwind for the performance of IHE.
IHE has an annualized standard deviation of monthly returns (three-year look back) of about 19%, so expect good volatility from this ETF. It also has a decent dividend yield of 2%, which suggests the ETF is for investors looking to make a quick buck from pharma bull run.
IHE must contend with a high level of regulation in the pharmaceutical industry. According to the industry group PhRMA, it takes 10-15 years on average to develop just one new drug from initial discovery through regulatory approval. This can make it difficult for companies in the industry to bring new medicines to market. Naturally, there is always the risk of a drug not working well enough to make it to market, even after putting so many years into the development process. A stronger trend toward tighter regulation, perhaps in part from political pressure on the industry, could impact the performance of the types of companies IHE holds.
One recent example involves IHE holding Pfizer (PFE). This stock received tremendous attention during 2020 and 2021, thanks to its key role in supplying a vaccine during the COVID pandemic. However, as the intensity surrounding COVID treatments fades, PFE is facing a decline in profits after a record year.
IHE is a very top-heavy ETF. Specifically, a 21% weighting in any one company can be treacherous for an ETF. As noted in the holdings discussion above, IHE has this potential issue with two companies.
The chart below is my technical view of JNJ, the stock that occupies about one-fifth of IHE's assets. Viewing this in a four-hour time frame, the 50-day exponential moving average (EMA) has crossed down through the 200-day EMA. This suggests a strong possibility of a downturn in JNJ's stock price. This could negatively affect IHE.
Figure 2: Technical Analysis of JNJ in a Four-Hour Time Frame With 200-Day and 50-Day EMAs
IHE has the potential to capitalize on the pharmaceutical industry's growth potential in Asia. According to a report by Statista, revenue in the Asian pharmaceuticals market is projected to reach $15.5 billion in 2023. This revenue growth could be driven in part by the increased prevalence of chronic diseases, an aging population in Japan and elsewhere, and increased adoption of personalized medicine. All of those factors are potential drivers for IHE's portfolio.
Another excellent opportunity for the types of businesses within IHE is the potential for new drug development and approval. Pharmaceutical companies are constantly researching and developing new drugs, and approving these drugs can lead to significant growth for the companies and the fund. For example, in 2022 CDER approved 37 new drugs never before approved or marketed in the U.S. This approval targeted many different disease areas, which can boost the performance of the companies and the fund.
A high level of competition in the pharmaceutical industry creates an interesting situation for IHE. With many companies vying for market share, it can take time for individual companies to maintain strong performance. This, in turn, can negatively impact the fund's performance.
Additionally, new entrants, such as biotech companies, can disrupt the market and impact the returns of IHE. So, the ETF might suffer from outside competition or cannibalization within its industry, which creates losers among its holdings that offset winners, thereby limiting the fund's upside.
Lastly, the pharmaceutical industry is subject to significant litigation and settlement risks. Companies might face lawsuits that can be costly and hurt company performance, whether they win or lose.
I like several aspects of this industry. However, I am bearish on any ETF that concentrates its holdings in giant-cap stocks and in two companies to the extent IHE does. A niche industry ETF is at best a piece of a portfolio. It comes with its own risks, as mentioned above. I am willing to keep an eye on it, but it is far from getting a positive rating from me.
Ironically, I might like this ETF better if JNJ and LLY fell hard, making IHE more diversified. When I consider the set of pros and cons noted above, I see potential here. But I'd need to be compensated more than is the case today, as investing in this highly regulated industry poses some concerns about its returns. Thus, my current rating is hold. I'm not a buyer, but the valuation picture prompts me to temper my urgency to suggest selling if you're a holder.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.