How to Play Healthcare Until 2016

The healthcare sector has been on an absolute tear since the economic recovery began in 2009, with the SPDR Health Care ETF (NYSE: XLV) climbing more than 140%, and the Fidelity Select Biotechnology Portfolio mutual fund (FBIOX) soaring 320% by the end of February of this year.

But in the two months since, healthcare has seemed a little fatigued and sickly. From March to mid-April, the pharma-based XLV lost 8% and subsequently regained only half of that loss, while biotech-based FBIOX lost 24% and regained only a fifth of its tumble.

Why has biotech taken more damage? Because painted on FBIOX’s graph is the common pattern of a momentum stall which is about to turn into a breakdown – categorized by three distinct features noted in the graph below: a gradual upward curve (blue), leading into a parabolic spike (green), which itself forms the head in a head-and-shoulders pattern (Orange).

Source: BigCharts.com

Are we currently seeing the formation of the right shoulder in the healthcare sector? A break below the neck-line (which is actually the armpit line) in the $170 area for FBIOX, and the $55 area for XLV could trigger a precipitous fall to who-knows-where.

The near-term does not look good for healthcare. Looking ahead at changing government policy, the longer-term doesn’t look that great either.

Not All Funds Are Created Equal

Just because one sector fund starts showing signs of fatigue does not by itself mean the entire sector is going to fall on its face.

The two healthcare funds noted above – Fidelity’s FBIOX and SPDR’s XLV – did not have precisely the same run up, and will likely not have the same correction down. They are composed and managed differently, producing notably different results, as tabled below.

Source: Own

That FBIOX is comprised of mostly medium caps gives it more thrust during upward runs, as can be noted in the two funds’ 1-5 year comparisons. Just looking at some of the names they hold explains why.

In FBIOX’s top two holdings of Amgen Inc (NASDAQ: AMGN) and Gilead Sciences Inc (NASDAQ: GILD) lay 23.26% of the fund’s $8.13 billion of assets – almost a full quarter in just two stocks. Over the past 3 years, GILD’s stellar climb of 290% contributed significantly to helping FBIOX register 116% growth to beat XLV’s 63% gain, which holds only 4.86% in GILD.

Two other moonshots helped boost FBIOX into parabolic mode recently. First, Intercept Pharmaceuticals Inc. (NASDAQ: ICPT) blasted off in early January from $70 a share to over $440 in a matter of days for a gain of 528% on news the company’s new drug for non-alcoholic steatohepatitis – the only drug in existence for treating liver fibrosis – had met its primary goals by delivering positive results in 50 percent of trial participants.

That was followed by InterMune Inc’s (NASDAQ: ITMN) catapult in late February from $14 to $38 for a rise of 171% on news that the company’s idiopathic pulmonary fibrosis drug successfully completed its phase 3 trial and could be released as soon as Q2 of this year, possibly generating as much as half a billion dollars in sales annually.
But along with those periodic explosive charges, medium caps also carry a greater risk of downward corrections, as FBIOX’s two-month loss of 16.5% shows.

SPDR’s large cap configuration, on the other hand, has taken the recent 5-year bull run a little more evenly paced, with the ETF’s average stock prices resting below the Healthcare sector’s averages to earnings, book, sales and cash flow. Compared by the same metrics, FBIOX’s average stock prices are definitely overheating.

Biotech’s high valuations may be signaling that it’s time for investors to pull back, or perhaps migrate into the relatively safer large caps of XLV, whose top three holdings comprising almost 29% of the fund’s assets include the ever steady mega cap Johnson and Johnson (NYSE: JNJ), and the enduring large caps Pfizer (NYSE: PFE) and Merck (NYSE: MRK).

But even these could end up costing you over the longer term. It all hinges on the next phase of U.S. Federal Reserve policy – the raising of interest rates – which tends to deliver a severe blow to the healthcare sector.

Interest Rates May Hospitalize Health Stocks

Any near-term correction in the healthcare sector could be short, perhaps confined to just the typical summertime lull. There are still plenty of new drugs in the pipeline that could easily spur the healthcare sector along another bull-leg through to the end of 2015.

For instance, Gilead has its new Hepatitis C drug Sovaldi, expensive though it is. While Celgene (NASDAQ: CELG) has its new pill Otezla to treat psoriatic arthritis, plus a few agreements with research companies making inroads in cancer treatments.

But heading into 2016 when the U.S. Federal Reserve will likely begin raising interest rates, things may get much tougher for the healthcare sector, as they did the last time rates rose from 2004-07. From early 2004 to late 2005, FBIOX remained perpetually in the negative. By early 2007, it was sitting at $60, the same as at the spring of 2004 – essentially flat during the entire three year period of rising interest rates.

Why? Because of biotech’s heavy dependence on research, which is already expensive enough even at today’s low interest rates. As the following table shows, the current period of easy money and cheap loans has set many health stocks up for a terrible fall when rates start to rise.

Source: Own

In a selection of the top holdings of FBIOX and XLV, debt has been rising as companies take advantage of historically low rates. Unfortunately, their interest payments have been rising as well, especially in 2012 when bond yields and bank loan rates shot upward. The expense will only steepen when the overnight Fed rate begins its steady ascent over the medium to longer terms.

But not all healthcare stocks will fare the same. Investors need to make an important distinction.

Differentiating Between the Two Health Sectors

While FBIOX leans toward the biotech hemisphere of healthcare, XLV leans toward pharmaceuticals – impacting their performance more than you might think.

“The chief difference,” explains Value Line, “is in the approach that each uses to develop their respective drugs… Biotech drugmakers essentially use microorganisms or highly complex proteins from genetically-modified living cells as components in medications to treat various diseases and conditions, from cancer to rheumatoid arthritis to multiple sclerosis. By contrast, conventional pharmas rely on a chemical-based synthetic process to develop small-molecule drugs.”

Their different approaches make biotech companies much more capital intensive and costly:

“Biotechs focus primarily on research and development, beginning with the discovery of novel compounds, which then get ushered into the clinic for further testing,” Value Line elaborates. “The discovery and development process is often more lengthy, difficult, and costly for biotechs than it is for their standard chemical-based counterparts. For this reason, R&D expenses tend to be very large for biotechs. In many cases, they operate at a loss for an extended period of time.”

Biotechs may occasionally market the drugs they invent, but typically they will simply “partner up with another company that agrees to handle those costly functions in exchange for a portion of sales”.
Pharma companies, on the other hand, have a slightly easier go of R&D which does not typically involve making new scientific discoveries. Some pharmas will even skip R&D all together, and will simply market the drugs they license from the biotechs.

You might think of biotechs and pharmas as the healthcare counterparts of the two Steves who started Apple Computers. Where tech wizard Steve Wozniak engineered the systems, the marketing genius Steve Jobs sold them to the world.

The difference between biotech and pharma explains the outperformance of biotech-laden FBIOX over pharma-stocked XLV over the past five years, as biotechs benefitted greatly from easy access to cheap R&D capital.

Over the longer term, look for the XLV to take the lead over FBIOX as capital becomes steadily more expensive to acquire.

Joseph Cafariello