BME - BME: A Discounted Opportunity In The Healthcare Space

2023-09-20 01:24:56 ET

Summary

• BlackRock Health Sciences is trading at an attractive discount, creating a potential opportunity for income investors.
• BME employs a covered call writing strategy and has a history of steady monthly distributions.
• The fund's portfolio is focused on large and stable healthcare companies, providing defensive characteristics in volatile markets.

Written by Nick Ackerman, co-produced by Stanford Chemist.

Historically, it's been rare for BlackRock Health Sciences ( BME ) to trade at a discount in the last decade. However, this year, we've seen a fairly attractive discount open up as the fund's portfolio is performing fairly well while the share price is dropping. This could create a long-term opportunity to gain healthcare exposure for an income investor, as this fund also pays an attractive monthly distribution.

The last time we covered this fund was earlier this year when this discount trend started to emerge. At a 2% discount, though, it was still fairly narrow relative to its historical level. Now that the fund is flirting closer to between 5 and even near a 6% discount, it looks like a more attractive offering.

The Basics

• 1-Year Z-score: -1.33
• Discount: -5.75%
• Distribution Yield: 6.52%
• Expense Ratio: 1.09%
• Leverage: N/A
• Managed Assets: $590 million
• Structure: Perpetual

BME's investment objective is "total return through a combination of income, current gains, and long-term capital appreciation." They will attempt to achieve this by a pretty simple investment policy - "under normal market conditions, at least 80% of its assets in equity securities of companies engaged in the health sciences and related industries and equity derivatives with exposure to the health sciences industry."

They will then implement a covered call writing strategy against positions in their portfolio. The last reported overwrite of the fund was at 35.55%; this is between their 30 to 40% overwrite target. They write against individual positions in the portfolio rather than some funds that implement call-writing against indexes. That takes away the potential for unlimited losses, and potential losses can be known by management when they enter into a contract.

The fund doesn't employ any leverage through borrowings or preferred offerings, which is perfect for a fund that is supposed to be pretty boring in the first place as a healthcare fund. It also means one less area to have to worry about in a rising interest rate environment.

Performance - Discount Opens Up To Create A Potential Opportunity

The declines from our last update stem from the opening of the fund's discount between now and then.

If we looked at total returns on the NAV level since our last update, things would have been more flat in terms of performance. I've included below the changes in price and NAV, as well as their total return figures that would factor in the fund's distributions.

Of course, when this sort of NAV and price divergence happens, that's what creates the opportunities we can exploit in closed-end funds with their discounts/premiums. For BME, the absolute discount isn't necessarily that deep. However, it is attractive from the historical perspective given that the fund's relative discount to that is looking quite tempting.

During the last decade, we haven't seen a discount persist for any really significant period of time for this fund. Even during the Covid market collapse, the fund's discount may have come near 10%, but it made an almost immediate recovery.

Of course, this doesn't mean that the discount can't get wider from here, but looking back at historical discounts/premiums in CEFs has often led to a reversion to the mean. This is generally in shorter periods, and even over the last year, this fund is looking relatively cheap. The last year shows an average discount of -1.91%, which puts the 1-year z-score at -1.33.

A z-score gives us how cheap or expensive a fund is relative to its average over a given period. The deeper the negative number, the relatively cheap it is and the higher the number, the more expensive it would indicate that a fund is. At -1.28, I'm not willing to say this is necessarily a screaming deal, but from the perspective of a long-term income investor, I wouldn't mind picking up shares at this level. So I feel comfortable currently switching from a 'Hold' rating to a 'Buy'.

In general, healthcare hasn't been a rocking sector this year. It's one of the few sectors that's currently negative YTD.

One of the ways that BME has been able to outperform on a YTD basis and provide some slight positive total returns on an NAV basis is through its utilization of covered call writing.

In addition to the option writing that brought in premiums for the fund that helped contribute to gains, portfolio positioning also appeared to be better for BME. Below is a highlighting of the gains from the options written in the realized capital gains bucket, though they were sitting on a sizeable pool of unrealized losses due to their options writing as well in the first six months of the year. Additionally, we can see that they realized capital gains from their underlying portfolio in addition to seeing unrealized gains from the portfolio.

One thing to note about covered call writing funds is that they can cap upside as well. If there is a strong run in healthcare, then that could limit some of the upside.

6.52% Distribution Yield Looking Enticing

The fund is one of only a handful of CEFs that have not only never reduced their payout to investors but it also launched before the global financial crisis in 2008/09. A history of no cuts from a CEF can be impressive, but if the fund was launched after the GFC, then it certainly didn't face the types of challenges that these older funds had.

Part of the steady payout could go back to what we touched on above, the fund's covered call-writing strategy that can generate gains when the market is sideways or even down. The options premiums taken in during a sharply lower down year aren't likely to offset all of the losses realized from the portfolio, but it certainly does soften the blow a bit.

Since the portfolio's NAV distribution rate comes to 6.15%, we know that the underlying portfolio names certainly don't pay that much. For some context, XLV's dividend yield comes to only 1.57%. So, we know they will require capital gains to support it. This would also be the main argument that these two funds, while healthcare-related peers, shouldn't necessarily be compared. One is for producing a much more attractive monthly cash flow, and the other would be going for the total return approach with more capital appreciation potential.

Those gains from the options premiums coming in help support the fund's payout. As we can see below, the fund's net investment income coverage comes to only around 6.6%. Meaning the vast majority of the distribution will have to be covered through capital gains.

We discussed the taxes in our previous update; here is a recap:

Despite what was a fairly big shortfall in distribution coverage from capital gains, the fund still only had a small portion of the distribution classified as return of capital for 2022 . The largest contributor was long-term capital gains, which both have their own tax benefits.

ROC reduces an investor's cost basis so it doesn't become taxable unless it is sold at a profit in the future. Generally, this isn't the type of fund you'd see ROC from regularly, but it can happen in weak years. LTCG also qualifies for a lower relative tax rate than ordinary income. The small portion that was identified as income was classified as qualified dividends. This can all make the fund more appropriate for a taxable account.

BME's Portfolio

I know the healthcare sector isn't the most exciting or sexy place to invest; as we saw, even this year, the broader sector has been lackluster, resulting in slight losses. Despite this, the healthcare sector is often a more defensive sector that can see limited losses relative to the rest of the market in bear markets.

In 2022, we saw the S&P 500 Index produce some sharp losses as measured by the SPDR S&P 500 ETF ( SPY ). Admittedly, the path was fairly bumpy for BME, too, with periods of it seeing a correction of 10% or greater declines. However, the fund ultimately didn't see nearly the same amount of losses as the broader market.

Therefore, exposure to healthcare can often be a hedge against the more volatile areas of one's portfolio. For BME, their portfolio is tilted toward all the largest and best-known healthcare companies. Those that often generate steady business no matter the environment. Hence their defensive nature, even in a slowing economy, healthcare remains vital and not an option for most people.

The top holdings have remained fairly consistent since earlier this year. New names to the top ten include Intuitive Surgical ( ISRG ), Vertex Pharmaceuticals ( VRTX ) and Johnson & Johnson ( JNJ ). With those three rising to the top ten, we've seen the removal of Danaher Corp ( DHR ), Abbott Laboratories ( ABT ) and Amgen ( AMGN ).

Instead of a conscious decision on the part of the fund managers, at least some of what we see here would have resulted in performance divergence between this group. ISRG and VRTX, in particular, saw a strong performance that likely pushed their values and, therefore, weightings up higher.

According to their N-PORT filing, the management also took their ISRG position from holding 56,844 shares at the end of March 31, 2023 , to holding 63,429 shares at the end of June 30, 2023. These same filings also show that VRTX received a small bump in shares being held from 47,119 to 48,713.

BME takes a fairly concentrated portfolio approach, with these top ten representing over 41% of the entire fund's assets. However, the fund lists 136 total positions overall. Once you get out of these top positions, the weightings to each end up falling pretty drastically.

For some context, though, XLV actually runs an even narrower focused portfolio with a total of 67 positions. That ETF lists its top ten as nearly 55% of the entire portfolio. So, while BME is fairly concentrated for equity CEFs as a whole, it could still be considered more diversified than its ETF counterpart. This also highlights why, beyond just the covered call strategy, these two funds can have diverging performance through various periods.

Conclusion

Healthcare isn't often the most exciting place to place bets on when investing, but it can be a defensive sector that allows for some downside protection during bear markets. When the economy gets tough, healthcare generally remains fairly stable due to the vital nature of what it provides. It often isn't a choice if a person receives the medication or treatments needed, but it is vital for survival or comfort. Investing in this space through BME also gains exposure to their covered call writing strategy on top of the healthcare approach. Additionally, and maybe more importantly, the fund's discount is starting to grow to a level where it's more tempting to start a position.

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