BMEZ - HQH: Remains Beaten Down But Also Remains An Interesting Prospect

2023-12-21 04:41:09 ET

Summary

• abrdn Healthcare Investors continues to face pressure as healthcare and biotech sectors remain out of favor.
• HQH remains an attractive buy if one believes that the healthcare and biotech space can rebound in time and also offers a significant discount.
• HQH offers an attractive distribution while waiting for the sector to turn around to more favorable times.

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

abrdn Healthcare Investors (HQH), formerly the Tekla Healthcare Investors fund before abrdn completed their takeover , is continuing to face pressure. The fund remains deep and incredibly attractive. In fact, the discount has widened a bit further since our summer update.

However, healthcare and biotech continue to remain under pressure. This was something we highlighted again recently with our update on BlackRock Health Sciences Term Trust (BMEZ), another fund with a sleeve that is heavy in the biotech space. Those two factors combined helped drive the fund's poor performance since our prior update .

The fund remains interesting at these levels, and if one believes that healthcare and the biotech subsector aren't going away, this fund will then remain a compelling 'Buy.' The fund has posted its latest annual report for the twelve months that ended September 30, 2023 , so it's time for an update.

The Basics

• 1-Year Z-score: -1.16
• Discount: -17.21%
• Distribution Yield: 9.97%
• Expense Ratio: 1.18%
• Leverage: N/A
• Managed Assets: $921.1 million
• Structure: Perpetual

HQH's investment objective is "to seek long-term capital appreciation." They will attempt to achieve this through "investing primarily in securities of healthcare companies." More specifically, they will place "an emphasis on mid to large cap biotechnology and pharmaceutical growth companies with a maximum of 40% of the Fund's assets in restricted securities of both public and private companies."

Performance - Discount Remains Attractive

While the discount could have widened some from the fact that abrdn took over management, it is important to note that besides the name change, the actual managers also went with the transition. The investment policy and strategies also remained the same; the name had a slight adjustment, and the managers now collect a paycheck with "abrdn" on top rather than "Tekla." If anything, I believe having access to a much more global company with significantly more resources could really only be a positive.

Therefore, I believe the outlook on overall healthcare and specifically the biotech sector is more important in terms of performance rather than the fund having a new sponsor. HQH is just over 60% invested in biotech companies, so that's why it plays a significant role in the outcome of the fund. This year, healthcare has been under continued pressure, but for a fairly brief period of time, biotech did attempt to make a rebound. More recently, it was at a deep sell-off along with the broader market but has come back up to come in about where the overall healthcare sector has performed.

That said, if we zoom out further to the last five years, we can really see just how poorly biotech has performed after coming down from its peak in early 2021. This space goes through some vicious cycles of coming in and out of favor, and these cycles can be quick. Therefore, even the modest recovery we've been seeing in the biotech space would mean that anyone buying in later 2020 or through 2021 is still down substantially.

Thus, one who may have invested in HQH or its sister fund, abrdn Life Sciences Investors (HQL), is down substantially as well during this time. They are going to be impacted even more than the SPDR S&P 500 Biotech ETF (XBI), a passively managed ETF. This is because of the closed-end funds structure that allows for significant swings between discounts and premiums.

When areas of the market go in favor, a CEF can really go in favor and outperform due to investors pooling into these instruments. That puts it in a situation where the discount can narrow materially or - as we can see in the case of HQH - even hit a premium when there is enough demand.

This is why HQH could have seen an even more dramatic fall in the last several years because of this discount widening, which would be why investors could be incredibly frustrated in the fund. That's what really creates the strong argument that today, with both biotech beaten down and the fund's discount excessively wide, it is a compelling buy.

Distribution - Get Paid While You Wait

One of the features of HQH is that it also comes with a distribution. This distribution is comprised entirely of capital gains, as there is no income generated from this fund when factoring in expenses. The fund generally has a negative net investment income amount because the space isn't one where most of the investments pay generous dividends. Instead, that capital is retained to fund research in new products. The fund's total investment income might be around $10.3 million in the last report, but with expenses coming in at around $11.5 million, that is where we get the negative NII.

That said, an investor is still getting something in return for holding HQH and waiting for an eventual recovery in the space. That can make it much easier for many investors to hold onto a position long term.

The way the distribution policy works here is that they calculate 2% of NAV based on the prior pay date. This creates a situation where if the NAV is rising, the payout will also be going higher. Alternatively, when the fund is performing poorly, the distribution will also be reduced. That can be a negative for some income investors who want a level amount, but it also creates a situation where it helps to retain more assets to rebound when there are better times for the fund.

For fiscal 2023, the fund classified the entire distribution as being long-term capital gains. However, the fund will report the final determination to shareholders at the start of 2024.

During the last fiscal year ended September 30, 2023, the Fund made quarterly distributions totaling $1.61 per share, which were characterized as $1.61 per share of net realized long-term capital gains. Final determination of the tax character of the distributions paid by the Fund in 2023 will be reported to shareholders in January 2024.

HQH's Portfolio

HQH's approach to investing across the capital stack of companies can provide it with plenty of diversification and flexibility. That said, the bulk of the portfolio has regularly been comprised primarily of common stock positions. With this latest update, there has been no material change, as the fund's equities still comprised 87.7% of the portfolio. That would have been down only a touch from the 89.9% earlier this year.

Additionally, biotech continues to come in as the largest allocation of the fund. Earlier this year, it was at a 62.2% weight, with pharma positions at 17.9%.

The fund may note that it can invest in private or restricted securities up to 40%, but this tends to be a fairly small part of the fund. The last report showed restricted securities at a 7% weight. Primarily, the fund is invested in public securities, with the bulk of the portfolio classified as level 1 securities. That can be important because private valuations may not always be the most accurate. If private companies aren't seeking new funding, then often the valuations aren't changed from the prior funding round levels.

This is sometimes why funds with a meaningful allocation to private investments are scrutinized as the accuracy of what that then means for the fund's discount. If the value of the portfolio really should be adjusted lower, that would mean the discount of the fund would be reflecting that skepticism in the underlying valuation. At most here, I believe we would be looking at maybe a couple of percentage differences on the extreme end due to the fairly small allocation to level 3 securities at 7.46%, according to their annual report.

Instead, the fund primarily focuses on the publicly traded biotech names and a few in particular command a fairly sizeable allocation of the fund. CEFConnect lists 141 total holdings, and the top ten make up a sizeable 43.3% of the funds' entire portfolio.

The top five alone command a 31.4% allocation, as the percentage weightings fall fairly dramatically once we reach the tenth largest holding. Going from AbbVie's (ABBV) 1.8% weight and comparing it to Regeneron Pharmaceuticals (REGN) 7.7% is quite a swing between the two. So, while the fund is fairly diversified if we look at it in terms of a number of holdings, they still also take some higher conviction plays in a handful of positions.

These positions were also similar to what we saw earlier this year. REGN has taken over the largest position from Gilead Sciences ( GILD ), but GILD still remains a sizeable position at number four. ABBV appeared on the list when it wasn't previously, but at that time, it was still a holding earlier this year . The weighting of the position simply wasn't enough to get it on the top holdings list.

Conclusion

HQH remains at an attractive and deep discount. The fund's performance has been rather lackluster, but that's a result of the overall healthcare space performing poorly. This could be precisely the time when one would want to start building a position when the fund is at a deep discount in a beaten-down area of the market. At the same time, the fund places an emphasis on the biotech space. So overall it is a more cyclical sector that tends to make HQH much more volatile than a straightforward healthcare fund that is focused more on the other subsectors of healthcare, which tend to be much more defensive and aren't as volatile.

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