HQL - HQL: 13% Discount Creates An Opportunity

2023-06-29 08:06:53 ET

Summary

• Tekla Life Sciences Investors is a closed-ended equity fund that primarily invests in the life sciences sector, with a heavy focus on biotech and pharmaceuticals.
• The fund's dividend history has been stable over the last 10 years, ranging from $1.16 to $2.80 per share. The fund has provided decent income growth for investors who have held it for a few years and reinvested dividends.
• The fund relies on dividends as well as share price appreciation from its holdings to support its dividend yield, so investors should be comfortable with this.

Tekla Life Sciences Investors (HQL) is a closed-ended equity fund that specializes in the field of life sciences. Technically the fund invests in several sub-sectors such as biotech, pharmaceutical, diagnostics, managed healthcare, medical equipment, hospitals, healthcare IT, healthcare services, healthcare devices and supplies as well as healthcare infrastructure but in reality it invests about 90% of its assets into biotech (78%) and pharmaceutical (12%) with a pretty heavy focus while other sectors get a much smaller focus (10% combined). The fund currently yields 9.3% annually which attracts a lot of income oriented investors.

The majority of the fund's equity holdings have dividend yields of 3% or below (with the exception of preferred stocks held by the fund which make up 7.5% of its total assets) which begs the question where the 9.3% yield comes from. The fund pays its dividends from a variety of sources including the dividends it receives from its holdings, capital gains, and return of capital (which some investors don't like but has its tax advantages). The fund doesn't do any options plays such as writing covered calls which means it will need capital appreciation of its holdings in order to maintain or raise its high dividend yield.

One thing the fund has going on for itself is current discount against its NAV. Currently, the fund's share price is $13.62 versus its NAV of $15.70, indicating a deep discount of -13.25%. This is one of the deepest discounts in fund's history. In fact, the fund has traded at a slight discount of less than -5% for much of its existence which is another explanation for how it can pay a higher dividend yield that it historically did. In the last decade, the only time this fund traded at a lower discount was during the midst of COVID-19 crash in March 2020.

The fund's dividend history is interesting. In the last 10 years, the fund's dividend payments ranged from $1.16 to $2.80 per share with most annual payments falling between $1.25 and $1.65. If you don't count a couple exceptional years, the dividends have been range-bound or flattish for most years without any significant growth or drop. Investors who like stability will enjoy this while those looking for consistent and predictable dividend growth might want to look elsewhere.

One thing for sure though. If you had bought this fund anytime in the past, held for more than a few years and reinvested dividends, you would have grown your income at a pretty decent rate. For example, if you had bought $10k of this fund 20 years ago and reinvested your dividends, your annual income for 2022 would have been $6,400 which would represent a yield of 64% on your original investment.

Here is another scenario. Let's say you started buying this fund in slow installments 10 years ago where you are putting $1,000 into it every month while also reinvesting your dividends. Your income would have grown nicely to an annual $16k at the end of the decade. This is basically how the snowball effect works but it takes a lot of time and patience. Also, this model assumes that you are growing your assets in a tax-free account such as within a 401k or IRA which you should anyways if you are planning on holding on for decades.

The fund's top 10 holdings account for 50% of its weight and these companies include Amgen ( AMGN ), Gilead Sciences ( GILD ), Vertex Pharmaceuticals ( VRTX ) and Regeneron ( REGN ). Weight-wise a great majority of the fund's assets are tied to established and highly profitable companies even though it also invests in some biotech companies that are still in pre-revenue or development phase. The fund also invests into pre-IPO or pre-venture biotech start-ups but these make a very small percentage of its total assets (even though the fund's paperwork says they can invest up to 40% of their assets into pre-IPO ventures). Since pre-IPO and pre-revenue companies in early development stages can't pay dividends, the fund will have to rely completely on capital appreciation or an IPO-payout for those types of investments in order to support its dividends.

Interestingly enough, the fund's paperwork (or webpage) don't list all of its holdings. We can only see the top 10 holdings which make up about 50% of its total weight. One thing we know is that the fund invests about 7.5% of its assets into convertible preferred shares and another 1.2% into milestone investments and these could indicate the size of non-traditional assets it invests into. If investors don't feel comfortable with this type of arrangement and would like to know every stock held by their funds, they might not be very happy with HQL. Also keep in mind that HQL is actively managed and its holdings can change very frequently.

Healthcare is considered a recession-proof industry and the industry's earnings tend to be very stable over the years but this doesn't mean that healthcare stocks don't see any volatility. As a matter of fact, healthcare and pharmaceutical industries have been 2 of the weakest performing sectors in 2023 so far. Since the beginning of the year, S&P 500 index ( SPY ) has been up 14.4% while the US pharmaceutical index is down 4.66% and healthcare index is down 2.67% YTD. This doesn't mean that the sector will continue to underperform or that it always underperforms. This just means that investors should be ready for periods of underperformance and realize that being a recession-proof industry doesn't make this industry immune from stock losses.

In the long run, the world population is growing and aging. Not only that but people are also getting sicker sooner . The number of people who experience chronic diseases like diabetes, high blood pressure, heart disease at young ages is increasing exponentially because of our dietary habits and lack of exercise. Now people need to manage their chronic diseases for multiple decades because they get sick younger and live longer which opens an opportunity for pharma companies like never seen before. Below is a quote from one study :

The number of people in the United States aged 50 years and older will increase by 61.11% from 137.25 million in 2020 to 221.13 million in 2050. Of the population 50 years and older, the number with at least one chronic disease is estimated to increase by 99.5% from 71.522 million in 2020 to 142.66 million by 2050. At the same time, those with multimorbidity are projected to increase 91.16% from 7.8304 million in 2020 to 14.968 million in 2050.

This is a sad development for humanity but still creates a generational opportunity for healthcare investors. One could even invest into HQL as a "healthcare policy" for the long term where future dividends help pay one's future healthcare costs as they grow older over time.

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