BMYMP - IYH: Healthcare Stocks Will Likely Outperform In The New Year

Summary

• As most of you know, a high inflation and rising interest rate environment favors defensive sectors that typically outperform in recessionary periods.
• Healthcare is one such sector. This year, the iShares U.S. Healthcare ETF has outperformed the S&P 500 by 14%.
• The IYH ETF has a 10-year average annual return of 13%+ and its top holdings include UnitedHealth Group, J&J, and Eli Lilly.

The 2022 bear-market has mauled many investors who will likely welcome the New Year with open-arms and hopes of higher returns. That said, inflation is still running high and the outlook is for more interest rate increases by the Federal Reserve. That being the case, it would appear prudent to allocate capital to sectors which are a bit more defensive in nature and tend to do better during challenging economic times. One such investment to consider along these lines is the iShares U.S. Healthcare ETF ( IYH ). Today, I'll take a look at this fund and see if it might be a good addition to your portfolio.

Investment Thesis

The Healthcare Sector is considered to be defensive because by-n-large these companies consistently pay dividends and are generally less affected by volatile markets. That's because the sector's services (drugs, hospitals, doctor visits, medical procedures, etc. etc) typically cannot be postponed and are in demand regardless of the macro-economic conditions. In addition, healthcare providers are typically able to pass-through inflationary price increases directly through to the consumer (or, as is often the case, to the insurance companies). This is why the Healthcare Sector is likely to outperform in the New Year.

With that as background, let's take a look to see how the IYH ETF has positioned investors for success going forward.

Top-10 Holdings

The top-10 holdings in the iShares U.S. Healthcare ETF are shown below and come directly from the iShares IYH ETF homepage , where you can find additional information on the fund. These top-10 holdings equate to what I consider to be a relatively concentrated ~55% of the entire 116 company portfolio:

The #1 holding with a 9.5% weight is UnitedHealth Group ( UNH ). UNH is diversified health care company that operates through four segments: UnitedHealthcare, Optum Health, Optum Insight, and Optum Rx. The company is expected to generate FY23 revenue of over $355 billion and has a long track-record of excellent dividend growth:

UNH's current dividend is $6.60/share, which represents an estimated payout ratio of ~29%. The stock is up 5.2% over the past 12-months and currently trades with a rather rich forward P/E = 24x.

Johnson & Johnson ( JNJ ) is the #2 holding with a 8.9% weight. JNJ manufactures and sells a variety of popular name-brand healthcare products. These include the Aveeno brand of baby &beauty brands, Listerine, Neutrogena, Tylenol, Sudafed, Benadryl and Zyrtec allergy products, Motrin, and the Nicorette smoking cessation products - among many others. JNJ is +4% over the past 12-months, yields 2.6%, and trades with a forward P/E = 17.6x.

Pharmaceutical companies are well-represented in the fund with Eli Lilly ( LLY ), Pfizer ( PFE ), AbbVie ( ABBV ), Merck ( MRK ), and Bristol-Myers Squibb ( BMY ) holding down the #3 through #6 and #10 positions, respectively. In aggregate, these companies have a ~25% weight in the portfolio and typically pay strong dividends. Indeed, their returns over the past year are shown below:

As you can see, big pharma - with the exception of Pfizer - have performed very well this year. Pfizer's performance is somewhat of a mystery to me considering that China is, apparently, going to be heavily reliant on PFE's Paxlovid Covid-19 treatment as it attempts to remove the "Zero-Covid" restrictions for a population that is nowhere near herd immunity and is under-vaccinated.

Abbott Labs ( ABT ) is the #8 holding with a 3.6% weight. As I reported in a previous Seeking Alpha piece, Abbott faces tough year-of-year comps going forward as demand for its Covid-19 tests is likely to fall dramatically (see ABT Prepares For A Tough 2023 ). ABT shares are down 22% this year, yet still only yield 1.89%.

As for the entire IYH portfolio, it has allocated capital into the following healthcare sub-sectors:

As can be seen, the fund is heavily weighted toward big-pharma and biotechnology, which together represent ~50% of its total market value.

Performance

As mentioned earlier, the IYH ETF has an admirable 10-year average annual returns of 13.1% (as of end of September).

The following graphic compares the 5-year total returns of the IYH ETF with some of its peers: the Fidelity Healthcare Fund ( FHLC ), the SPDR Health Care Select ETF ( XLV ), and the Vanguard Health Care ETF ( VHT ):

As can be seen - with the exception of the FHLC ETF - these funds have relatively closely tracked each other, with the SPDR Healthcare Select Fund outperforming the IYH ETF by 5.2% over the past 5-years. Much of that out-performance is likely due to the fact that the XLV expense fee of 0.10% is a full 29 basis points lower than the IYH ETF's 0.39% fee. That is a considerable difference which, over time, certainly adds up.

Risks

Although a diversified healthcare ETF is, in general, more defensive in nature than the broad S&P500, it is not without the current macro-environment risks of high-inflation, higher interest rates, and the negative impact of Putin's war-on-Ukraine which has arguably broken the global energy & food supply chains. Any or all of these factors could lead to a significantly slower global economy and/or a recession that would put downward pressure on the overall market and the healthcare sector as well. That being the case, for investors wanting to establish a core-position in the healthcare sector, I would suggest dollar-cost-averaging over time so as to take advantage of market volatility to buy on dips.

Summary & Conclusions

Healthcare would appear to be an excellent thematic choice for the New Year given the still challenging macro-investment environment. That said, given the IYH ETF's relatively high expense fee of 0.39%, and although I like the fund's portfolio, I see little reason to choose it over the XLV ETF - which has outperformed IYH over the past 5-years and can save you 29 basis points on the expense fee. That being the case, I rate IYH a HOLD and advise investors to BUY the XLV ETF instead.

I'll end with the chart below, which is a 10-year total returns comparison of the two funds:

For further details see: