FTXH - PPH: Ignore The Election Scare Buy Pharma And Healthcare

2024-01-19 07:03:28 ET

Summary

• Pharmaceuticals underperformed the S&P 500 in 2023 but have been outperforming the broader market in 2024.
• The PPH fund offers exposure to pharmaceutical stocks and has outperformed its peers in terms of performance and liquidity.
• The fund is undervalued compared to the projected earnings growth of its top holdings, making it a compelling pick for investors.

Investment thesis

The healthcare sector massively underperformed the S&P 500 Index in 2023. The pharmaceuticals and drugs category within the broader healthcare sector was among the worst hit. While the S&P 500 Index ( SP500 ) rose 24% last year, the Pharmaceuticals Industry Index (SP500-352020) lost 2.2% in value. On the other hand, the VanEck Pharmaceutical ETF (PPH) was still marginally better than the broader Pharmaceutical Industry Index last year, etching out gains of just 4.7%. PPH's top two holdings, Eli Lilly (LLY) and Novo Nordisk (NVO), were a handful of pharma stocks that stood out with impressive gains in 2023.

Three weeks into 2024, and I see how pharmaceuticals have been outperforming the broader market indices. While the S&P 500 Index is still flat in terms of YTD performance this year, PPH is up 3.6%. Risks still persist for pharmaceutical stocks, but I believe the worst has been priced in, and I expect PPH to begin outperforming broader market indices starting this year.

About the PPH fund

PPH is owned and managed by the NYC-based asset management firm VanEck. The fund offers exposure to pharmaceutical stocks mostly in the U.S. markets but may also allocate capital towards large pharmaceutical stocks globally. According to the PPH's prospectus, the fund "seeks to track the most liquid companies in the (pharmaceutical) industry based on market capitalization and trading volume."

The fund achieves this objective by tracking the MVIS US Listed Pharmaceutical 25 Index as closely as possible. Constituents of this underlying index are capped at a maximum weight of 20% of the entire index, with each company generating at least 50% of its revenue from pharmaceutical-related products and services, as per the underlying index methodology. In addition, the index stipulates that the daily trading volume should be at least $1 million on a three-month basis to keep the index, and hence, the PPH fund is fairly liquid, in my opinion. Given that the pharmaceutical sector constantly involves its own unique risks when it comes to investing, I like the ability to invest in the PPH fund with narrow bid-ask spreads, made possible due to the liquid nature of the ETF. I will cover the risks of investing in pharmaceutical stocks in a later section.

I have also added an overview of the fund's holdings below and will use this to compare the fund to its peers in the next section.

Peer comparison

The first observation I will note from the charts in my holding analysis above is that PPH holds some of the largest pharmaceutical companies in the world. Moreover, in addition to providing exposure to some of the largest U.S.-based pharmaceutical conglomerates, the fund also offers exposure to some of the largest multinational pharmaceutical companies around the world, like Novo Nordisk and Novartis. I have added a comps chart below that compares PPH with its peers. I have excluded the SPDR S&P Pharmaceuticals ETF (XPH) because of its consistent lack of performance, low-to-no history of dividend growth, and fairly high portfolio turnover.

It's really easy for any investor to notice how PPH stands out in stark contrast to all its peers. Having launched just over a decade ago, I see a dichotomy in the performance of PPH over its peers over all the time periods that I highlighted above in the chart. Further, the fund is at least three times more liquid than any of its peers and offers the largest dividend yield of the lot at over 2%, while costing the average investor just 36 cents for every $100 invested in the fund.

Fund performance

Given how PPH stands out with its peers, I am compelled to compare the fund to the larger healthcare sector via the Health Care Select Sector SPDR Fund (XLV) and measure performance over time while also juxtaposing the benchmark S&P 500 index's performance.

In terms of broader performance, while the broader healthcare sector XLV outperforms the PPH over a 5-year horizon, the latter has started to perform much better on shorter time frames such as 3-year, 1-year, and especially the 6-month and 1-month time frames. Moreover, taking into account the extreme volatility that we witnessed in 2022, I see how PPH competes not only with the XLV but also with the S&P 500 index on a 3-year basis. Add to these performances the relatively low-cost dividend yield the PPH fund offers, and I strongly feel PPH becomes a compelling pick to gain exposure to the pharmaceutical sector on a performance basis.

Valuation

To estimate the value of the fund, I looked at the projected EPS gains of the top 15 stocks in the PPH fund, which represent ~80% of the fund's assets, and compared them with their forward PEs on average.

Given that the S&P500 is projected to grow its earnings by ~11.4% this year as per FactSet , the average estimated gain in earnings to be seen by the pharma stocks that represent about 80% of the PPH fund's assets makes for a compelling risk-reward bullish case. I find the PPH fund undervalued given that the average forward premium I am expected to pay to gain exposure to the pharmaceutical sector is just 19.5 for an expected average gain of 51.5% in EPS. I find the bearishness in this sector unjustified.

Risks to bull thesis

Unlike most other sectors, exposure to the pharmaceutical sector always has its own unique risks, the biggest of all being regulation. Within regulation, one of the biggest concerns that plagued some large healthcare and pharmaceutical sectors was antitrust regulation. However, I believe that the worst of those fears is already baked into stocks within the PPH fund since some of the largest acquisitions in the pharmaceutical sector ( Pfizer's acquisition of Seagen and Amgen's acquisition of Horizon Therapeutics ) were cleared by the FTC a month ago. I believe this could be one of the reasons why investors allocated their capital towards pharmaceutical stocks, leading to PPH performing better than the S&P500 index and XLV over the past month, as I observed in an earlier section.

Another big reason that usually challenges the bullish thesis for pharmaceutical stocks and the PPH fund is elections. According to analysis done by the WSJ , the broader healthcare sector returns around 17% on average in pre-election years. But these returns fall to around 7% in election years based on Dow Jones Market Data going back to each sector's inception.

Per my observation, pharmaceutical stocks are usually the subject of intense political debate during election years, with topics such as drug price reforms and healthcare affordability being leading themes in the election campaigns of presidential candidates. However, I believe the worst may be priced in here as well. Last month, the current White House administration announced efforts that authorized concerned governmental agencies to invalidate patents on certain high-priced drugs. Still, the PPH fund and other pharmaceutical stocks continued to beat the markets in terms of performance, despite the announcement last month. By observing this, I believe again that the PPH could be poised for some gains this year, unlike what most market participants may believe.

Takeaways

PPH is clearly the most cost-effective, high-yielding, yet best-performing ETF when it comes to gaining exposure to the pharmaceutical sector. There are risks that exist when it comes to investing in the PPH, but my strong belief is that most of the risks are already priced in, and the PPH is currently poised for modest gains. I rate the PPH ETF as a buy.

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