XLV - XLV Likely Back To Outperforming

2023-12-20 21:46:55 ET

Summary

• The Health Care Select Sector SPDR® Fund ETF has historically outperformed the S&P 500 with lower volatility.
• The ETF has underperformed this year, potentially due to the strong performance of the tech sector.
• Consensus estimates suggest that the ETF may see revenue growth and EPS growth in the coming years, indicating a potential recovery.

Summary

The healthcare sector is generally synonymous with two very positive traits sought out by investors, defensive or inelasticity of demand and growth. Key drivers are an aging and longer-lived population, a sedentary lifestyle, and technological advances that create a virtuous cycle of increasing demand. To fund these miracle drugs, equipment, and procedures humans, in the USA, rely on health insurance that completes or starts the vitreous cycle. The Health Care Select Sector SPDR® Fund ETF ( XLV ) lives up to these traits and has outperformed the SP500 ( SPX ) with lower volatility (0.68 Beta).

Performance

As mentioned above, the XLV has outperformed the SP500 with lower volatility in the last 20 years. However, it is almost flat this year while the market is up 24% for a significant negative alpha. The ETF has never underperformed so poorly since its inception and has beaten the SP500 by 1.5% on average. This event may mean that the tech side of the SP500 has carried the performance or is something wrong with the healthcare sector?

Portfolio Overview

The XLV has 64 holdings of which I gathered consensus data for 35 or 90% of the AUM. I calculated a weighted upside potential of 10% from analyst YE24 price targets. This suggests that the ETF may reverse the poor results seen in 2023. There are several outliers with over 20% potential upside: Merck ( MRK ), Bristol Myers ( BMY ), and HCA ( HCA ). There are only two stocks with downside: Humana ( HUM ) and Agilent ( A ).

Revenue and Margins

The basics of most companies is to sell more services or products every year and maintain or improve margins along the way. Revenue growth comes in many forms, the best is market creation i.e., creating demand via innovation. Then there keeping up with the growth of the market i.e., GDP, population, and other demographics that in the case of the healthcare sector are structurally high. Finally, growth can come from market share gain, which means the company is executing better than its competition. Growth via M&A, in my view, does not count.

The fund, on consensus estimates, could see revenue growth of 6% in the YE24-25 period which is indicative of a more mature sector and especially the market leaders. The main EPS drive is an increase in margins with estimates pointing to a 300 basis point gain by YE25 driven by Eli Lilly ( LLY ) and Merck.

EPS Growth

Using consensus estimates I calculated that the ETF may produce EPS growth of 11% in the YE24-25 period, in line with the SPX’s 11% estimate. It appears that YE24 is a significant recuperation year with almost 22% EPS estimated after a poor YE23 that was greatly influenced by a return to normal earnings post-pandemic. Merck and Elevance stand out with over 35% EPS growth. Index and ETF heavyweights, United Health ( UNH ) and Eli Lilly have consistent 12% EPS growth forecasts.

Valuation

The ETF is trading on a weighted average PE of 19x for YE24 on consensus estimates vs EPS growth of 11% and a PEG of 1.7x, which is a bit lower than the SPX. This is not a value portfolio; the healthcare sector has rarely traded below the broader market given its resilient growth characteristics. I would venture to say that healthcare has a good chance of outperforming the market in 2024, especially in the face of a GDP slowdown.

Conclusion

I rate XLV a Buy. The healthcare sector should continue to offer investors resilient growth through economic cycles that can outperform the broader market over the long term. Heading into 2024 the ETF's underperformance may begin to reverse especially in a GDP slowdown.

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