2023-09-17 06:55:11 ET
Summary
- Healthcare sector faces negative trends in 2023: higher interest rates, Medicare drug price negotiation, and capital flows favoring technology.
- BlackRock Health Sciences Trust is a solid long-term performer with a modest distribution.
- We give you three reasons why we prefer it over THW.
Healthcare has been at the crossroads of multiple negative trends for 2023. Higher interest rates have made the defensive sector unappealing. The Medicare drug price negotiation has put additional pressure on the growth story. Finally, investor love for Artificial Intelligence has meant that no other sector other than technology has been a beneficiary of capital flows.
We have covered a funds in this sector before and these have included Tekla Healthcare Opportunities Fund ( THQ ), Tekla World Healthcare Fund ( THW ) and Health Care Select Sector SPDR® Fund ETF ( XLV ). Today we add one more to the list, BlackRock Health Sciences Trust ( BME ) and tell you why this gets our rare buy rating. We also tell you three reasons why we prefer it over THW.
The Fund
BME's investment objective is to provide total returns through a combination of income and capital appreciation. Their mandate is to invest 80% of their capital in health sciences industry, though they tend to get this number to almost 100% most of the time. The fund had 145 holdings as of June 30, 2023 with UnitedHealth Group Inc. ( UNH ) making it to the top of the list.
The fund is modestly concentrated at the top end, but unless this is the only security you plan to own, the concentration should not bother you.
It also sells covered calls on the underlying equities, and as of the most recent check, this figure covered about a third of the total holdings.
The fund has been around since 2005 and has racked up impressive returns since its inception. The returns on NAV have been extremely impressive, and what is even more impressive here is that it has done so while doling out big distributions.
Most funds struggle with balancing high distributions with NAV preservation. The end results is usually that NAV gets depleted over time. Investors may think that this hurdle is the same as trying to outperform the market. But it is actually different. When you have to constantly give distributions that exceed the underlying holdings' dividend yield, you have to make decisions as to which securities you need to sell. That makes it even harder to outperform markets compared to funds that don't have a managed distribution plan.
In BME's case, the regular distributions have only gone up since inception, The fund's switch from quarterly to monthly payouts coupled with the above fact has endeared it to many income investors.
Comparing To THW
THW is in the same sector and has a similar amount of total assets under management. Both funds offer a solid yield and also use covered calls to augment returns.
While we can pick a multitude of targets to run comparisons against, we tend to pick ones where a switch would prove most beneficial. In other words, there has to be some alpha to be had in the suggested move, and we will avoid comparisons with funds that are close to our protagonist. As you shall see below, there are three distinct reasons we prefer BME.
1) NAV Preservation
A critical criteria for our choice is that the managed distribution should not erode NAV over time. While some investors are happy ignoring this critical detail in lieu of getting a regular payout, we cannot do that. Eventually the underlying NAV is the limiting factor in what can be paid out, and the distributions have to be cut. We have seen that in several funds recently including, Duff & Phelps Utility and Infrastructure Fund Inc. ( DPG ) and Brookfield Real Assets Income Fund Inc. ( RA ).
As we can see below, BME truly excels at this, while, THW is really struggling.
THW does boast the larger distribution yield of 10.93% versus, 6.54% for BME. It is important to note that the higher yield of THW is entirely due to the falling NAV. In other words, THW failed to generate enough capital appreciation to keep NAV stable, and hence the yield has risen. This presents a mounting hurdle for THW, one we don't think it will be able to meet.
2) Leverage
There is a time in the cycle to embrace leverage, this is not it. BME is unleveraged, with debt being a rounding error.
THW sports a similar set of total assets, with leverage driving almost 20% of the total.
THW's leverage costs have been exploding and that will make funding the distribution even harder.
The Fund maintains a $125,000,000 line of credit with the Bank of Nova Scotia (the Line of Credit) which expires on January 24, 2024. As of March 31, 2023, the Fund had drawn down $120,000,000 from the Line of Credit, which was the maximum borrowing outstanding during the period. Between October 1, 2022 through January 27, 2023, the Fund was charged interest at the rate of 0.75% plus a SOFR Adjustment plus the relevant SOFR rate. Starting January 28, 2023, the Fund is charged interest at the rate of 0.95% plus a SOFR Adjustment plus the relevant SOFR rate. The Fund is also charged a commitment fee on the daily unused balance of the line of credit at the rate of 0.10% (per annum). Per the Line of Credit agreement, the Fund paid an upfront fee of 0.05% on the total line of credit balance, which is being amortized through January 28, 2023. The Fund pledges its investment securities as the collateral for the line of credit per the terms of the agreement. The weighted average interest rate and the average outstanding loan payable for the period from October 1, 2022 to March 31, 2023 were 5.2088% and $120,000,000, respectively.
3) Pricing
This is quite simple, and BME trades at a 7% discount to NAV. We saw something similar, briefly, during the COVID-19 crisis. Outside that, this level of discount is unheard of.
THW trades at a silly 4.23% premium, completely unwarranted for this fund. THW's premium has been even higher in recent times, but we expect this to move to a discount eventually, and a big one, when the distribution is eventually cut.
Verdict
There are few easy switches out there every few months, and these present relatively easy ways to add extra alpha to your portfolio. In this case, we expect pricing dislocation to be the biggest driver of alpha between the two. If you visualize both funds trading at even NAV, we get about a 11% alpha in favor of BME over time. BME is likely to be the better performer over the long-run, and it does sell covered calls generally on a larger portion of its portfolio. That and the lack of leverage make it likely that it performs even better in an equity bear market. Those enamored with the higher distribution should note that you can get the distribution yields from BME by just selling some stock for the amount you need. But by focusing on the superior fund, you always come out ahead.
In the analysis below, we started off with $10,000 in both funds. We reinvested the distributions from both funds but withdrew $80 per month. In other words, we forced both funds to create a $960 payout per year or 9.6% on starting NAV. That analysis link can be seen here .
While both funds would be depleted over time in this timeframe, THW would do far worse.
We wish we could do a further back test, but we could only go as far back as THW's inception.
BME represents a good quality player that is distribution just 6.1% on NAV. We believe this amount is sustainable, especially with its generous use of covered calls. We rate it a Buy, and it gets a 4 on our potential pain scale.
THW on the other hand is distributing 11.39% on NAV, something we think is ripe for a cut at some point. On our last coverage of this fun d, we gave it a "Strong Sell".
Since then, the premium to NAV has compressed (gone from 12.58% to 4.23%). Hence, we upgrading it to a "Sell". THW now gets an 8 (10 previously) on our potential pain scale.
We could make the switch between THW and BME.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
BME: BlackRock's Health Sciences Fund Is A Solid Alternative To Pricey THW