2023-05-02 00:03:08 ET
Summary
- IHE invests in U.S. pharmaceutical stocks.
- Based on consensus forward earnings growth estimates, IHE looks undervalued.
- A high IRR is possible, especially if the portfolio's long-term earnings multiple can expand.
- While IHE might be characteristically "defensive", I think IHE should be more popular.
iShares U.S. Pharmaceuticals ETF ( IHE ) is an exchange-traded fund that provides investors with exposure to U.S. companies that manufacture prescription or over-the-counter drugs or vaccines. The fund had $390 million in assets under management as of April 28, 2023, with an expense ratio of 0.39%. IHE also only had 42 holdings, making it rather concentrated. The fund's benchmark index is the Dow Jones U.S. Select Pharmaceuticals Index.
IHE is, therefore, a relatively unpopular fund. The fund is liquid though, with a 30-day median bid/ask spread of just 0.07%. However, net fund flows were only about $14 million over the past year.
Healthcare is conventionally viewed as a defensive sector. While biotechnology companies can be high risk, and often small-cap stocks, IHE ETF invests in major companies such as Johnson & Johnson ( JNJ ) and Merck & Co Inc ( MRK ) as depicted below. The top 10 holdings represented 77.23% of the fund's net assets as of April 28, 2023.
The most recent factsheet for IHE can be found on the S&P Dow Jones website , which reveals trailing and forward price/earnings ratios of 28x and 14.86, respectively. The price/book ratio is stated as 3.25x, with an indicative dividend yield of 2.13%. Morningstar , meanwhile, report a three- to five-year average earnings growth expectation of 9.46%. Using an arbitrary earnings growth trajectory geared toward achieving a similar result as expected by Morningstar, but stripping out the noisy short-term effect of the difference between the trailing and forward earnings as reported by S&P Dow Jones, and keeping most other factors constant, I generate a simple IRR gauge for IHE of 12.23% per annum over the next five years.
The underlying equity risk premium is very high, especially if adjusted for the fund's five-year beta of just 0.60x. However, based on my own analysis of historical price data, while the longer-term beta is indeed lower, the more recent relative volatility for IHE (vs. the S&P 500 index) is closer to 0.9-1.2x. The beta tends to converge to a lower value over the long run, but this is in part in exchange for lower returns. You do see some softer troughs for IHE vs. the broader indices, so IHE does seem to serve as a reasonable suppressor of downside volatility, but the equity exposure is volatile to some important degree all the same.
In any event, for a fund offering the potential for an IRR exceeding 10% (possibly as much as 12% per year, then), the volatility-adjusted return profile of IHE is very good. I also think there is some potential for the earnings multiple to expand. IHE is solely exposed to companies listed in the United States, and pharmaceutical stocks are not going to disappear. The long-term earnings multiple should take this into account; I expect this to expand over the long run. An expansion to 18x (based on zero net earnings growth in real terms, plus a 5.5% equity risk premium) would boost my IRR gauge from 12.23% to a massive 16.08%. In volatility-adjusted terms, this would be very safely above average.
Therefore, while IHE is characteristically "defensive" and perhaps contrary to how one might intuitively invest in accord with the business cycle (more economically sensitive and/or cyclical stocks are expected to perform into new business cycles), IHE looks attractive. Pharmaceutical companies will always be in demand, and even by taking a more modest outlook on long-run earnings growth, IHE looks like an objectively undervalued portfolio and should be more popular.
For further details see:
IHE: Pharmaceutical Stocks Are Cheap And Offer High Long-Term Returns