The crowd at Merrill Lynch came up with an interesting way to describe where to invest during various market cycles. In the “overheat “stage of the cycle, for example, the firm recommends investors loading up on technology and basic materials, rotating into commodities and cyclical value afterwards. It advocates to buy defensive value in times of stagflation or weakening growth, calling for an allocation to healthcare and other consumer staples, for example.
The question of whether a diversified basket of healthcare equities is the right choice of allocation at this point in time would largely depend on the view of the US and global economy in the coming 12-24 months. In the “hard landing” camp, one may be more attracted to statistical discounts within broad healthcare. Those in the quote “soft landing” camp may be more interested in the biotech spectrum, or even medical technology plays.
The point is that either side of the coin would likely prefer more selective opportunities within the realm of healthcare. Owning a diversified portfolio of growth and value healthcare securities may appeal to both sides, or, may appeal to none at all-precisely one of the major headwinds with investing in the space. Healthcare is inherently a broad stratum of various industries that may or may not have adjacent qualities. Different sub-industries within this group also perform at vastly different magnitudes over a 5 to 10-year horizon. Most specifically, these sub-industries are likely to exhibit favourable economics at different times within the business cycle and investment cycle.
Nevertheless, with the recent snapback rally in broad equities since the Fed Reserve’s decided to pause its hiking cycle for the second time since July, all names within the sector are worth a thoughtful analysis.
For investors seeking this broad exposure to the healthcare domain, the S&P 500® Equal Weight Health Care ETF (NYSEARCA:RSPH) is one holding that deserves attention. The fund has been around since 2006 and invests in US public markets. All holdings are concentrated in the various healthcare sectors. It has nearly matched the capital appreciation of the S&P 500 index over the last 10 years and aims to track the S&P 500 equal-weight healthcare index. Because this benchmark includes primarily constituents of the actual S&P 500 index, movements in the broad market main weigh in heavily on the fund’s short term performance.
The top 10 holdings, of which there are 66, comprise 18.5% of the entire portfolio. Its biggest names are those such as Cardinal Health (CAH), UnitedHealth Group (UNH) and Vertex Pharma (VRTX), so investors can own a portfolio of some of the major healthcare names in the US, albeit with one instrument in owning RSPH.
Dividends that are paid quarterly currently yield 0.74% on cost on a trailing payout of $0.19. It has $858mm in assets under management and charges and expense fee of 40 basis points on this amount. YTD performance has lagged other prominent sectors and the fund is down nine percentage points this year.
There are additional factors to consider in the RSPH investment debate. For one, healthcare is a continuum and owning selective opportunities within the space may be a better alternative right now. This is especially true with the pressure on market breadth seen this year.
Secondly, investor risk appetite has been reunited with a fresh flame over the past two weeks following the Federal Reserve decision outlined earlier. Capital flows will likely be biased towards high beta names with more exciting growth prospects, at least in the near term.
Finally, long-term earnings growth for the healthcare sector as a whole could lag behind its counterpart in technology, services, and other consumer cyclical segments. If it is capital appreciation one is after, versus income for example, then it would appear more prudent use of capital to (i) search for more selective opportunities within the space or (ii) consider allocations to adjacent portions of the market.
In that vein, my recommendation across all three investment horizons are the following:
- Short term (coming 12 months) – neutral; despite compressed market values, the fund still trades at around 20x earnings putting it at the upper bound of valuation across sectors and selective instruments. This reduces the scope for outsized returns in the coming 12 months, and I also believe it would be difficult to outgrow its valuation at this premium. Needs a major pullback to 13-15x earnings.
- Medium term (1-3 years) – Neutral; earnings growth in healthcare was softer than expected in Q3, and projections were equally as soft looking ahead. One has to consider the opportunity cost in this instance, and whilst there may be individual opportunities of earning growth within the domain, broadly speaking, high starting valuations and lagging earnings growth aren’t attractive combinations for a medium-term Horizon. I would avoid adding on pullbacks and potentially consider other instruments for exposure to the space.
- Long-term (three years plus) – neutral; related to point number two, with US GDP still in reasonable shape looking forward, full conviction is needed that healthcare in the large caps will exceed returns on business capital and dividend + earning growth. Either look for selective opportunities within the space or look for separate sectors.
Collectively my outlook on RSPH is balanced and I rate the fund a hold based on the factors raised in this report.
Figure 1. RSPH long-term price evolution-broke 50DMA + 200DMA, testing support level + bottom of 2022.
- Potential disruptions to consider?
Healthcare, in many respects, is a kin to the technology and communications sectors in that disruption and speed of innovation are rife. In an equal number of ways, this is for good cause. Improving medicines, surgical procedures, medical devices and so forth are critical factors in improving our quality of life. in the mid-80s and early 90s came the biggest advancements to treating blood pressure in the form of blood pressure medications. Naturally, all treatment-related sectors serving blood pressure were immediately impacted.
We have a similar phenomenon occurring now with the emergence of anti-obesity medications (“AOMs”), which have arrived on the scene as a crossover therapy from diabetes. Ozempic is the major label that comes to mind; however, research from Goldman Sachs (GS) estimates that the AOM market was $6Bn this year, and by 2030 it could increase by 16 times to $100Bn. The firm notes:
The Centers for Disease Control and Prevention estimates that obesity-related medical costs in the US were about $173Bn in 2019. The World Obesity Atlas estimates that the total costs attached to obesity – both healthcare and productivity related – will exceed $4 trillion worldwide by 2035, or about 3% of global GDP.
These are no small numbers. And it would appear that many healthcare sectors could potentially be impacted. We saw the kidney and dialysis providers sell off sharply when Ozempic and other GLP-1 agonists demonstrated favourable results in kidney disease. The diabetes names have been hit equally as hard.
All of this is within an interesting trend that presumes these medications will be the resolve for a great number of medical conditions, which the market seems to assume will have a negative bearing on the companies involved. Whether or not this will be the case remains to be seen. But I guess the point is there is a continued threat of disruption within healthcare. In many instances, this drives capital investment, research and development, and other investments in the space so that the top players don’t get complacent and remain at the tip of the spear. Still, a threat looms for these players as technology integrates increasingly into the various industries. In that vein, it would be wise to pay attention to AOMs.
- Healthcare majors still constructive on long-term outlook
As the economy wrestles with a number of macroeconomic and geopolitical headwinds, it appears that healthcare majors are still reasonably constructive on the future. The 2023 midyear business leaders outlook for healthcare conducted by JPMorgan (JPM) earlier this year captures this sentiment well.
The analysis made a number of critical findings, including the following:
- The executives of middle-sized healthcare companies in the US are more optimistic on the US economy than at the end of last year,
- The majority of healthcare leaders quote anticipate a recession in 2023″,
- Despite this, many organisations are robustly planning their strategies to deal with a potential downturn in business,
- Around 50 to 60% of those surveyed are considering telehealth and remote monitoring. There are benefits of scale and more efficient allocation of time under this structure. 70% of respondents also said they were looking at AI integration.
If we were to enter a recession, then US healthcare companies would be looking at strategies like those outlined in Figure 3.
The majority would prioritise their most profitable product lines and consider strategic investment to maintain their competitive position. However, a large body would also still consider introducing new products or services and expand into new avenues of distribution.
This is quite encouraging as it clearly demonstrates that leaders within healthcare are prepared to commit growth capital to risk regardless of the economic environment. This is precisely why Merrill Lynch, in its investment clock discussed earlier, advocates for healthcare within more uncertain times. This is certainly a balancing fact for RSPH, and it will remain on my watchlist as we continue navigating the current market cycle.
- Q3 earnings + forward estimates strong in most sectors, except healthcare
Q3 earnings were reasonably strong across all reporting sectors but were exceptionally strong in tech, communication services and financials. Healthcare on the other hand, missed bottom-line estimates on aggregate despite performing with respect to sales growth. In fact, more than 70% of financials, communications and healthcare companies reported revenues above consensus estimates last quarter, per FactSet analysis.
Despite this, healthcare reported the third largest YOY decrease in earnings across all sectors, with a median 17.7% decline. Around 60% of the segment reported weaker earnings than Q3 2022, with pharmaceuticals and biotechnology down 42% and 20% YOY respectively. It was only healthcare providers/services and equipment suppliers that grew earnings 8% and 6% YoY respectively.
Curiously enough, earnings growth forecasts for 2024 have healthcare in third place with 15.7% projected, likely from such a low base this year (Figure 4).
For RSPH this has quite profound implications:
- On the one hand, the fund is trading at a premium of around 20x earnings, ahead of being category average of 17.61x earnings and FactSet’s segment average of 13.6x.
- On the flip side, this is roughly in line with the benchmark indices’ 20x forward P/E (Figure 5), or with exceptional growth forecasts currently baked in these multiples.
What is needed in this vein is a surprise or revision to expectations to the upside. Difficult to accurately identify what this might be for it to impact the entire healthcare sector and, therefore, an instrument with balanced weightings in its portfolio.
Figure 5. S&P 500 12m Fwd. P/E (Source: UBS)
As such, my judgement on the outlook for US healthcare is mixed at this point in time. The predictability and distributions of future cash flows are equally as mixed, and whilst there is potential fortitude in the projected earnings growth in the sector, my judgement is that this is typically confined to pockets of the market and not the sector in its entirety at one point in time. This supports a neutral view.
1. Regarding momentum
- The jump into November saw us climb above the 20-day moving average low and high. Although, we have not set a period of new highs and lows.
- The 2x gaps up coincided with a bullish cross of the MACD, and this has held to this date, along with a reversal showing on the parabolic SAR.
- Like many instruments, shortly after the reversal rally, the trend exhausted quickly, and the rate of change lost momentum. We are now tracking back to the short-term moving averages.
2. Skew, price distribution
Observations: We completed the distribution in October, which saw the market find balance around the $27s (Figure 7). Interestingly enough, we opened November below the balance, and the distribution has expanded to the downside. For context on the directional view, note the three pockets of low usage in Figure 8. Price control is currently contained within the new distribution, but if it expands beyond the current balance, it could look to fill these low-usage areas. The high-volume ledges would serve as clear points of resistance, given the heavy competition noted at these marks. If it continues to fill the distribution by expanding below the previous balance, we know the market is imbalanced and it is best to wait to look for a directional view. Until then, the full distribution is not yet completed, so a directional hinges on the market’s ability to expand out of this current balance to the upside.
Key levels: Investors should watch key resistance levels as the three measures on the historical profiles to the upside at $27 $28 and $29, and we could find support at the bottom of the profile, which is around the $24s.
Actionable strategy: given the positive skew of the distribution with multiple peaks, expansion away from the previous balance to the downside, and price control in the lower distribution, I would look for price to trade at the tops and bottoms of value to hold the new point of compression. Range is therefore supported over a directional set up.
3. Directional trend bias
Observations + key levels
Figure 9. Short-term (60-minute chart, looking to coming days)-
- There is still time to retrace 50% of the latest down wave, which corresponds with the top of the marabuzo candle of last week.
- We reversed off the lows fairly convincingly with a bullish and golfing candle and continuation pattern where range has continued higher at each subsequent session.
- We still have time to retrace 50% of the move as mentioned, and from here, we would be looking to the $26.30 region at the top of the cloud and then past $26.50 as the cloud top by the end of this week. Above $26.70 has completely retaken the previous high.
Figure 10. Medium-term (daily chart, looking to the coming weeks)-
Observations + key levels
- Less convincing on the daily chart, with the gap higher in November retaken following the bearish engulfing candle and new marabuzo line last week.
- Move came from the fundamental catalyst and was seen in the hammer and subsequent 2 green candles to confirm the reversal end of last month.
- With the attempted breakout to new highs last week, selling volume was immense and above the three-week average. Last time we saw this in October RSPH sold off sharply.
- Key levels to watch are the $27s to $28s. Above $27.20 by December would have us testing the cloud. I am neutral based on this chart.
Figure 11. Long-term (weekly chart, looking to coming months)-
Observations + key levels
- We remain within the long-term downtrend despite the attempted reversal over the last two weeks. This started in August when broad equity markets began to roll over.
- Each attempted reversal since the selloff began has been met with fierce opposition and resulted in nothing but tight closes/doji setups. there has been no conviction from the buyer over this time.
- The key levels to watch are those seen at 2) and 3) as these correspond with marabuzo levels that have been tested and rejected in the past few months. These are in the $26s-$28s. On the downside, anything below $25 would be remarkable and indicate a further selloff.
In short, my judgement on RSPH is mixed and there is a lack of conviction on the fund’s performance over (1) adjacent sectors with high beta characteristics, and/or (2) selective opportunities within the healthcare sector that display idiosyncratic properties.
As we’ve seen in this analysis, for investors to lift the bid on the entire healthcare domain, a truly remarkable catalyst is required. More likely is the performance of various subsets within the spectrum.
Then we have the mixed growth economics illustrated by healthcare companies in Q3 earnings and forward projections. On the one hand the sector underperformed technology and financials peers, but on the other, expectations for earnings growth next 12 months are strong. But RSPH’s technicals are weak and starting valuations of 20x forward earnings is a bit of a stretch that could clamp upside over the coming year if paying those prices. Collectively, I rate RSPH a hold.