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Playing Defense With A Top Healthcare ETF

By: SeekingAlpha
Posted: 12/3/2012 7:51:00 AM
Referenced Stocks: GSK;NVS;SNY;SPY;XLV
By Morningstar :

By Robert Goldsborough

Back in June, the U.S. Supreme Court ruled that the Affordable Care Act's individual mandate provision is constitutional. And earlier this month, the American people effectively weighed in as well, giving the president another four years in office. That will allow continued implementation of the Patient Protection and Affordable Care Act, or PPACA.

Even before the election, it was evident investors felt that the PPACA is here to stay. The stock prices of healthcare companies largely have kept up with--or outpaced--the rest of the market and have not reacted meaningfully to either the Supreme Court's decision or the results of the election. Had investors felt, by contrast, that the entire law would be overturned, we would have expected to see negative investor sentiment (investors hate uncertainty) and compressed earnings multiples across the sector.


Fundamental View

Many Big Pharma and biotech companies are seeing the same early effects from reform: Higher rebates for Medicaid patients (bad for biotechs because companies see lower net prices for drugs), and now, the firms are being hit by an industry tax. These drug companies will also be responsible for covering half of the "doughnut hole" costs, which is the difference between Medicare's prescription drug program's initial coverage limit and the catastrophic coverage threshold. The doughnut hole isn't as big of an issue for a lot of biotech firms as it is for Big Pharma because the doughnut hole relates to Medicare Part D drugs, and many biologics are Part B drugs. This dynamic fundamentally benefits the biotech sector because drugs reimbursed as medical benefits are Part B and not Part D drugs. This means that, because of lower out-of-pocket costs, patients don't have to go through the doughnut hole and perhaps are more likely to start or continue therapy despite the economy.

Also, Medicare Advantage cuts will hurt profitability. First, many Medicare Advantage patients likely will shift to private supplemental insurance. Second and more important, because private-payer reimbursement rates are benchmarked to Medicare, Medicare Advantage cuts will mean that private payers will follow suit by cutting reimbursement rates, particularly affecting the outpatient services that health-service providers historically have used to gain better margins from higher private-payer reimbursements.

Morningstar's equity analysts show XLV to be trading at 93% of its fair value. That compares with the S&P 500 as a whole, which trades at 91% of fair value.

Portfolio Construction NVS GSK SNY

Fees ETFs

Vanguard Health Care ETF (VHT) provides similar exposure to the sector (but has more holdings--293 in total) and charges a low 0.19% expense ratio. Fully 100% of XLV's holdings are held in VHT, and the funds' performance correlation over the past five years has been an extremely high 99%. Another alternative would be iShares Dow Jones US Healthcare (IYH) (0.47% expense ratio), which holds 115 stocks and sports a 99% performance correlation with XLV over the past five years.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

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