FHLC: Healthcare Dashboard For April (NYSEARCA:FHLC)

This monthly article series reports aggregate industry metrics in healthcare. It is also a top-down analysis of ETFs like Health Care Select Sector SPDR ETF (XLV) and Fidelity MSCI Health Care Index ETF (NYSEARCA:FHLC), whose largest holdings are used to calculate these metrics.

Shortcut

The next two paragraphs in italic describe the dashboard methodology. They are necessary for new readers to understand the metrics. If you are used to this series or if you are short of time, you can skip them and go to the charts.

Base Metrics

I calculate the median value of five fundamental ratios for each industry: Earnings Yield (“EY”), Sales Yield (“SY”), Free Cash Flow Yield (“FY”), Return on Equity (“ROE”), Gross Margin (“GM”). The reference universe includes large companies in the U.S. stock market. The five base metrics are calculated on trailing 12 months. For all of them, higher is better. EY, SY and FY are medians of the inverse of Price/Earnings, Price/Sales and Price/Free Cash Flow. They are better for statistical studies than price-to-something ratios, which are unusable or non-available when the “something” is close to zero or negative (for example, companies with negative earnings). I also look at two momentum metrics for each group: the median monthly return (RetM) and the median annual return (RetY).

I prefer medians to averages because a median splits a set in a good half and a bad half. A capital-weighted average is skewed by extreme values and the largest companies. My metrics are designed for stock-picking rather than index investing.

Value and Quality Scores

I calculate historical baselines for all metrics. They are noted respectively EYh, SYh, FYh, ROEh, GMh, and they are calculated as the averages on a look-back period of 11 years. For example, the value of EYh for healthcare providers in the table below is the 11-year average of the median Earnings Yield in this industry.

The Value Score (“VS”) is defined as the average difference in % between the three valuation ratios ((EY, SY, FY)) and their baselines (EYh, SYh, FYh). In the same way, the Quality Score (“QS”) is the average difference between the two quality ratios ((ROE, GM)) and their baselines (ROEh, GMh).

The scores are in percentage points. VS may be interpreted as the percentage of undervaluation or overvaluation relative to the baseline (positive is good, negative is bad). This interpretation must be taken with caution: the baseline is an arbitrary reference, not a supposed fair value. The formula assumes that the three valuation metrics are of equal importance.

Current data

The next table shows the metrics and scores as of writing. Columns stand for all the data defined above.

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Value and Quality chart

The next chart plots the Value and Quality Scores by industry (higher is better).

Evolution since last month

The value score has improved across the sector, especially in pharmaceuticals and biotechnology.

Momentum

The next chart plots median returns by subsector.

Interpretation

According to my monthly S&P 500 dashboard, the healthcare sector is overvalued by 14% based on 11-year averages. Healthcare providers are overvalued by only 6%, whereas other subsectors are overvalued by 18% to 30%. Healthcare equipment is the less attractive industry, combining the lowest value and quality scores.

Fast facts on FHLC

Fidelity MSCI Health Care Index ETF started investing operations on 10/21/2013 and tracks the MSCI USA IMI Health Care Index. It has 368 holdings and an expense ratio of 0.08%, similar to XLV fee (0.09%).

The portfolio is quite concentrated. The top 10 holdings, listed in the next table with fundamental ratios, represent 48.4% of asset value and the top 3 names weigh 23.5% in aggregate.

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Ratios: Portfolio123.

Since its inception, FHLC has underperformed XLV, as reported in the next table. However, the gap in annualized return is only 26 bps, which is not really significant. The risk measured in maximum drawdown and standard deviation of monthly returns (“volatility”) is similar.

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Fidelity MSCI Health Care Index ETF has more holdings than XLV (368 vs. 66), but it has not made a significant difference in performance since October 2013. These ETFs are equivalents for long-term investors. Nevertheless, XLV has a much higher trading volume, making it a better choice for swing trading and tactical allocation. Both funds are concentrated in the top 10 holdings. Investors seeking a more balanced portfolio may prefer Invesco S&P 500 Equal Weight Health Care ETF (RSPH).

Dashboard List

I use the first table to calculate value and quality scores. It may also be used in a stock-picking process to check how companies stand among their peers. For example, the EY column tells us that a large pharma/biotech company with an Earnings Yield above 0.0344 (or price/earnings below 29.07) is in the better half of the industry regarding this metric. A Dashboard List is sent every month to our Investing Group subscribers, with the most profitable companies standing in the better half among their peers regarding the three valuation metrics at the same time. The list below was sent to subscribers several weeks ago based on data available at this time.

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It is a rotational model with a statistical bias toward excess returns on the long term, not the result of an analysis of each stock.