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An Effective Approach to Healthcare Investing

Silver-rated Fidelity Select Health Care skillfully blends steady growers, fast-growing established firms with focused product lines, and emerging companies with innovative products.

Christopher Davis, 09/02/2017

The following is our latest Fund Analyst Report for Fidelity Select Health Care Fund FSPHX

A differentiated, well-executed investment process, a well-resourced team, and relatively low costs justify Fidelity Select Healthcare's Morningstar Analyst Rating of Silver.

Manager Eddie Yoon seeks firms that can grow cash flows rapidly. He buckets prospective picks based on the predictability of their cash flows, giving the most stable stocks heaviest weight. These names provide a counterweight to the faster growing biotech, drug, and medical equipment stocks that he favors. The latter tend to have more unpredictable fundamentals, a risk he manages by holding smaller positions. The largest holdings have far lower levels of fair value uncertainty, a Morningstar equity research measure of business predictability, than his smallest picks. Morningstar attribution data indicates Yoon has added value over the fund's benchmark, the MSCI US IMI Healthcare 25-50 benchmark, across the predictability spectrum.

Yoon's taste for firms with less diversified product lines makes it especially important to correctly assess the size of a treatment's target market and prospects with regulators, doctors, and patients. The fund benefits from investing know-how and scientific expertise. Yoon has approximately 15 years as a healthcare investor, including nearly a decade here. He draws upon Fidelity's large, 15-person analyst team. This group includes younger analysts serving shorter stints; Rajiv Kaul, who has been lead biotech analyst for more than a decade; and Yoon himself, who follows medical equipment stocks. Two analysts, one covering biotech and the other pharmaceuticals, have deep science and investing backgrounds. Yoon and his team have blunted stock-specific risk with sound portfolio construction, but the fund's smaller-cap bent and reliance on names with less-certain fundamentals have helped make it more volatile than its benchmark. He has made such volatility worthwhile with benchmark-beating risk-adjusted returns. The fund's Sharpe ratio beats 95% of health fund peers over Yoon's tenure. The fund's moderate expense ratio--it is the second-cheapest actively managed diversified healthcare fund--improves Yoon's odds of continued success.

Process Pillar:
 Positive | Christopher Davis 08/24/2017
Manager Eddie Yoon seeks firms he and his analyst team believe can generate ample free cash flow relative to industry peers. Yoon primarily looks for firms that can reduce costs in the healthcare system, though he also buys firms he believes can justify charging higher prices for innovative products.

Yoon splits the portfolio into three categories: stable firms with steady growth prospects, faster-growing but established firms with focused product lines, and emerging companies with new and innovative products and services. Most of the fund's assets fall into the first two categories, while the fund spreads just 10%-15% of assets across the third, more speculative category. Yoon and his analyst team develop normalized free cash flow estimates by forecasting sales growth and margins, and evaluate how well management allocates capital. The less predictable the cash flows, the lighter its weighting in the portfolio. Skimping on the sector's biggest players exposes the portfolio to stocks with more uncertain fundamentals. Yoon has managed this risk effectively with sound portfolio construction and a strong research game, earning this fund a Positive Process rating.

As Fidelity's lead healthcare analyst, its diversified managers often follow Yoon's lead into such names, giving parent FMR large stakes in the companies. This constraint could limit Yoon’s flexibility, but it doesn’t appear to have done so yet.

Eddie Yoon invests broadly across healthcare subsectors, but the fund has long been underweight growth-starved pharmaceuticals. Without big-cap drug stocks like Johnson & Johnson, its 17% stake is about half the MSCI U.S. Investable Market Health Care 25/50 Index's 31% weighting. Instead, he has favored biotech names like top holding Amgen. The subsector makes up 27% of the fund, versus 23% of the index. This overweighting has shrunk in recent years to make room for more medical equipment makers, including blue chips such as Boston Scientific and Illumina, which makes DNA analysis tools.

The portfolio is more concentrated than usual in its largest holdings, with nearly 50% of assets in the top 10 (43% is the average under Yoon). Yoon says larger-cap names have become more attractive on valuation and that their relative stability allows him to build bigger positions. While large caps account for a bulk of the portfolio, small caps still account for 20% of assets, well above 8% for the benchmark.

Christopher Davis is a senior fund analyst with Morningstar and editor of Morningstar's Fidelity Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. He welcomes e-mail but cannot give investment advice. Click here for a free issue of the Fidelity Fund Family Report.

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