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ETF Specialist

Big Pharma Looks Abroad to Continue Its Run

This pharmaceutical-themed ETF uses a stock-selection methodology rather than a traditional index-weighting scheme.

The pharmaceutical industry has delivered strong stock-price performance over the past several years as investor sentiment toward Big Pharma has shifted. The subsector's valuation was pressured several years ago as investors became concerned about some of the upcoming patent expirations for some pharmaceutical companies' large and profitable drugs. In a nutshell, the investment community feared that Big Pharma was losing some of its cash cows.

Since 2010, however, pharmaceutical companies have done a solid job of outperforming the broader U.S. equity market. Firms have cut costs more than analysts had expected, and a "next generation" of drugs has come out and impressed investors, such as  Bristol-Myers Squibb (BMY) and  Pfizer's (PFE) anti-clotting drug Eliquis and Bristol Myers-Squibb's advanced melanoma drug Yervoy. Now, the sector's valuation has come up some, and investors largely now are looking beyond any patent cliffs.

Is there any upside left for investors interested in pharmaceutical companies, or has everyone missed the party? That depends in large measure on one's view on emerging markets. Morningstar's equity analysts believe that investors are discounting some strategic upside in emerging markets for Big Pharma, largely because of recent economic slowdowns and higher volatility in emerging markets.  Over the longer term, we believe that the growth opportunity and potential profitability for drugmakers in emerging markets is real. Why? Rising gross domestic product in emerging markets is directly correlated with drug spending, and consumers in emerging markets generally have been shown to prefer stronger brands, particularly when faced with generics and widespread counterfeit drugs. And while pricing power is not as strong in emerging markets, marketing expenses such as compensation costs for sales representatives are much lower, and drug prices are high enough to offer drugmakers 20%-plus operating margins. China in particular is set to become one of the most important growth drivers for Big Pharma over the next decade. Drug spending there has grown at a compound rate of 22% per year over the past six years, and our equity analysts believe Big Pharma is positioned to gain market share in a highly fragmented market.

For investors interested in a basket of pharmaceutical firms, we like the exchange-traded fund  PowerShares Dynamic Pharmaceuticals (PJP). It offers exposure to the pharmaceutical space, and it's a narrowly focused, dynamic ETF, which means it uses a quantitative index that employs proprietary screens aimed at improved security selection. Over the past five years, PJP has outperformed competing pharmaceutical ETFs. For most investors, this fund probably would work best as a specialty satellite position in a diversified portfolio. This ETF also could function as a way for investors to add some Big Pharma firms to their portfolios while avoiding exposure to health-care services and medical-device firms that comes from investing in a broader health-care ETF.

Fundamental View
No one would dispute that the health-care sector is seeing added growth from an aging America. Demand is relatively stable because people require treatment regardless of the economy, and the need for greater treatment among approximately 78 million baby boomers in the United States makes for a compelling secular growth story. An aging population bodes well for the industry's future prospects because the majority of lifetime medical costs are spent in the final few years of people's lives. 

With health-care reform now here to stay, the big unknown in the health-care industry relates to sequestration. If sequestration happens, the year should be challenging for the health-care sector. If lawmakers strike a deal, the industry should begin seeing some modest benefits from the new health law, particularly in 2014.

Big Pharma shouldn't be meaningfully affected by the health reform that already has been passed, given that fees levied on the industry should largely be offset by more new patients. However, Morningstar's equity analysts do have some concerns about a possible upcoming sequel to health-care reform, which has some bipartisan support. The potential new law would involve 9 million patients who qualify for both Medicare and Medicaid but who are reimbursed at Medicare pricing levels being switched over to Medicaid pricing, which is roughly 20% to 30% below Medicare. If lawmakers enact such legislation, it could represent a 7% or more hit to earnings for certain pharmaceutical companies, such as Bristol-Myers Squibb,  Eli Lilly (LLY),  Celgene , and Actelion . The impact on other pharma companies would be far less meaningful.

Our analysts place less than a 40% probability on this legislation being passed, but the possibility is one that pharmaceutical investors should be factoring into their investment decisions.

Also in Big Pharma, merger activity is continuing, as firms have sought to spruce up their drying pipelines by acquiring biotech firms with promising drugs and innovative research and development programs. Recent merger and acquisition activity in the space has included  Teva Pharmaceutical Industries(TEVA) acquisition of German generic drugmaker Ratiopharm Group International,  Sanofi's (SNY) acquisition of Genzyme, Merck of Germany's takeover of Millipore, and Pfizer's acquisition of pain drugmaker King Pharmaceuticals.

Portfolio Construction
This quantitative-active ETF tracks the Dynamic Pharmaceuticals Intellidex Index, which selects and ranks pharma stocks based on capital appreciation potential using a 50-factor proprietary model. The 30-stock index chooses pharmaceutical stocks from the 3,000 largest U.S.-domiciled and U.S-listed firms in terms of market cap. The index provider splits pharmaceutical companies into two categories by size. It first takes 10 of the top-ranked relatively larger stocks and gives them a 50% index weight. These 10 pharma stocks are the ones that have the best model score in their size subgroup. Then, the index provider takes 20 of the top-ranked relatively smaller stocks and gives them a total of 50% of the total index weight. Again, these 20 relatively smaller pharma stocks are the ones with the best model score in their size subgroup.

The index differs meaningfully from market-cap-weighted ETFs, in that position sizes of its top holdings seldom get much above 5% (in a cap-weighted ETF, mega-caps' position sizes can approach 10%). The number of portfolio holdings isn't meaningfully different from other pharmaceuticals ETFs (most other such funds have between 25 and 40 stocks). The benchmark rebalances quarterly after evaluating holdings based on criteria such as price momentum, earnings momentum, quality, management action, and value.

PJP's 0.63% expense ratio is low both in absolute terms and when compared with the typical health-care mutual fund. At the same time, it exceeds those of rival ETFs that track purely passive benchmarks.

Investors seeking "pure-play" exposure to the pharmaceutical industry have three other ETF alternatives that they can consider:  SPDR S&P Pharmaceuticals (XPH) (0.35% expense ratio),  iShares Dow Jones US Pharmaceuticals (IHE) (0.47%), and  Market Vectors Pharmaceutical ETF (PPH) (0.35%). While the three ETFs employ different weighting schemes, they still share many of the same holdings. Given the three funds' distinct weighting methodologies, there are considerable differences between the funds' size profiles. PJP has an average holdings-weighted market cap of $13 billion, while XPH's is $8.2 billion, IHE's is $15.9 billion, and PPH's is $61 billion. Over the past five years, the performance of PJP has been 92% correlated with that of XPH and 94% correlated with that of IHE. Formerly a part of Merrill Lynch's now-defunct HOLDRS family, PPH recently was reconstituted under a new provider and thus has very short performance history in its present form.

For broader exposure to the health-care sector, investors also might consider  Health Care Select Sector SPDR (XLV) (0.18% expense ratio) or  Vanguard Health Care ETF (VHT) (0.14%) as a way to gain their desired exposure. Note that pharma and biotech stocks make up approximately 62% and 58% of XLV and VHT, respectively. And, over the past five years, the performance of PJP has been 91% correlated with that of XLV and 92% correlated with that of VHT.


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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.