An Effective Approach to Healthcare Investing

The following is our latest Fund Analyst Report for Fidelity Select Health Care Fund FSPHX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

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.

Consistent with Yoon’s cash flow-focused approach, the portfolio's expected cash flow growth averages 21.6%, versus 14.5% for the index. Faster growth rates reflect his emphasis on firms early in their growth cycles. The trade-off is lower profitability; the fund's 6.4% average return on equity is a third of the index's. The portfolio has a less-defensive posture than the benchmark as a result.

Performance Pillar: Positive | Christopher Davis 08/24/2017 Since manager Eddie Yoon's August 2008 start, the fund returned 15.8% annualized through July 2017, outpacing the MSCI US IMI/Health Care 25/50 Index and the health Morningstar Category average by 3 percentage points per year. Yoon's smaller-cap focus and reliance on names with less-certain fundamentals drove above-average volatility, but long-term returns still stand out on a risk-adjusted basis, resulting in a Positive Performance rating.

Yoon added value across the largest healthcare subsectors. The fund benefited from its heavy overweighting in biotech--the best-performing subsector over Yoon’s tenure--while big winners like Inhibtex helped more. Underweighting pharmaceuticals was a plus, as were strong performers such as Allergan. A passel of smaller-cap device makers also gave the fund a boost. Not everything came up roses, as the fund’s health services picks lagged.

Investors shouldn't always expect smooth sailing. The fund badly trailed its benchmark in 2008, falling 32% while the index lost 21%. It also lagged in the volatile third quarter of 2011 by 4 percentage points. In 2016, it turned in lousy results thanks to an above-average biotech weighting and stakes in Teva Pharmaceuticals and scandal-plagued Valeant Pharmaceuticals. Returns have been consistent overall, though, under Yoon's watch: The fund beat the benchmark in 91% of 73 rolling three-year periods since August 2008. People Pillar: Positive | Christopher Davis 08/24/2017 Manager Eddie Yoon has been a healthcare investor for his entire career. From 2002-07, he covered healthcare stocks at J.P. Morgan, serving as a co-portfolio manager from 2005-06. In May 2007, he joined Fidelity and was named manager of Fidelity Select Medical Equipment/Systems, which he still runs. That fund has outperformed its benchmark nicely under his watch. Yoon took over this offering, and leadership of Fidelity's healthcare team, in October 2008.

Yoon draws upon the team’s 15 members, of which 10 have subsector specialties, for support. In recent years, Fidelity added three region-focused healthcare analysts in Boston, London, and Hong Kong. This mix varies in experience, but the team’s most-seasoned members reside in areas where specialized knowledge is most necessary. Rajiv Kaul, the longtime manager of Fidelity Select Biotechnology, and Eirene Kontopoulos, a biotech analyst who joined Fidelity in 2007 after earning a neuroscience doctorate, are key members. Karim Suwaan de Felipe, a comanager at Fidelity Select Pharmaceuticals, joined Fidelity’s institutional arm in July 2010 and has a doctorate in molecular biology.

Yoon is heavily invested, with $1 million-plus held in the fund. With deep resources and well-aligned financial interests, this fund earns a Positive rating for People. Parent Pillar: Positive | 04/18/2017 Long one of the industry's biggest asset managers, Fidelity has faced pressure as investors have pulled money from the active U.S. equity funds for which the firm is best known. While significant outflows could gravely impact some firms, Fidelity is shielded by its diverse mix across asset classes (including its own competitively priced index funds), success in other business lines, and private ownership that helps it escape quarterly earnings scrutiny.

The asset-management division remains well-staffed amid cost-cutting across the firm. Still, the firm could stand to rationalize its active-equity fund lineup: There are many redundant or mediocre funds alongside the standouts run by longtime star managers and up-and-comers. Retaining talent remains critical, particularly following the unexpected retirement announcement of a talented young small-cap manager. To its credit, Fidelity has handled equity manager transitions better than in the past. Meanwhile, Fidelity's fixed-income division remains among the industry's best, with a team-oriented approach assuaging key-person risk. Fidelity's target-date funds have improved, and the firm's technology and trading resources remain topnotch.

Even as it has raced to address competitive headwinds by unveiling a handful of factor-based exchange-traded funds, Fidelity remains capable on the actively managed side, earning a Positive Parent rating.

Price Pillar: Positive | Christopher Davis 08/24/2017 While this fund is significantly more expensive than passive alternatives like sibling Fidelity MSCI Health Care ETF, which tracks a similar benchmark and whose expense ratio is a mere 0.08% per year, it is a relative bargain by sector fund standards. The fund's 0.72% annual expense ratio, down from 0.80% in 2012, easily places in the cheapest quintile of sector funds in its distribution group. That's also the second-lowest expense ratio among active funds in the category. As such, the fund receives a Positive rating for Price.