SmartMoney: Street Smart - Sector Watch: First, Do No Harm
Dow Jones Newswires
This story appears in the May issue of SmartMoney magazine.
By John Protos
If there was any sector of the market investors should have flocked to over the past five years, it was health care. These stocks have easily outperformed the sizzling Standard & Poor's 500-stock index and have even kept pace with the market's other highflying sector-technology stocks.
But investors who chose mutual funds to take advantage of these gains have been sorely disappointed. While health care stocks have jumped an average of 31 percent a year for the past five years, health care sector funds posted average annual returns of only 19 percent. Worse, the gap keeps widening. Last year, for instance, one out of four funds in the sector lost money even though the average health care stock was up 39 percent.
Why the discrepancy? As in the rest of the market, performance in the health care sector has been dominated by a handful of large-company stocks, particularly big pharmaceutical companies. Pfizer, with a market cap of $184 billion, has seen its stock price rise 870 percent in the past five years. Shares in Merck, a $205 billion company, have shot up 438 percent. At the same time, small-company stocks in areas such as biotech, medical devices and medical services have fared much worse, hit hard by government cuts in insurance payments and rising medical costs. In fact, since 1994, large-company health care stocks -- those with an average market cap of $93 billion -- soared, while small-company health care stocks increased only 5 percent.
Still, most fund managers invested in those losing small-company stocks. The median market cap for the average health care fund portfolio is only $26 billion, and many managers are addicted to even smaller stocks than that. Says Ken Cam, manager of the FirstHand Medical Specialist fund, 1999's best year-to-date performer, "As a manager you try to avoid what's expensive. That's meant going where there seems to be faster growth and lower P/Es, and that's been in small caps."
A perfect illustration? Franklin Global Health Care, based in San Francisco. Manager Kurt von Emster favors small, undervalued names in subsectors like specialty services and medical equipment makers. "They have stronger earnings growth," he explains, adding that investors also want the diversification.
Even heat from the fund's board of directors wouldn't budge von Emster. Says the manager, "When we were in the bottom half of our category, our board asked us what was going wrong with our style and what we were doing about it." Von Emster's reply? The market would have to eventually reward tiny stocks like Renal Care Group and Serologicals, which boasted single-digit P/Es and growth rates in the high teens.
By contrast, AIM Global Health Care's manager, Michael Yellen, also traditionally a small-company investor, finally threw up his hands early last summer. "You can only fight the tape so long," he says. Consequently, Yellen sold off obscure companies like surgical-product maker Mentor and replaced them with shares of pharmaceutical giants such as Astra and Zeneca. But his change of heart couldn't have come at a worse time for von Emster at Franklin Global: August brought the year's worst market downturn, and von Emster's fund took an extra hit from Yellen's housecleaning. "We crossed on so many positions," explains von Emster, "that when he sold off his stocks, it damaged their prices for our holders." The result? Von Emster's 1998 return was minus 8 percent, while Yellen's fund was up 18 percent.
Of the 23 health care funds available to investors, only three have repeatedly come close to the gains of the health care stock index over the past five years. Invesco Health Sciences (see "Top of the Charts," April) and Merrill Lynch Health Care have even bested the index during the past 12 months thanks to heavy doses of drug stocks, but over the long term, each has lagged.
Only one fund is a true standout. Fidelity Select Health Care's average annual returns have equaled or bested those of health care stocks for the past one-, three-, five- and even 10-year periods. Launched in 1981, the fund has been managed for the past two years by Beso Sikharulidze. While he follows all the commonly tracked ratios -- price/earnings, price/book and price/cash flow -- to find undervalued stocks, Sikharulidze focuses on growth, looking for companies that post improving earnings, return on capital and cash-flow generation. This two-pronged approach helps Sikharulidze separate true undervalued gems from the simply cheap and ensures that he doesn't miss a growth-inspired rally. Last summer, for instance, he was convinced that drug stocks would continue to outperform despite their temporary downturn. So he added to his holdings in Eli Lilly and American Home Products. By late March they were up 33 and 31 percent, respectively. Sikharulidze expects large-cap drug stocks to continue to outperform, thanks to strong demographic trends, new product introductions and seasoned sales forces. And he, for one, isn't about to buck the trend. Says Sikharulidze: "If someone is sitting in small-cap names for years, saying that the market has been stupid and he's been smart -- that's not a legitimate view."
Jim |
