Fidelity MSCI Healthcare Index ETF (NYSEARCA: FHLC) is an exchange-traded fund that provides investors with direct exposure to healthcare stocks, designed to track the performance of the fund’s chosen benchmark, the MSCI USA IMI Health Care Index. FHLC is run at a lower cost, with a net expense ratio as reported of just 0.08%. Net assets under management were $2.7 billion as of September 30, 2022, and this follows positive net fund flows of approximately $275 million over the past year (see below).
Stocks have generally sold well into 2022, but FHLC has performed relatively well. The fund has fallen around -8% since the start of the year, but this compares to the S&P 500 US Equity Index (a popular benchmark for US equities) of around -20% on the same period. Healthcare stocks tend to do relatively well during the late and recessionary phases of the business cycle, as shown in the chart below from Fidelity.
Fidelity also performs Company cycle positioning analysis. In the fourth quarter of 2022, the United States would be at the end of its current economic cycle, which has admittedly moved very quickly to date.
This is based on moderate economic growth, tighter credit availability, earnings pressure, “contradictory” (tighter) policy (i.e. fiscal, monetary) and tighter inventory-to-sales ratios. students. In my last article on FHLC, published June 7, 2021, I commented that “I wouldn’t be surprised to see FHLC materially outperform SPY on a twelve-month forward-looking basis,” with similar reasoning. Since then, the positive price-only outperformance has been just over 10% against the S&P 500 according to Seeking Alpha data at the time of writing.
The United States is yet to be recognized as being in recession, helped in part by low unemployment, as well as modest but still positive GDP growth. GDP increased by 1.8% in the third quarter of 2022, year-on-year.
What comes next is almost certainly a recession, especially since an extremely reliable indicator has just signaled it. This is an inversion of the US 10-year 3-month bond yield spread.
Nevertheless, this recession is not necessarily destined to be imminent, nor severe. Still, we should probably consider the risk to be high that a recessive position will come next. This means that FHLC is still likely to be cyclically well positioned in the short term. However, markets are also looking to the future, and so once a recession becomes the consensus and belief understood, it will become more likely that FHLC will start to underperform against riskier sectors (cyclical and economically sensitive ) (for example, technology, or even financial).
Morningstar currently has a consensus three- to five-year earnings growth estimate of around 9.33%. Using the previously referenced MSCI report (for FHLC’s benchmark) as a base, I constructed the basic DCF model below holding the earnings multiple constant over the period and assuming a risk-free rate of 4% (close to the current US 10 -annual return). I have also incorporated the assumption that the projected return on equity of 23.8% drops to around 16% by year six. FHLC’s underlying earnings are unlikely to ride out a recession so smoothly, but that brings my average three-to-five-year earnings growth to around 9.3-12.9% (9.3% on five years, which roughly matches the Morningstar Consensus Index). I also assume a constant dividend payout rate and no redemptions.
The implied IRR of 8.43% is fair and implies an underlying equity risk premium of 4.43%, which is good given the fund’s low historical beta of around 0.72. You could argue a beta-adjusted ERP well above 6%, which is high and would generally indicate undervaluation. However, either my estimate or consensus analyst estimates are optimistic. A decline in earnings during a -10% recession, followed by a rebound, could easily take the risk premium out of futures equities negative.
Healthcare stocks are generally seen as safer and more recession-proof in some respects, hence why demand may pick up late in the cycle given their “safe haven” characteristics (at least in the world of stocks). Thus, a large impact on earnings could be unlucky (and unlikely). But we also assume a constant price/earnings ratio. Arguably, a mature industry with a nominal earnings growth rate of 2-3% to infinity, with a relatively modest risk premium of 4.2% and a risk-free rate of 4%, should show a Forward P/E ratio no higher than 19.23x, and arguably as low as 16.13x. The current forward multiple of around 18x by MSCI (although Morningstar estimates 15.3x as of October 28, 2022) suggests that FHLC may have little room for growth on the valuation side.
Since Morningstar’s numbers often seem somewhat bullish, I’d better trust MSCI’s FHLC benchmark data. Overall though, FHLC’s valuation appears to be within normalcy, and relatively smooth years ahead (even if a recession does indeed occur within the next 1-2 years) would seem to suggest that FHLC is appropriately valued. If US rates were to fall post-recession, this could also support the post-recession valuation multiple, helping to provide protection against any medium-term decline in earnings.
So I think FHLC is probably quite valued and positioned to deliver returns of around 8% per year (including reinvested dividends) over the next few years. Any significant deviation from this return line would likely warrant a review of the fund. From a cyclical point of view, FHLC still looks attractive, as a recession does not appear imminent, but once an acknowledged recession occurs, investors would probably be wise to start considering a rotation. A recession would likely result in a Fed pivot, as monetary policy changes can take up to 18 months to take effect on real growth and earnings (even longer for inflation), which would likely allow sectors more risk of outperforming health care.