Mainly Just Good in Health Care Sector ETFs

Our top picks for the Health Care sector ETFs are: Biotech HOLDRS (BBH) and Pharmaceutical HOLDRS (PPH). We also rate the investment merit of the top-9 health care sector ETFs.

Per our first-quarter-2011 review of U.S. Equity Sector ETFs, the health care sector is one of only three sectors that gets our “Attractive” rating. In addition, this sector has more “very-attractive-rated” ETFs than any other sector. Some of our top-rated stocks in this sector are Eli Lilly (LLY), United Health Care (UNH), and Bristol Myers Squibb (BMY). Figure 2 shows how the health care sector’s stocks and the market value attributed to them stack up under the microscope of our risk/reward rating system.

Figure 1: Health Care Sector – Capital Allocation & Holdings by Risk/Reward Rating

Sources: New Constructs, LLC and company filings

The health care sector has only 10% of its value invested in dangerous-or-worse-rated stocks and 46% of its value invested in attractive-or-better-rated stocks. Relatively low allocation to dangerous-or-worse-rated stocks enables the health care sector to earn our attractive overall risk/reward rating.

The key takeaway here is that the health care sector offers both good and poor investment opportunities. The value of each ETF is derived from its constituents, so ETFs that overweight attractive-or-better-rated stocks, like BBH and PPH, are great investment opportunities while ETFs that overweight neutral-or-worse-rated stocks should be avoided.

When analyzing the health care sector ETFs, we started by identifying those ETFs with acceptable structural integrity as measured by XTF, an ETF research firm. We chose the 9 ETFs whose XTF rating was above the sector average XTF rating.

Figure 2: Health Care ETFs With Acceptable Structural Integrity

Sources: New Constructs, LLC; XTF and company filings

Figure 2 shows clearly that not all health care ETFs are made the same. Different ETFs have meaningfully different numbers of holdings and, therefore, different allocations to holdings. Given the differences in holdings and allocations, these ETFs will likely perform quite differently.

After determining the structural integrity, we analyzed the investment merit of each ETF based on how it allocated value to each stock it held. Figure 4 shows how the 12 health care sector ETFs stack up versus each other and the overall sector based on their overall risk/reward ratings and the allocation of their holdings by rating.

Figure 3: Investment Merit Based on Holdings and Allocations

Sources: New Constructs, LLC; XTF and company filings

Attractive ETFs:

BBH, PPH, XLV, IHF, VHT, FXH, IHI, and IYH – these 8 ETFs earn an Attractive-or-better Overall Risk/Reward rating and therefore, are the only Health Care ETFs we recommend. Our top picks from this group are BBH and PPH.

Neutral ETFs:

PRN allocates its value in a way that earns it a Neutral Overall Risk/Reward rating. We recommend investors buy the very attractive and attractive stocks in this sector before buying any of the Health Care ETFs except those we recommend. Figure 5 contrasts the differences in investment merit between PRN, BBH and the overall sector.

Dangerous ETFs:

This report does not include any Dangerous-or-worse-rated ETFs.

Benchmark Comparisons

Sector Benchmark

BBH outperforms the overall Health Care sector in quality of earnings ratings. BBH earns a Very Attractive Economic vs. Reported Earnings rating because its Economic Earnings are positive and rising while the sector’s Economic Earnings are positive and decreasing. BBH also outperforms with an ROIC of 20.4%, earning it a Very Attractive rating, compared to the sector’s ROIC of 11.7%.

BBH also outperforms the sector in valuation ratings. BBH has a Price-to-EBV of .6, earning it a Very Attractive rating, and a GAP of 4 years compared to the overall sector’s Price-to-EBV of 1.0 and a GAP of 11 years.

Figure 4: BBH – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 5: Health Care Sector – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

BBH more effectively allocates capital to attractive-or-better-rated stocks than the overall Health Care sector. Per Figure 4 above, BBH allocates 76.6% of its value to Very Attractive-rated stocks while the sector only allocates 33.08%. However, BBH allocates 17.13% of its value toward dangerous-or-worse-rated stocks compared to the sector’s dangerous-or-worse weightings of 10.18%.

Market Benchmark

BBH outperforms the S&P 500 in quality of earnings ratings. BBH earns a Very Attractive Economic vs. Reported Earnings rating because its Economic Earnings are positive and rising while the S&P 500’s Economic Earnings are positive and decreasing. Although both BBH and the S&P 500 earn a Very Attractive ROIC rating, BBH’s ROIC of 20.4% edges out the S&P 500’s ROIC of 18.2%.

BBH also outperforms the S&P 500 in valuation ratings. BBH has a Price-to-EBV of .6, earning it a Very Attractive rating, and a GAP of 4 years compared to the S&P’s Price-to-EBV of 1.5 and a GAP of 26 years.

Figure 6: BBH – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 7: S&P 500 – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

BBH allocates capital more effectively than the S&P 500. Per Figure 3 above, BBH allocates 76.6% of its value to Very Attractive-rated stocks while the S&P 500 only allocates 21.47%. BBH also only allocates 17.13% of its value toward dangerous-or-worse-rated stocks compared to the S&P 500’s dangerous-or-worse weightings of 24.51%.

Methodology

This report offers recommendations on Health Care sector ETFs and benchmarks for (1) investors considering buying Health Care sector ETFs and for (2) comparing individual ETFs to the Health Care sector and the S&P 500. Our analysis is based on aggregating results from our models on each of the companies included in every ETF and the overall sector (415 companies) based on data as of 04/05/11. We aggregate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to analyze ETFs in the same way they analyze individual stocks.

To make an informed ETF investment, investors must consider:

1)    The structural integrity of the ETF and its ability to fulfill its stated objective. We use XTF, an ETF research firm, to find the top 12 ETFs with the best structural integrity rating.

2)    The quality of the ETF’s holdings. We determine and ETF’s quality using our overall risk/reward rating system.

Given the success of our Rating system for individual stocks, we believe its application to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buying decisions. Barron’s regularly features our unique ETF research. The first article is “The Danger Within”.

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