Investors seeking exposure to the U.S. health care sector should look no further than the ( SWHFX) Schwab Health Care Fund or the ( SHSAX) BlackRock Health Sciences Portfolio . Ratings gives the funds a B+ and a B rating, respectively, and they are No. 1 and No. 2 mutual funds in our health care universe.

Our strategy behind recommending these funds is essentially a contrarian play, as the holdings of both are concentrated in the pharmaceutical sector, which in the past two to three years has been out of favor with investors, primarily because of:

  • Product-liability issues, especially Merck's, (MRK) problems with Vioxx.
  • A reduction in Medicare reimbursement rates.
  • A dearth of new drugs in the industry's pipeline.
  • Patent expiration and the related generic competition.

Now, however, investors may be taking a renewed look at health care and, in particular, pharmaceuticals. While the above concerns and issues have not disappeared, our models are showing that the returns garnered by these two funds suggest a change in investor attitude toward the sector.

There are a number of reasons for the change in attitude about these types of funds, including the trend of pharmaceutical companies outsourcing their research and development functions to biotech firms, general industry restructuring and further advancements in human-genome mapping, which have made it much easier to design drugs for specific -- and often lucrative -- markets. All of these factors have generated profit for companies in the sector.

However, there may be more fundamental reasons for this investor interest: uncertainty about the direction of the U.S. economy and the resulting reallocation of capital to more risk-averse sectors -- such as pharmaceuticals -- that can maintain demand for their products in an environment of slowing growth. Ratings analyzes this contrarian investment play in three areas in which we think these funds have a winning formula: pharmaceutical-sector focus, portfolio concentration and relative performance.

Let's take a closer look. The following table compares each fund's major sector allocations.

Funds With Similar Strategies
Schwab Health Care Fund BlackRock Health Sciences Portfolio
Sector Percentage Allocation Sector Percentage Allocation
Pharmaceuticals 42.91% Pharmaceuticals 50.67%
Health care - Services 16.71% Biotechnology 16.03%
Health care - Products 16.25% Health care - Services 15.28%
Electronics 8.05% Health care - Products 10.93%
Consumer Services 5.62% Electronics 3.43%
Insurance 3.67% Retail 2.29%
Source: Ratings

Pharmaceuticals are the focus of both funds, and health care products and services account for around 33% of the Schwab fund and 26% of the BlackRock fund. One difference: BlackRock Health Sciences has a 16% stake in biotechnology, whereas the Schwab fund has taken a position in consumer services and insurance. Remember that though the biotech field is volatile, it is also an arena of possible stellar returns. If, for example, a company's new drug gains Food and Drug Administration approval, its share price can enjoy extraordinary gains. The BlackRock portfolio clearly puts an emphasis on the biotech field, a difference in the funds worth considering.

The next table compares the top 10 holdings and the percentage of total assets held in these positions. An interesting point: Merck is the only stock that makes an appearance in the top 10 holdings of both funds.

Top 10 Holdings
Schwab Health Care Fund - (assets: $561.6 million) BlackRock Health Sciences Portfolio - (assets: $734.5 million)
Holding Position Holding Position
Applera - Applied Biosys (ABI) 4.66% Schering-Plough (SGP) 5.24%
Becton Dickinson (BDX) 4.45% Merck (MRK) 5.21%
King Pharmaceuticals (KG) 4.34% Novartis (NVS) 4.50%
Pfizer (PFE) 4.32% Alexion Pharmaceuticals (ALXN) 4.11%
Merck (MRK) 4.20% Wyeth (WYE) 3.95%
Sierra Health Services (SIE) 4.18% Roche Holdings 3.65%
McKesson (MCK) 4.10% Manor Care (HCR) 3.63%
WellPoint (WLP) 4.07% Waters (WAT) 3.18%
AmerisourceBergen (ABC) 4.05% Varian Medical Systems (VAR) 2.99%
Express Scripts (ESRX) 3.89% Quest Diagnostics (DGX) 2.90%
Total Percentage Held in Top 10 42.26% Total Percentage Held in Top 10 39.36%
Source: TheStreet.Com Ratings

In an important development, Ratings' stock model, which rates individual stocks rather than funds, has of late been upgrading an increasing number of health care shares, especially those in the pharmaceutical space. The following table lists our ratings of the top 10 holdings in each fund, as well as any recent changes to a company's rating.

Stocks and Ratings
Schwab Health Care Fund BlackRock Health Sciences Portfolio
Holding The Rating Change in Rating Holding The Rating Change in Rating
Applera - Applied Biosys Buy No change since 01/28/2005 Schering-Plough Buy Upgrade from Hold to Buy (7/28/2006)
Becton Dickinson Buy No change since 01/15/2003 Merck Buy Upgrade from Hold to Buy (4/25/2006)
King Pharmaceuticals Buy Upgraded from Hold to Buy (05/10/2006) Novartis Buy No change since 9/21/2004
Pfizer Buy Upgraded from Hold to Buy (08/24/2006) Alexion Pharmaceuticals Sell No change since 11/09/2001
Merck Buy Upgraded from Hold to Buy (04/25/2006) Wyeth Buy No change since 12/27/2005
Sierra Health Services Buy No change since 01/13/2004 Roche Holdings Not Rated N/A
McKesson Buy Upgraded from Hold to Buy (01/30/2006) Manor Care Buy No change since 04/11/2003
WellPoint Buy No change since 02/12/2004 Waters Buy No change since 01/13/2004
AmerisourceBergen Buy No change since 04/15/2005 Varian Medical Systems Buy No change since 11/09/2001
Express Scripts Buy No change since 11/09/2001 Quest Diagnostics Buy No change since 10/08/2003
Source: Ratings

The majority of each fund's top 10 holdings are rated buy according to our models. However, it should be noted that the Schwab Health Care Fund holdings have recently enjoyed more upgrades than those of the BlackRock Health Sciences Portfolio. The BlackRock fund, in addition, includes the only sell-rated stock, Alexion Pharmaceuticals ( ALXN).

The funds' concentrated portfolios also make them appealing. The Schwab fund's top 10 holdings account for 42.26% of its entire portfolio, while BlackRock's top 10 positions represent 39.36% of its investments. A nondiversified strategy does, of course, present more risks. However, investors are paying fund managers to make the best stock picks they can, and in both cases the managers here have, in our opinion, done just that.

Finally, relative performance is our third reason for selecting these funds. As seen below, their one-week, one-month and three-month returns come in very close. The year-to-date figures give the advantage to BlackRock, but in the very near term, the advantage goes to Schwab. In addition, the three-month returns of both funds are higher than their year-to-date records, making this a great time for investors to take some action in two investment vehicles we consider ripe contrarian plays. (For comparison, the funds' benchmark, the S&P 500 Composite Total Return Index, has returned 6.59% year to date, 7.22% over the last three months and 4.03% over the last month.)

Comparing Returns
Schwab Health Care Fund BlackRock Health Sciences Portfolio
Sector Return as of 9/14/06 Sector Return as of 9/14/06
1 Week 2.75% 1 Week 1.02%
1 Month 4.18% 1 Month 3.42%
3 Month 9.36% 3 Month 10.44%
Year To Date (YTD) 0.67% Year To Date (YTD) 6.20%
1 Year 5.87% 1 Year 9.86%
3 Year 22.12% 3 Year 15.41%
5 Year 10.69% 5 Year N/A
Source: Ratings

A final note: A wise investment strategy could be buying an equal proportion of each of these funds, noting their slight differences. However, the deciding factor may be their expense/cost structures.

The Schwab portfolio is the cheaper one to purchase, as it has an expense ratio of 0.89%. It does, however, have an early withdrawal fee of 2%. BlackRock, on the other hand, has an expense ratio of 1.55%, a 12b-1 fee of 0.1% and a front load of 5.75%. It also has an early withdrawal fee of 2%.

Either way, Ratings is confident that investors looking at the health care and pharmaceuticals sectors should examine these two funds.
Sam Patel, CFA, is the manager of mutual fund research for the Ratings.

In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Patel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.