5 Health Care Funds for a Healthy Portfolio

By William Ehart of InvestorPlace

The notion that health care stocks and mutual funds are recession resistant or defensive in nature has been lost in a thicket of worry about stocks in general as well as sector-specific fears about health care reform and patent expirations. Major pharmaceutical stocks with rock-solid financials are lagging on growth and regulatory concerns; biotechs offer growth and innovation but can't get a break as investors flee risk.

In today's market, investors would rather collect 2.95% on Johnson & Johnson ( JNJ) 10-year bonds than 3.70% on its common shares.

But we don't need to look far afield for evidence health care stocks can offer shelter from the storm. The sector held up much better than the Standard & Poor's 500 Stock Index during the 2008 bear market, although it lagged in last year's rebound. The Biotech HOLDRS ( BBH) actually gained 10% in 2008 versus the 37% decline of the S&P 500. But the shares rose just 11% last year compared with the nearly 27% gain of the market.

When all is said and done, the Biotech HOLDRS, the iShares Health Care Select Sector SPDR ( XLV) and all the funds listed below have outperformed the S&P 500's 9% loss over the three years ended Thursday.

Meanwhile, valuations in the sector are at historical lows. According to data cited in the latest quarterly T. Rowe Price Report newsletter, health care valuations haven't been this low since a Clinton-era attempt at health care reform put fear into the markets in the early 1990s.

The data, compiled by Ned Davis Research using earnings estimates from Zacks Investment Research, show the price/earnings ratio of the S&P Health Care Sector is just 85% of that of the S&P 500 as a whole. Historically, the sector has traded at a premium to the index, and often a substantial one.

Concerns about the impact of President Barack Obama's health care reform, slower drug approvals, patent expirations and a lack of blockbuster new products from big pharmaceutical companies are very real. But the savvy portfolio managers behind some of the nation's best health care funds say the sector is due for a rebound given low valuations and even lower expectations. The likelihood health care reform will prove less onerous than expected also is real.

All of the following funds are rated four or five stars (out of five) by independent mutual fund rating firm Morningstar. All are no load, have expense ratios below 1.5% and have had the same portfolio managers for at least three years. Each is significantly less volatile than the overall market and held up substantially better than the S&P 500 during the bear market.

VANGUARD HEALTH CARE FUND ( VGHCX) Managed by Edward P. Owens since 1984 and Jean M. Hynes since 2008; total assets of $18.6 billion; expenses of 0.36%; minimum initial investment of $25,000.

The biggest of all health care funds by far and bearing a tiny expense ratio, Vanguard Health Care Fund follows what longtime manager Owens calls a diversified "all weather" approach with an eye for valuation. And he's not kidding: The fund's annual portfolio turnover ratio is just 6%, lower than that of the S&P 500. Unfortunately for investors, the minimum initial investment in this four-star fund is a steep $25,000 (this helps keep costs down).

Just 10% of fund assets are in the biotechnology sector. The top five holdings as of July 31 were Merck & Co. ( MRK), Forest Laboratories ( FRX), British drug giant AstraZeneca ( AZN), drug distributor McKesson ( MCK) and Eli Lilly & Co. ( LLY).

"Following the sector's significant underperformance in what may prove to have been a bear market rally, we believe health care is now positioned to perform well relative to the rest of the market. Valuations are reasonable," Owens and his co-managers wrote to shareholders in their semiannual report dated Aug. 12. "If the health care reform package ends up on the moderate side, the outlook could be quite favorable."

Vanguard Health Care Fund has outperformed the Morningstar Health category year to date and over the past year, and has beaten the category and S&P 500 over the past three-, five-, 10- and 15-year periods.

The fund lost 19% in 2008, compared with the 37% loss of the index, and gained 21% last year versus the 27% gain of the index.

T. ROWE PRICE HEALTH SCIENCES FUND ( PRHSX ) Managed by Kris H. Jenner since 2000; total assets of $2.1 billion; expenses of 0.87%; minimum initial investment of $2,500.

The four-star T. Rowe Price health sciences fund takes a more aggressive approach than its Vanguard counterpart, with 34% of the fund in biotechnology. Jenner got his medical degree from Johns Hopkins University School of Medicine and a doctor in philosophy in molecular biology from Oxford University.

Jenner looks to biotechnology for the innovation lacking in giant drug firms. Still, he says companies such as Merck and Pfizer ( PFE) are so beaten down that their performance may surprise investors in the years ahead. Pricing will be pinched, but the companies will benefit from health care reform starting in 2014 as an increase in insured patients boosts sales. But managed care is in for a rough ride, since it is the "whipping boy" of health care reform, Jenner said in an interview in the latest T. Rowe Price Report.

The fund's top five holdings as of July 31 were midcap biotechnology company Alexion Pharmaceuticals ( ALXN), Amgen ( AMGN), small-cap biotech BioMarin Pharmaceutical ( BMRN), Celgene Corp. ( CELG) and Gilead Sciences ( GILD).

The fund is not particularly defensive. It fell 29% in 2008 versus the 37% decline of the S&P 500 but surged 32% last year versus the 27% gain of the index. It has outperformed the Morningstar Health category year to date and over the past year and has exceeded the return of the category and the S&P 500 over the past three, five and 10 years.

FIDELITY SELECT MEDICAL EQUIPMENT & SYSTEMS FUND ( FSMEX ) Managed by Edward Lee Yoon since 2007; total assets of $1.3 billion; expenses of 0.90%; minimum initial investment of $2,500.

This fund, narrowly focused on medical equipment, gets five stars from Morningstar. Yoon tries to capitalize on health care reform by targeting investments in companies whose innovations could help save money. As you would expect, the fund's portfolio is quite concentrated, with nearly 47% of assets in the top 10 holdings.

Its top five holdings as of June 30 were Irish equipment maker Covidien ( COV), C.R. Bard ( BCR), pacemaker manufacturer Medtronic ( MDT), cardiac equipment maker Edwards Lifesciences ( EW) and genome analysis equipment maker Illumina ( ILMN).

With valuations so low, Yoon expects price-to-earnings multiples to expand once investors have more clarity on health reform.

Fidelity Select Medical Equipment & Systems Fund has lagged the Morningstar Health category in more recent periods but has outperformed the category and the S&P 500 over the past three, five and 10 years. It has the best 10-year return of all the funds mentioned here.

FIDELITY SELECT PHARMACEUTICALS FUND ( FPHAX ) Managed by Andrew Oh since 2006; total assets of $257.7 million; expenses of 1%; minimum initial investment of $2,500.

Another narrowly focused Fidelity fund rated five stars by Morningstar. Nearly 47% of the fund's assets are in its top 10 holdings. Oh is actually negative on the big drug stocks because of expiring patents, a shortage of products in development, a slower approval process at a risk-averse Food and Drug Administration and uncertainty over health care reform's impact on pricing.

That said, valuations are low and drug stocks should be attractive to investors seeking defensive holdings because of their high dividend yields and strong free cash flows, Oh says.

The fund's top five holdings as of June 30 were Merck & Co., Johnson & Johnson, Pfizer, Swiss drug giant Novartis ( NVS) and Danish drug maker Novo Nordisk ( NVO). Oh trades aggressively, with an annual portfolio turnover ratio of 221%.

The Fidelity Select Pharmaceuticals Fund has outperformed the Morningstar Health category and the S&P 500 year to date, over the past 12 months and over the past three and five years. (The fund does not have a 10-year record.) The fund fell 23% in 2008 versus the S&P 500's 37% decline and rose 25% last year versus the S&P 500's 27% gain.

SCHWAB HEALTH CARE FUND ( SWHFX) Managed by Larry M. Mano since 2000, Vivienne Hsu since 2004 and Paul Alan Davis since 2006; total assets of $373.9 million; expenses of 0.83%; minimum initial investment of $100.

Schwab Health Care Fund is another solid offering with a strong 10-year record, yet is easily accessible to mutual fund investors with a minimum initial investment of just $100.

Performance has benefited from smaller-cap value stocks in the United States, but the fund's top five holdings as of June 30 were all giants: Johnson & Johnson, Pfizer, Amgen, Merck & Co. and Abbott Laboratories ( ABT).

The fund has outperformed the Morningstar Health category year to date and over the past 12 months and 10 years. (It has lagged the category over the past three and five years.) Schwab Health Care has outperformed the S&P 500 over the past three, five and 10 years. It fell 25% in 2008 compared with the S&P 500's 37% loss and gained 20% last year compared with the index's 27% gain.

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