Healthcare for Growth Potential and Income

February 24, 2020
Healthcare for Growth Potential and Income

Paul MacDonald, CIO and Portfolio Manager at Harvest ETFs joins us for an in-depth conversation about the investing fundamentals and opportunity within the healthcare sector. We also discuss his firm’s ‘covered call’ income strategy which, in addition to the growth potential, produces sustainable, tax-efficient, non-interest-rate sensitive income for investors.

Pierre Daillie (PD): Joining us right now is Paul McDonald, Chief Investment Officer and Portfolio Manager at Harvest ETFs. Paul, thanks so much for joining us today.

Paul MacDonald (PM): It’s great to be here, thanks for having me.

PD: Healthcare is one of the most compelling long-term investment themes in the markets today. Given that last year was a great year for the market it was interesting to see that Healthcare had a challenging first three-quarters and towards the end of the last year in the fourth quarter sentiment started to change.

It was surprising given that that we’re entering the political season and given that there seems to be a lot of uncertainty surrounding policy in the healthcare sector in terms of what Republicans hope to accomplish with healthcare, versus what Democrats hope to accomplish with healthcare. What do you think happened there in terms of the change in sentiment? How did that shift?

PM: Very loaded question, and certainly you’re right about the the permanent non-cyclical drivers – things like aging populations, and technological innovation, developing markets those are the long-term and medium-term drivers and are here to stay.

The shorter term driver, though, as you pointed out, is very much politics and so what we saw earlier in the year last year is fairly extreme viewpoints and health care tends to be a political lightning rod so it does capture politicians attention. They like to bring it up the reality is though that within the parties the Democrats and Republicans, the views differ vastly which has made it very difficult to actually implement change, and so really, the first three quarters up coming into the third quarter, the sentiment towards this sector was very negative we had comments surrounding things like ‘Medicare for all,’ and socializing the system and so as time came through the the third quarter it became more apparent that affecting those types of changes, in those extreme changes, just given the differing views between Republicans and Democrats is challenging let alone the vast differences within the parties themselves

PD: Yeah, you had Trump trying to reverse, I mean for most of his administration, so far, there’s been a lot of talk trying to reverse Obamacare or the Affordable Care Act, and, leading into the Democratic primaries and the election year we’ve had a lot of Democrats pushing in terms of their political platforms. What would be your best explanation for for why that’s an opportunity rather than than a hold off?

PM: Great, great question. I actually think if they called it Trump care, perhaps there would be a different perspective on how the system is actually run and so I think one of the things on drug prices, which is what comes up quite often, is a misunderstanding perhaps of how drugs are priced and who actually pays for for the drugs. And so, my great example that I like to use is back in 2016 when Bernie Sanders was was in the headlines again saying you know he was coming after a company like in Eli Lilly that had a 700 percent increase in one of their drugs.

Whilst it was true that that drug price was up on a list basis by the time you factored in the various types of rebates to the pharmacy benefit managers, the pharmacies, the insurance companies and the price was modestly up for Eli Lilly. And so there is a misconception on, on, pointing the finger right away at the companies.

There has been actually some positive changes in in branded drug prices we’ve seen an increase in the number of approvals, the speed on biosimilars, but we would suggest that it’s it’s easy for a politician to point a finger. But, when you actually peel back the layers it’s a very, very complex system and very difficult to actually effect change and there’s been several of examples of that just in the recent time the Trump administration came out with their their blueprint in 2018.

One of the items in there was to have drug prices for television adverts, so if you have if you have a drug that you’re advertising on TV a rule came into place that said you have to put the list price of the drug, the price of the drug on that commercial, and so it wasn’t only a few months later that a judge actually came out and said, well actually you don’t have to do that. The Center for Medicaid Services, and Health and Human Services overstepped their their powers given to them by Congress. And so, the companies no longer have to do that, to post their prices.

My point on that would be; that’s one example of perhaps 15 different types of examples, where to get a simple thing like the price on an advertisement would seem like it would be simple to do but the system is very complex. And so some of these very extreme changes, and and from a Canadian perspective makes a lot of sense. Why wouldn’t you have Medicare health for all?

And so to implement something like that is extraordinarily difficult, when you can’t even get the drug prices changed. So you’d have to have complete overhaul of the entire system, not just the healthcare, but political and taxation. And I just don’t envision that happening in the near term.

PD: Yeah, it sounds like, I mean it sounds like like judging by what you’re saying there was a lot of noise last year. But in the same vein, if you’re an investor, then, ideally you’re looking to enter the healthcare sector at an attractive price, and then sit there for the long term, as opposed to getting into the technology sector, where prices are at all-time highs.

And I just want to reframe, going back to the beginning, that that that despite the fact that last year wasn’t as good for the healthcare sector as it was for the broader market you guys still eked out a double-digit return at the end of the year. And, and the healthcare sector wasn’t that bad after all.

It just didn’t perform as well as the broader market.

PM: A hundred percent concur that last year was, it was still a good year you know we were up just under 14 percent, relative to a market though, that there, was up significantly more than that. We were in health care, the second second worst performing sub-sector. But that was really a tale of two halves: you kind of had that first half where a lot of that extreme viewpoint was was used to put put flags in the sand. It really started to narrow and come closer to center, as I mentioned before as it became apparent that a lot of these these extreme proposals or viewpoints would be very difficult to implement.

So that was one part of the sentiment that we started to see shift. In, in and around the third quarter. We also noticed the the broader media, the broader analyst community, and we really saw a change in the language, And that came ahead of the third quarter earnings season which came in very robust for most of the companies and the companies that beat their their earnings were rewarded with positive price performance, versus, in previous quarters when we had a lot of that political noise they would they would be they would tend to just be flat even though they were you know they were making making you know great financial performance.

And so, as we look out through 2020 we’ve done a fair amount of work on on how healthcare has performed within election cycles, and could it be different this time? Absolutely. What we did find broader markets, in general, we don’t see any seasonality. As we look at various six-month and intervals leading up to an election, we don’t see any seasonality, or sort of concrete evidence that volatility would increase, or that there’s a specific performance path that would happen in and above, in and around, an election, or even post an election.

What we did see is in some some of the sub sectors, though, within healthcare, sort of some of the distributors, and also to a lesser degree, the managed care companies did have positive performance post-election, although it was a little bit more mixed coming into the election. But, outside of that very small small anomaly, we really haven’t seen any sort of statistical significance coming into into an election.

So, as we start to see some of the some of the proposals will likely have some some championing on both sides of the aisle, so to speak, Certainly Trump has endeavoured to do fairly big things in healthcare in his 2018 blueprint, which, not a lot of actually got done. Some of it did, but not a lot of it got done, so another great example, we’ll probably start to hear about international drug pricing and how Trump wants to peg American prices to an international basket. And so, of course in 2018 when they came up with their blueprint; that wasn’t part of the blueprint and the reason why that was according to one of the senior government officials is because they thought it was just a gimmick now it’s becoming a part of a their platform.

And so, although we might hear about it the implementation of such a such a proposal is is very difficult and even as we start to see that come through in the election and the political discussions around it, we’re still only looking at a pilot over a five-year period on an international price today. So we’re going to have these little bits of noise, and, and championing in and around on look what we’ve done, or look what we can do.

We may get volatility, we may not get volatility. Perhaps the market looks through that. Our view would be is if you do get any type of volatility, or downside because of that noise. For those that are looking medium-term – This is it, this is when you buy you buy into that noise, the, the effective changes that are likely to impact financial performance are very limited from our perspective.

PD: It sounds like the Trump administration, or at least Trump would like to have his name on it as he likes to have his name on everything. Let’s talk about the fundamentals for healthcare. There’s three of them that you’re focused on, starting with the aging population?

PM: Outside of us, the world is aging, and it’s a phenomena. We can see it in North America, and developed markets, all around the world. As people age, they spend exponentially more money on health care, and there’s a large cohort of people aging at the same time. So that is that’s permanent non-cyclical driver.

The second one that we would have is technological innovation, and there we talk about some of the robotic surgery, and medical devices, and minimally invasive surgeries for pacemakers, and the like, so that’s on the medical technology side. But also in the pharmaceutical and the biotechnology side and gene therapies. I would argue were in very early innings of a long game of really how data and information can transform drugs essentially, And so we’re seeing tremendous amounts of innovation on, on, the drug side as well.

And then the last spot that we would see is developing markets. And there’s a disproportionate amount of increase in wealth gets spent on health care, meaning that you know perhaps your your income goes from, you know, two thousand to four thousand dollars, Your healthcare spending might go from from 250 to a thousand. And so that percentage increase is significantly different. It’s disproportionate.

So, when we put those three items together, the medium to longer-term fundamentals are structurally sound, But at the same time you’ve got a sector, because of the shorter term political noise, really does have valuations that are that are very attractive both on a fundamental valuation, but also relative to their growth, that they have so. We very much like the sector and and believe any type of volatility as an opportunity to to bring bring up to a market-weight exposure, and in Canada there’s very little ways to get exposure to this sector. I believe it’s only 2% of the Canadian market, versus, and when you look under the hood, of that it’s tends to be marijuana companies and one or two pharmaceutical companies, versus in the global market it’s closer to 14 or 15 percent.

So, and significant scale and depth as well with, you know, I know, we have 20 companies in our portfolio. Their market cap is larger than the TSX index of those 20 companies. So, you do get scale in depth just not in the Canadian market.

PD: So, speaking of which you manage the HARVEST HEALTHCARE LEADERS INCOME ETF, the largest healthcare ETF in Canada. How do you go about narrowing down to the top 20 healthcare companies?

PM: A great question and I’ll touch on the income component in just a second, because I think that’s important, and then I’ll touch on diversity as well, which I also think is important.

So for our 20 companies we started with a universe of perhaps 2000 companies, and I can’t cover 2,000 companies right or fundamentally follow them so we put in some very basic financial metrics, so the minimum market capitalization that we use as ten billion, has to be North American listed, and has to have options on it, because we use a covered call strategy, right, and really all this does is it peels the 2,000 down into about 75 companies, and then from those 75 companies, we pick 20, on a fundamental basis.

We are looking at various types of financial metrics, but we also want to ensure diversity. We want to have exposure to medical devices, we want to have pharmaceuticals, biotechnologies, managed care companies, and insurance companies, the like of which we don’t have in Canada, and facilities.

And so we we want to make sure we’re not overexposed in any particular area within healthcare in any of those sub sectors. So, in, in, pharmaceuticals, we follow what drugs each company has, and we don’t want to be overexposed in any particular area, so using that in sort of foundation as a diversified portfolio, we then follow our financial metrics, in which we have to satisfy specific metrics on our 20 companies as a whole, being things like price to earnings ratio, and return on equity ratios that are better than that 75 universe. And these are just very simple metrics that really help us avoid some… of what I like to say:

We’ll miss some of the the rockets, but then we’ll also miss some of the torpedoes.

Right, and so that gets us down to our 20 companies. My advice to advisors and to investors is for this sector you want to be diversified. So if you own … Johnson and Johnson’s a great company. We own it in our health care leaders fund, however one news release from a lawsuit could cause volatility to the downside, and so you want to ensure that you have diversity because of those types of risks but also I look at a company like a Merck and a Bristol-Myers both of which are holdings in health care leaders.

Merck Science was just working better, and so it became the the dominant – so to predict that science is extraordinarily difficult, and so, for us, being diversified and having that exposure to multiple companies really is a risk reducer. And so, what we do in Healthcare Leaders, we go through that process on a quarterly basis. We pick the 20 companies, and we equally weight them, and then we go every quarter and run that process.

In between the quarters we also will have what’s called a covered call strategy, in which we essentially generate additional income on our portfolio using options, and we forego a little bit of the upside, because of that. And so I bring that up, because I want to focus on that diversity side. If you want health care and income, that’s where health care leaders in HHL comes in. But if you just want health care exposure don’t own just one or two individual stocks own a basket.

PD: Adding the overlay of the covered call strategy as an income building strategy is quite compelling. Looking at the behavior of the portfolio without the covered call strategy, and with the covered call strategy, you get a smoother ride as a result of the covered calls.

You might not get the full beta of owning those twenty stocks, because of it, but you’re making up for it with the added income from the cover from writing the covered calls. Could you explain the writing of covered calls, and how that works, and and how that benefits investors, both from the income standpoint, and from the risk standpoint?

PM: Absolutely, that was a great summation of the covered calls, how they work and so we we write options on a third of each one of our holdings. So up to 33%. And what that means is is that we get paid a premium every time we do that.

So if I have a stock for example at $100, and I write write 33% on a position that we own, we perhaps get two dollars and fifty cents, “bird in the hand” income, Now if the stock goes up to a hundred and ten dollars we’ll still participate on 66% of that, but not on the third that we’ve written in which, we’ve gotten the $2.50, and so the the point of that is, is, that we still participate on the upside, but we actually get get income generated, each month.

And so, every month we go out and we say how much do I have to write on the portfolio using live prices, real prices to generate the net income, for that month and so that’s what we do at Harvest ETFs. When we do our cover call strategies. We want to be generating that income each month in a tax efficient manner and so really that’s that’s a very broad example, or a simple example on how we’re trying to do it, and you’re you’re you are right. We will forego a little bit of the upside, so you won’t have the full beta to the upside. But the trade-off of that is a very attractive attractive income.

PD: Given that that investors are in search of yield your strategy of of combining growth, with the income from the covered calls, is quite compelling from a valuation standpoint and compelling from a fundamental standpoint.

PM: We’ve got 20 leading healthcare companies and we follow a very similar option strategy across multiple over of our funds, whether it’s sector, or global funds. We do a very similar strategy in order to generate that additional income. Really that’s part of our philosophy is that income does happen here, that equity income is a way, in what we think is a lower for longer rate environment, to really generate income through your equity positions. We think it’s very very well positioned. Then we also think healthcare given given where the valuations are, it’s a very very attractive time to be looking at at the sector. The same time you mentioned volatility earlier…

PD: …But that benefits the Covered Call overlay, right, when they have a higher implied volatility, in the market, then you’re actually going to be able to garner more of a premium from writing those covered calls.

PM: That’s right and that’s how that’s how options are essentially – part of the key pricing for them is not necessarily ‘what was the volatility,’ but what is the expected volatility going to be, and so we’re usually writing our options 30 days out, fairly close to what we would say ‘at the money’ so if the stocks at a hundred dollars on average we would be writing our price at about a hundred and one.

And so, what we find though, is that as expectations for volatility increase, that’s when we get paid a lot more. And so within our healthcare fund, in particular, there’s lots of reasons why expected volatility may increase.

It’s not just one political dynamic. So coming in to things like the New Hampshire and and Iowa Caucus primaries and you know, ranging from, you know, political events to medical conferences, to expected trial releases, things like competitor trial releases, and earning season.

Those are all areas that were constantly following to say why are we getting paid a particular volatility in any month. And we should we speak like that because that’s what we’re looking for volatility is as a measure of why we’re getting paid what, from our perspective. So absolutely in more volatile markets we actually are able to generate more income.

PD: So volatility is something to embrace in this case.

PM: Yes to some degree it’s a like I said the volatility when it does happen is never never fun, particularly when that volatility is to the downside, but from our perspective that’s typically when we’re earning more income, and I say income – the actual taxation of the option premium, though, is CAPITAL GAINS, which is very favorable from from a taxation perspective, yes.

PD: Paul thank you so much for explaining that.

PM: Thanks for having me.

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