Global prescription for healthy yields

Rising demand from emerging markets will bolster healthcare stocks, predicts Polar Capital’s Daniel Mahony, whose limited life trust promises attractive yields over the next few years.

Difficult fundraising conditions have forced investment trust managers to become more imaginative as they seek shareholder support. Among the more innovative launches this year was Polar Capital Global Healthcare Growth & Income. The trust, which raised £89m in June, against an initial target of £100m, has a fixed life-span to January 2018 and a performance fee payable on wind-up.

The fund aims to generate dividend income and capital growth by investing in a global portfolio of healthcare stocks selected by co-managers Daniel Mahony and Gareth Powell. Mahony and Powell, healthcare specialists who joined Polar Capital from Morgan Stanley and Axa Framlington in late 2007, also run the firm’s £45m offshore Healthcare Opportunities fund – a high-conviction open-ended portfolio.

Mahony says the trust’s limited life structure aims to tap into an opportunity in healthcare stocks – attractive yields over the next few years, followed by a capital uplift from a sector re-rating. “Pharmaceutical companies are being priced as though they’re going ex-growth and we don’t think that’s true,” he says. “We think they will correct over a five-year period, and certainly by the middle of this decade.

”If we’re right, and pharma stocks go from being on eight times earnings to 12 times earnings, we’ll make people a lot of money”

“If we’re right, and pharma stocks go from being on eight times earnings to 12 times earnings, we’ll make people a lot of money, but the yield of the fund will be a lot lower at the end. So it was designed as an idea-driven product – we think seven years is probably enough to see this correction. The return profile of the fund will look very different in year six than it did in year one.”

About 80% of the fund is invested in income stocks, with three-quarters of the allocation in large pharmaceuticals. Mahony says concerns that cheaper generic drugs threaten the future of such companies, as their products go “off-patent”, are overblown and more than priced into stocks. In particular, markets are yet to recognise the likely impact of rising demand from the emerging markets. (article continues below)

The American and European drug market was worth between $500 billion (£320 billion) and $600 billion last year, compared with about $90 billion for the emerging markets. However, Mahony says the big players are all investing heavily in infrastructure in China and Brazil, and he expects emerging market economies to account for $300 billion to $400 billion of drug sales by the end of the decade.

He says the stockmarket’s recognition of the trend could be triggered by the results of one firm in particular – Pfizer. “Pfizer is the largest drug company and it has one of the biggest drugs in the world, Lipitor, which is a cholesterol-lowering drug,” he explains. “It goes off-patent towards the end of 2011 and come 2012, Pfizer will be making more money outside of the US than it is inside the US. To me, that’s a real tipping point. The prevailing wisdom in healthcare for the last 20 years has been that you generate products and sell them in the US, because that’s where everybody makes their profit. Now [investors will see that] we’re in a different world.” Until a re-rating occurs, Mahony says investors in big cap pharma stocks such as AstraZeneca, GlaxoSmith-Kline and Pfizer can expect dividend yields of 4-5%.

Elsewhere in the income book, he holds American healthcare real estate investment trusts (Reits), which generate high yields from hospitals and nursing homes. The allocation also includes companies offering doctor and nursing services, an Australian health insurer, and a Brazilian manufacturer of rubber gloves and low-end medical supplies. “They’re not growing that fast, compared with the rest of Brazil, but they’ve got a 7% dividend yield – they generate heaps of cash,” he adds.

The growth book, which contains about 30 stocks, most of which also appear in the open-ended fund, is split between what Mahony calls the “three ’i’s of healthcare”: innovation, inefficiency and infrastructure. Innovation focuses on companies developing products, although Mahony says the fund holds just 2% in high risk/reward biotechnology stocks, and its one holding is already profitable.

Infrastructure includes a Chinese orthopaedics firm selling to community hospitals – a market Mahony sees as attractive, because multi-nationals focus on big city-based teaching hospitals. But with government spending under greater scrutiny, “inefficiency” is where he sees the biggest opportunities.

“If you look at healthcare as a whole, the fundamentals are extremely strong in terms of an ageing population creating greater demand – not just from the retirement of the baby-boomers in developed markets like the UK or the US, but also from developing markets where people want more healthcare as GDP goes up,” he says. “The problem is how does the government, or whoever’s got to pay for it, foot the bill? So what we’re looking for is those companies which can deliver the same healthcare for less.”

The allocation contains companies benefiting from the privatisation of German hospitals and information technology firms. “That encompasses computer software to help manage processes, either within a hospital or helping district nurses make eight visits a day instead of five,” Mahony adds. “Healthcare has been conservative in implementing technology – the IT revolution hasn’t really hit the sector. But it is hitting, in terms of creating productivity gains.”