VGHCX: Creating A Strong Defensive Profile With Healthcare Investments

Originally published in the February issue Investor Guide to Vanguard Funds

Healthcare was one of the few bright spots in an otherwise down year for the stock market. Although the sector lost ground, strength in pharmaceutical stocks kept losses in the low single digits for most diversified sector funds. The actively managed Vanguard Health Care Fund Inv (MUTF:VGHCX) came out ahead of the pack with a decline of 1.05 percent, about 1 percentage point ahead of the overall sector. By comparison, the S&P 500 Index was weighed down by its hefty technology exposure. Vanguard S&P 500 ETF (VOO) slid 18.17 percent on the year.

The stable results by healthcare stocks in 2022 were consistent with their performance history. Major healthcare companies are typically large firms with diversified or stable income streams. Johnson & Johnson (JNJ) best exemplifies the diversified company. It sells all manner of goods ranging from medicine to household products. Shares gained nearly 6 percent in 2022. UnitedHealth Group (UNH) represents the other side of stable. It has a narrower business model, but consumers need healthcare year in and year out whether there is a recession or not.

Medical devices, pharmaceuticals and biotechnology make up the bulk of the remaining firms. These companies are often highly volatile in their early life because they have no income and trade entirely on the hope of hitting a discovery. If they make one, they graduate into being more stable earners.

Pharmaceuticals giants were the driving force behind healthcare gains last year with several enjoying double-digit gains such as Merck (MRK), Bristol-Myers (BMY) and Novo Nordisk (NVO). Pharma strength has waned early in 2023, although mid- and small-cap pharma companies are among the best-performing healthcare stocks this year. Medical devices and biotechnology, the two weakest subsectors in 2022, have led this year thanks to the bounce in technology and growth stocks.

The mix of growth and defensive subsectors makes healthcare a desirable sector for many investors. Other sectors experience boom-bust cycles where they lead for long periods and then underperform. Healthcare is a steadier performer often found in the middle of the pack because it has a healthy mix of growth and value exposure.

Vanguard has two main options for accessing this sector. Vanguard Health Care (VHT) is the passive ETF with an expense ratio of 0.10 percent and a yield of 1.31 percent. The other was the better performer in 2022: Vanguard Health Care Fund Inv (VGHCX). It has an expense ratio of 0.30 percent and 30-day SEC yield of 0.75 percent.

Management

Jean Hynes was named a co-manager of VGHCX in 2008 and took over as lead manager in 2013. She has been an analyst at Wellington Management Company since 1991, covering the healthcare sector. Two years ago, she was named CEO of Wellington. Despite the increased workload, she has stayed on as manager thanks in part to her large and capable team of analysts. She also stepped down from managing a separate healthcare fund, Hartford Healthcare (HGHAX).

VGHCX’s mandate calls for long-term capital appreciation. Management is tasked with investing in health services, medical products, specialty pharmaceuticals, major pharmaceuticals and international markets. The fund hunts for strong companies selling at a discount and will take contrarian positions in companies hit with negative events. The fund overweights the top holdings to the tune of about 30 percent of assets. Turnover is low at 15 percent, which translates to a nearly 7-year average holding period.

VGHCX has a 4-star and Silver rating from Morningstar.

Portfolio

VGHCX has an average market capitalization of $68 billion, more than the healthcare category average of $52 billion but below the index average of $102 billion. VGHCX is very similar to the index in that giant- and large-cap stocks make up 78 percent of assets versus 80 percent for the index. It differs from the category because it has less mid- and small-cap exposure.

VGHCX also differentiates itself geographically. It has nearly 9 percent of assets in Japan, 7 percent in the United Kingdom and 5 percent in Switzerland. The category has more than 90 percent invested in the U.S., and the index has nearly 100 percent.

Subsector exposure is led by 38 percent in pharmaceuticals, 22 percent in biotechnology, 14 percent in managed healthcare, 12 percent in healthcare equipment and 9 percent in life sciences tools and services.

The top 10 holdings as of December 31 were UnitedHealth Group 6.21 percent, Eli Lilly (LLY) 5.54 percent, AstraZeneca (AZN) 5.37 percent, Pfizer (PFE) 4.50 percent, Merck 4.14 percent, Novartis (NVS) 4.10 percent, Biogen (BIIB) 2.99 percent, Daiichi Sankyo (4568.JP) 2.90 percent, Stryker (SYK) 2.76 percent and Elevance (ELV) 2.70 percent.

VGHCX has a beta of 0.60 versus the 0.74 of the category and 0.67 of the index. The standard deviation is 15.54 versus 20.73 and 16.86 for the category and index, respectively. VGHCX is less volatile than the category and index and is also less volatile than VHT, which has a 0.68 beta and 16.92 standard deviation.

Performance

VGHCX has decreased 1.37 percent in 2022. That was 14 percentage points better than the category and 4 percentage points better than the index.

VGHCX has 3-, 5- and 10-year annualized returns of 6.83 percent, 9.74 percent and 12.64 percent.

It has outperformed the category over all of these periods, by 0.7 percentage points over 10 years and more than 2 percentage points annualized in the 3-year and 5-year periods.

VGHCX underperformed the index in the 3-, 5- and 10-year periods by an annualized 2, 1.4 and 0.8 percentage points, respectively.

Distributions

Over the past 5 years, the fund has paid dividends and capital gains equivalent to a minimum of 5.5 percent. Three years were above 8 percent and the highest was more than 12 percent in 2019. Investors should consider holding the fund in a tax-advantaged account.

Outlook

The strongest catalyst for healthcare is demographics. Most countries in North and South America, Europe, and Asia are rapidly aging. Healthcare demand rises as people age. Most countries are seeing their healthcare spending climb as a percentage of their economy. This will provide steady growth for the sector in both good and bad years for the overall economy.

Healthcare delivers a good defensive profile within a moderately weak stock market. Last year, investors rotated money from technology and growth into energy and value. This caused steep losses in technology and growth stocks, and indexes such as the S&P 500 Index were down close to 20 percent. Sectors without that exposure (including healthcare) saw small losses. Healthcare won’t offer much protection in a full-blown bear market where investors indiscriminately sell stocks, but even then, its losses might be meaningfully smaller than the broader markets. In the context of the current economy, technology and growth stocks are most at risk should inflation remain high, while energy and cyclicals stocks are most at risk should the Fed overdo it with rate hikes.

History tells us healthcare typically underperforms when investors are becoming aggressive and holds up better when they turn cautious. Slow and steady wins the race though. After last year’s pullback in growth stocks, healthcare is outperforming consumer discretionary and communication services over the past decade. Only technology has done better.

We recommend investors overweight healthcare stocks in most market conditions. VGHCX is a good option. Its higher international exposure offers some geographic diversification. Portfolios with heavy value exposure should check sector exposure to make sure healthcare isn’t too high a percentage of assets, but since the sector itself has lower volatility and steadier performance, a slightly high overweighting isn’t as worrisome as it would be in the energy sector, as one example.