Even if the Federal Reserve begins hiking interest rates later this year, the healthcare sector, notably pharmaceutical stocks and related exchange traded funds, could outperform on greater merger and acquisition activity.
Barclays analyst Douglas Tsao argues that M&A activity will continue through a rising rate environment, reports Ben Levisohn for Barron’s.
“Given the importance of M&A to U.S. specialty pharmaceuticals, the prospect of higher interest rates as a result of Fed tightening has become an increasing source of concern for investors in recent weeks,” Tsao told Barron’s. “However, we expect the continued financial benefits realized through tax and operational cost synergies would overwhelm any sensitivity to interest rates.”
Specifically, Tsao points out that deal activity will be fueled by balance sheet capacity, tax synergies after the wave of inversions, and overcapacity of sales infrastructure, which has made cost synergies easily harvested. [Healthcare ETFs: Specialized Drugs in Greater Demand]
The Barclays analyst pointed to some standouts in the pharma space, including Valeant Pharmaceuticals (NasdaqGS: VRX) and Jazz Pharmaceuticals (NasdaqGS: JAZZ). Tsao contends that Valeant will continue to grow as the market factors in the company’s improved organic growth prospects, and Jazz remains a “best-in-class name in the U.S. specialty pharmaceuticals industry.”
Investors who would like broad exposure to the space could look at pharmaceutical ETFs, including Market Vectors Pharmaceutical ETF (NYSEArca: PPH), SPDR Pharmaceuticals ETF (NYSEArca: XPH), iShares U.S. Pharmaceuticals ETF (NYSEArca: IHE) and PowerShares Dynamic Pharmaceuticals Portfolio (NYSEArca: PJP).
PPH has the greatest tilt toward larger pharma stocks, including 77.1% mega-caps and 18.9% large-caps. PPH has a 4.5% weight in VRX and 0.7% in JAZZ.
PJP also includes 46.6% mega-caps and 14.5% large-caps, along with a significant 29% position in small-caps.
IHE has a more spread out allocation, with 44.7% mega-caps, 11.2% large-caps, 13.6% mid-caps and 24.9% small-caps. IHE holds 2.7% in JAZZ.
Due to its more equal-weight methodology, XPH includes a bigger tilt toward smaller companies, including 12.2% micro-caps, 41.9% small-caps and 17.1% mid-caps, along with 20.4% mega-caps and 8.4% large-caps. The ETF has 2.8% in JAZZ.
RBC’s Randall Stanicky and James Chen believe that more buyers going after fewer sellers will also force pharmaceutical companies to acquire smaller firms like Akorn (NasdaqGS: AKRX), Flexion Therapeutics (NasdaqGS: FLXN) and Agile Therapeutics (AGRX).
“We continue to expect smid cap specialty to outperform on our simple thesis that there is more consolidator capital chasing fewer high quality assets in the sector,” according to the RBC analysts.
ETFs with a larger tilt toward smaller companies will have a better chance on capturing the sudden spikes in response to takeover bids. For instance, AKRX makes up 2.6% of XPH, 3.3% of PJP and 1.6% of IHE. [M&A Activity Will Continue to Support Market Sectors, ETFs in Next Rate Hike]
Additionally, investors interested in smaller companies in the growing industry can take a look at the ALPS Medical Breakthroughs ETF (NYSEArca: SBIO), which targets companies that have new drugs going through clinical trials. SBIO holds 3.9% AKRX and 0.4% FLXN.
For more information on the healthcare sector, visit our healthcare category.
Max Chen contributed to this article.