The PACER PERSPECTIVE
September 2022

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A Closer Look
at Health Care

- Danke Wang, Portfolio Manager

Currently, Health Care is one of the top sectors in the Pacer US Cash Cows 100 ETF (COWZ), occupying ¼ of the fund’s holding, the highest weighting since the fund's inception in 2016.

A sector with such a heavy weighting in one of our most popular funds deserves a closer look. Here’s what we found:

Key takeaways:

1. Fundamental growth, not multiple expansion, has been the driver of the Health Care sector's investment return.
2. Thanks to investment in intangible assets, the Health Care sector provides strong free cash flow generation and high free cash flow yield, revealing opportunities that investors can take part in.
3. The sector delivers both growth and stability with attractive valuation.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

Health Care’s major headwind is drug prices, which have been under considerable pressure since the middle of the 2010s. Specifically, there is a high degree of risk regarding legislation passing to curb drug prices. At the same time, Health Care names are facing a “patent cliff,” or a loss of market share and revenue as patents expire and generic drug challenges emerge. This pessimistic sentiment has been haunting Health Care companies resulting in low valuation levels.

Despite the uncertainty on drug policy and revenue growth, the Health Care sector has maintained strong fundamentals. During this period of muted multiple expansion, the sector delivered 152% cumulative earnings growth, not far behind the 173% growth from the Technology sector. And Health Care’s 146% Free Cash Flow growth is even slightly better than Technology names (144%).

Despite all the pessimism Health Care has faced during this time, the sector has churned out a 140% total return entirely driven by fundamental growth — not multiple expansion.

Source(s): Bloomberg

Bearish investors’ concerns that suppressed the sector’s multiple are justified to some extent, but there are a couple of things those investors might have overlooked:

1. Initiating policy changes is neither quick nor easy, especially with the complex political landscape and the strength of biopharma lobbying groups (even the Medicare drug price negotiation provision will not take effect until 2026, so the bill may only have a limited impact on growth).
2. Health Care companies can power future growth through their drug pipeline, innovation, and acquisitions, which may secure promising returns and profitability for investors.

Moving forward, biopharma companies should continue to have healthy business fundamentals, with minimal downside earnings risk compared to the broader market (though it is not guaranteed).

Is there anything else to like about the Health Care sector?

Yes.

Intangible Assets and Free Cash Flow
In the past two decades, more US companies are relying on a capital-light business model, differentiating their services or products by design, innovation, research development and intellectual property.

Source: Ocean Tomo, LLC Intangible Asset Market Value Study, 7/1/2020: https://www.oceantomo.com/intangible-asset-market-value-study/

With massive investment in drug development, Health Care’s source of cash flow comes from many intangible assets. Among S&P 500 companies, Health Care ranked #2 on the percentage share of aggregate Free Cash Flow (FCF) and #1 on the share of intangible assets¹, comparatively technology ranked #1 and #3, respectively.

(1)Intangible assets booked on the balance sheet

Source: FactSet

FCF and FCF Yield
The Health Care sector’s cash flow generation strength is reflected in the total FCF aggregate dollar amount and in the FCF generated in every dollar of sales (FCF Margin).

Larger companies or sectors tend to have a larger FCF dollar amount. So FCF margin paints a more complete picture regarding the strongest free cash flow generators.

Based on FCF margin, the top two industries within the Health Care sector are Biotechnology and Pharmaceutical, and both sectors are also overweighted in COWZ. Particularly, Biotechnology is producing the highest FCF margin among S&P 500 industries. At the same time, Biotech names trade at an 8.50% Free Cash Flow Yield, implying that the market is skeptical of the industry’s elevated level of profitability.

The market seems unconvinced these companies will continue to generate high FCF in the future, despite their strength in research and development and their uncanny ability to cash out intangible assets.

Source: FactSet

Growth
As previously mentioned, Health Care has delivered growth comparable to Technology in the past decade. And over the long run, it has been one of the fastest growing sectors in the market

But valuation-wise, the Health Care sector only trades at 15.3X on a forward earnings basis. Meanwhile, the Tech sector’s forward P/E is 22. Health Care’s valuation discount compared to the Technology sector is within the lowest quintile in history.

Stability
Large cap Health Care names are well-positioned in periods with high recession risk. Health Care is traditionally seen as a defensive sector along with Consumer Staples. Historically, the Health Care sector has demonstrated low earnings volatility over the long run and has had the lowest percentage of negative earnings growth periods since 1990.

Source: Bloomberg

Investors chase after defensive sectors such as Consumer Staples when facing recession risk and market volatility, pushing their valuation up. For context, the forward P/E of the Consumer Staples sector has averaged around 20 during the past two years, and now the sector is among the most expensive in the S&P 500. Meanwhile, as noted throughout this piece in other scenarios, Health Care (despite its defensive nature) traded at a discount.

Source: Bloomberg

The Pacer US Cash Cows 100 ETF (COWZ) invests in the top 100 highest Free Cash Flow Yielding companies within Russell 1000. The portfolio’s overweighting in the Health Care sector reflects where free cash flow is generated in the market and where such profitability is undervalued. With downward pressure on equity valuations, Health Care is better positioned than most other sectors.

Pacer US Cash Cows 100 ETF

Is a strategy driven exchange traded fund that aims to provide capital appreciation over time by screening the Russell 1000 for the top 100 companies based on free cash flow yield.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
This document is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. The user of this information assumes the entire risk of any use made of the information provided herein.
Free Cash Flow (FCF): A company’s cash flow from operations minus capital expenditures (expenses, interest, taxes, and longterm investments)
Enterprise Value (EV): A company’s market capitalization adjusted to eliminate any capital structure bias (i.e. by adding debt and subtracting cash or cash equivalents)
Free Cash Flow Yield (FCF/EV): Measures a company’s total free cash flow relative to its enterprise value. This is an internal statistic and does not constitute investor yield.
Forward P/E: Market Price per Share / next 12 month earnings per share