BME: Monthly Dividends Plus Growth

BME: Monthly Dividends Plus Growth

All eyes are on the health care sector as the Covid-19 vaccine gets distributed in the United States. The Covid-19 pandemic has made it apparent how critical the healthcare industry really is to the broader economy. Moreover, it’s accelerated innovation that will form the basis for many major investment opportunities in the coming years.

Even before Covid-19, the healthcare sector benefited from several secular tailwinds. The population in developed markets is rapidly aging, and as emerging economies move up the income ladder they are rapidly increasing their healthcare spending. The healthcare sector is unique in that it is both defensive and growth orientated.

The Blackrock Health Sciences Trust(BME) is a closed end fund that more investors should be following. Its strategy has delivered both income and capital gains over the past 15 years, and has great potential to benefit from the coming healthcare boom.

Portfolio

BME’s mandate defines the healthcare sector broadly so that it includes healthcare providers, along with companies involved in researching, developing, and distributing products and services for the medical, dental, optical pharmaceutical and biotechnology sectors. The portfolio is split almost evenly between healthcare, equipment and services (~51%), and pharmaceuticals/ biotech (~47%). The balance is held in cash, or in financial services and insurance company.

According to the most recent annual report, BME is still overweight medical devices stocks, but management increased the proportional allocation to biotechnology stocks throughout 2020. Consequently they have benefited from the recent flood of capital into that sector. The portfolio is focused on large cap US healthcare companies, which account for 86% of the portfolio, but it also has small investments spread across other markets such as Switzerland (~3%), China(~2%), and France (~2%)

BME holds over 130 holdings, but the top 10 holding account for ~37% of the portfolio. This table shows BME’s largest holdings.

Collected – Top Holdings

Weight

UNITEDHEALTH GRP ORD

7.18

ABBOTT LABORATORIES ORD

5.15

JOHNSON & JOHNSON ORD

4.82

THERMO FISHER SCIENTIFIC ORD

3.18

MEDTRONIC ORD

3.01

BOSTON SCIENTIFIC ORD

2.99

AMGEN ORD

2.79

EDWARDS LIFESCIENCES ORD

2.69

HUMANA ORD

2.46

PFIZER ORD

2.44

Source: Thomson Reuters Eikon

BME sells calls against some of its positions in order to generate income. Currently 38% of its portfolio is overwritten with call options. This partially reduces the maximum upside, but it also mitigates short term volatility, and provides consistent income.

Performance

BME pays monthly dividends, and currently yields around 5.2%. Yet since healthcare has been a secular growth play, BME has also grown its NAV consistently, unlike most income focused closed end funds. In fact NAV has increased from $27.19 in 2010, to $42.86 as of September 30, 2020.

Its annualized total return has been ~15% over the past decade. This chart shows trailing NAV and market price returns as of September 30, 2020:

Source: Fund Fact Sheet

BME has a gross expense ratio of 1.10%, making it much more expensive than the Health Care Select Sector SPDR(XLV), the most popular healthcare ETF, which has an expense ratio of 0.13%. However, its net returns that matter, and BME’s management does seem to be earning their fees. BME’s total return over the past ten years has narrowly edged out XLV on a total return basis over the past ten years, as this chart shows:

Source: Thomson Reuters Eikon

Although its lagged a bit over the past 6 months, BME has also consistently outshined the universe of equity closed end funds. In fact its 10 year annualized NAV return of 15.1% is nearly 2.5x its peer group NAV return of 6.32%.

Source: CEF Connect

Main Risks

BME’s portfolio faces two interrelated risks: regulation and disruption. Profit margins in the US healthcare sector are well above the global average, and something resembling Socialized medicine is becoming an increasingly mainstream political idea in the US. Additionally, the complex regulations currently in place for the healthcare industry tend to favor incumbents. If a new administration were to make more consumer friendly changes, profit margins would likely come down drastically.

Although there will certainly be a flood of capital into the health care sector over the coming years, its possible a lot of it will go to businesses that disrupt the profit generating ability of traditional healthcare companies. Indeed, Google, Amazon, or one of the other technology behemoths could potentially enter the space and drive profit margins down to nearly zero. On the other hand, as a recent article in The Economist noted, many new tech entrants into the healthcare space choose to cooperate with existing players, rather than try to navigate complex regulatory issues themselves. Additionally, companies in BME’s portfolio such as United Healthgroup (UHG) can use their massive cash flows to buy up any promising startups in the space.

Valuation

BME has mostly traded at a premium over the past five years. The current NAV premium of 4% is slightly above the five year average of ~3%, according to data from CEF Connect. This chart shows BME’s historical price compared to NAV:

Source: CEF Connect

Conclusion

BME’s management has demonstrated its ability to outperform the broader healthcare sector. As secular trends favoring healthcare accelerate, stocks should benefit. BME isn’t cheap, but it offers the rare opportunity to get exposure to a high growth sector in an income vehicle. Any time BME drops below NAV will be a major buying opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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