XHE: We Expect Consistent Double-Digit Returns For The Foreseeable Future

~ by Snehasish Chaudhuri, MBA (Finance)

During my last coverage almost 15 months back, I was bullish about SPDR® S&P Health Care Equipment ETF (NYSEARCA:XHE). I found that historically, this fund has been one of the best performers, and one of those rare funds to deliver a standout performance over the 2020 crash, when it grew by an astonishing 33 percent. As XHE’s portfolio was more or less equally distributed over 86 stocks, the fund seemed well protected from market volatility. The fund sustained a decent growth during the Covid-19 pandemic and generated decent price multiples. I had a feeling that XHE might enhance its asset base and invest more in those same stocks that constituted its portfolio. 15 months hence, I’d like to have a relook on this healthcare fund and assess its “investability.”

XHE Equally Invests in Stocks of Almost 80 Healthcare Equipment Firms

SPDR S&P Health Care Equipment ETF is currently invested in growth and value stocks of small-cap and mid-cap companies within the healthcare equipment sector. Investments are almost equally distributed among almost 80 stocks, which means a very small proportion of XHE’s assets is invested in a particular stock. The biggest advantage of such diversification is that it makes the fund less volatile.

During my last coverage, I found that medical devices, healthcare equipment, and healthcare supplies were the three healthcare segments that recorded positive and impressive returns post the pandemic period. Concentrating on those segments thus benefitted SPDR S&P Health Care Equipment ETF, as it was successful in generating quite a strong return.

SPDR S&P Health Care Equipment ETF seeks to track the performance of the S&P Indices Health Care Equipment Select Industry Index (SPSIHE), by using representative sampling techniques. To represent the benchmark index, XHE’s $546 million net assets are invested over almost 80 stocks that are selected from every sector, every geographic location, and over all types of market capitalization. Since its inception in 2011, XHE has been able to mimic its benchmark index SPSIHE. Between 2016 and 2021, XHE has generated an annual average total return of 18.24 percent. The fund has an expense ratio of 0.35 percent and has a turnover ratio of 42 percent. XHE is currently trading almost at par with its net asset value and doesn’t pay any dividend.

XHE’s Price Performance in Past 1 Year Was Better than that of S&P 500

Let’s have a look at the top 20 investments of SPDR S&P Health Care Equipment ETF. Stocks like ShockWave Medical, Inc. (SWAV), Heska Corporation (HSKA), UFP Technologies, Inc. (UFPT), Intuitive Surgical, Inc. (ISRG), Glaukos Corporation (GKOS), Inspire Medical Systems, Inc. (INSP), Penumbra, Inc. (PEN), Merit Medical Systems, Inc. (MMSI), DexCom, Inc. (DXCM), Lantheus Holdings, Inc. (LNTH), Haemonetics Corporation (HAE), and Boston Scientific Corporation (BSX) registered a price growth between 20 and 120 percent during the past 12 months. In one word – that’s incredible.

However, the price growth of XHE itself was not that impressive. It grew by only 4 percent during that period. However, the fund did at least register a better price growth than that of S&P 500 Index (SP500), which grew by only 2.57 percent.

Other stocks included within XHE’s top 20 investments are FIGS, Inc. (FIGS), Omnicell, Inc. (OMCL), CONMED Corporation (CNMD), AtriCure, Inc. (ATRC), NovoCure Limited (NVCR), ICU Medical, Inc. (ICUI), STERIS plc (STE), and Edwards Lifesciences Corporation (EW). Other notable investments of SPDR S&P Health Care Equipment ETF include Integer Holdings Corporation (ITGR), LivaNova PLC (LIVN), Medtronic plc (MDT), Becton, Dickinson and Company (BDX), Alphatec Holdings, Inc. (ATEC), Baxter International Inc. (BAX), Inari Medical, Inc. (NARI), The Cooper Companies, Inc. (COO), Teleflex Incorporated (TFX), and ResMed Inc. (RMD).

Unfortunately, most of these stocks failed to generate positive price growth. Only CNMD, ATRC, and ATEC were able to register a double-digit price growth during the past twelve months.

XHE Seems to Have Less Volatility, Thus, is Well Suited to Current Scenario

SPDR S&P Health Care Equipment ETF is a relatively steady fund. It delivered positive price growth during almost all the years since its inception. 2022 surely was a poor year for this fund. Otherwise, this fund has stood out when most of the funds suffered huge losses. This fund generated an average annual total return of 18 percent during the Covid-19 pandemic (2020 and 2021). The fund seems to be less volatile, primarily for three reasons. It is equally distributed among almost 80 stocks, it invests in less volatile segments of the healthcare sector, and it invests in mid-cap and small-cap stocks that are less volatile in nature. However, on the negative side, the XHE fund delivers below-average performance when the market is under a bull run.

XHE is a Good ETF, But the Current Valuation Seems to be on the Higher Side

The equity stocks held by SPDR S&P Health Care Equipment ETF has a relatively higher average price to earnings (P/E) ratio of 26.5. This is a more than 50 percent premium over the P/E of its benchmark index. The same is true about the average price to cash flow (P/CF) ratio. Average price to sales (P/S) ratio is almost double that of the index. This simply implies that the valuation of XHE is on the higher side. Such high price multiples surely create doubt in the mind of investors. But we need to understand that such high valuation was bound to happen, as the fund was consistently delivering double-digit returns for almost a decade – a time period when most of the funds witnessed high volatility and negative returns for a significant portion of that decade.

Investment Thesis

The healthcare equipment industry has been one of the more consistent top-performing industries in the last decade. Its returns seem to correlate with U.S. durable medical equipment spending trends, and since there is little evidence of this slowing down, I expect it to continue its steady performance. SPDR S&P Health Care Equipment ETF used to generate double-digit total return prior to the Covid-19 pandemic, and as the market stabilizes, achieving such a growth rate on a consistent basis is not far away.

Valuation concerns, though there, are a little overblown, as the XHE fund has always had a higher price multiple than average. There is little evidence that a high P/E ratio indicates these companies are truly overvalued. The industry is growing, it will continue to grow for the foreseeable future, companies are innovating like never before, and SPDR® S&P Health Care Equipment ETF’s low annual returns aren’t unjustified. In my opinion, this equal-weight ETF is a great investment option for long-term growth-seeking investors.