Could The Small Cap Healthcare ETF Be A Great Pick? (PSCH, SLXP, CBST, QCOR)

Eric Dutram: As the market remains uncertain heading into the summer months, a closer look at safe haven investing has been ordered by many investors.  Generally, this has centered on a few choice sectors with most of the dollars going towards utilities, consumer staples, and health care firms in order to prevent losses.

This strategy has held up nicely over the past month as these niches have been solid performers despite the overall downturn in the marketplace. However, in the case of health care—and specifically pharma—there could be some serious roadblocks ahead that should make any investor pause before buying securities in the sector (see more in the Zacks ETF Center).

That is because many firms in the pharma space are dangerously close to a patent cliff in which many of their top selling products will go off of patent soon and face generic competition. The main problem with this is that due to sparse product pipelines, there isn’t very much to replace these blockbuster products in terms of revenues, leaving many major pharma firms looking at a precarious situation.

Thanks to this, big companies in the space are moving to acquire smaller firms in the health care world in order to help boost product pipelines. Often times, these small companies have managed to make a name for themselves by making good progress on a particular drug although they may not have the marketing or research expertise to either bring it to market or make it a success afterwards.

As a result, they are often takeover targets by big pharma firms who are growing increasingly desperate now that the patent cliff is fast approaching. In fact, over the next three years, six big pharma firms have more than half of their drug portfolios at risk due to this phenomenon, leaving smaller firms in a great position. “We’re in an attractive M&A market as big-cap pharma companies are looking to acquire innovation to address their patent cliffs,” writes Moelis & Co.’s Rick Leaman.

This trend has already begun to take place, as evidenced by recent M&A activity in the field. In fact, the sector saw $33 billion in merger and acquisition activity in April alone, including several moves by a number of the most well-known companies in the segment.

Furthermore, not only do many companies have impressive war chests of cash at their disposal, but they are often increasing reserves by shedding ‘non-core’ activities too. Pfizer has recently moved a big piece of its business to Nestle while GlaxoSmithKiline has made similar—albeit smaller—steps down this path as of late as well (see Ten Biggest U.S. Equity Market ETFs).

These moves seem poised to result in a continuation of the M&A wave that investors are just starting to now see. As a result, it could be time to concentrate on the small cap segment of the health care world as an area which could see more promise over the next few years (read Five ETFs to Buy in 2012).

While taking positions in a few companies in the space could be a way to go, we think that an ETF approach, which looks at dozens of firms, is the best bet. That is because the M&A activity will be concentrated in a few firms and some investors may miss out on solid gains by picking the wrong firms. Instead, an ETF look bets on the ‘rising tide lifts all boats’ theory that the broad sector will be able to perform well with lower levels of risk overall.

For investors subscribing to this methodology, there is currently one small cap healthcare ETF that is currently on the market which we have highlighted below. The product could be the ideal way to play this trend and it could be a top pick for investors looking to gain more exposure to the pharma space, but with more growth potential.

PowerShares S&P SmallCap Health Care Portfolio (NASDAQ:PSCH)

This ETF tracks the S&P SmallCap 600 Capped Health Care Index which is a benchmark that tracks small companies in the business of providing healthcare-related products, biotechnology, pharmaceuticals, medical technology, supplies, and facilities. Currently, this produces a fund that holds about 67 firms while charging a relatively low 29 basis points a year in fees.

In terms of style, growth dominates as value securities only account for 18% of the total portfolio. Meanwhile, from a market cap look, small caps take up nearly three-fifths of the assets, while the rest is in micro cap securities, giving the product an average market cap of just $1.45 billion (see Medical Device ETFs: A Better Way To Play Health Care?).

This ensures that the product has a heavy focus on the smallest securities which could be excellent takeover targets for their large cap brethren. However, partially thanks to this perception, the PE ratio and PB ratio is rather high for many of the securities in the product, suggesting that the bar could be tough to match in terms of growth if many firms are not swallowed up by their larger counterparts.

With that being said, investors should note that the product is relatively well spread out from an industry perspective holding relatively equally portions of companies in the medical equipment, services, pharma, and biotech spaces. Top individual holdings include Questcor Pharmaceuticals (NASDAQ:QCOR),Cubist Pharmaceuticals (NASDAQ:CBST), and Salix Pharmaceuticals (NASDAQ:SLXP), while these three account for about 16% of the total (also see Forget Big Pharma, It Is Time For A Biotech ETF).

Overall, this fund could be far more volatile than others in the space while paying less in dividends as well. However, the growth is hard to deny for the segment and big pharma is likely to get even more desperate—and competitive—as the months pass. As a result, the risks seem to be worth taking in this ETF and those who are looking for more exposure to this segment could have a winner on their hands with this small cap fund.

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Written By Eric Dutram From Zacks Investment Research

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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