The Vanguard Health Care Fund

Although Vanguard has developed a reputation for its index funds, it actually has almost ⅓ of its assets under management for active funds with stock pickers. What has caught my attention recently is that the Vanguard Health Care Fund (VGHCX) has recently fallen in price. Back in December, Vanguard Health Care traded at $232 per share and has since come down in price to $190 per share as of Friday’s closing at $190.

I pay attention price declines in the valuation of health care stocks because of Dr. Jeremy Siegel’s research documenting 13% annual returns for healthcare investors between 1956 and 2003, second only to the tobacco sector of that time frame. The profit margins in the sector are enormous, and the only recurring risk for investors is what I call the “Pfizer” effect–the rebasing of earnings that occurs when cash cows like Lipitor lose patent exclusivity and profits fall in a way that can’t be offset from new product launches or growth from the rest of the existing portfolio. In the past decade, Eli Lilly and GlaxoSmithKline shareholders have also suffered from this effect.

What I like about the Vanguard Health Care Fund is that it invests in biotech and health-care stocks early in the life cycle and then holds them through to maturation. The turnover rate for the Vanguard Health Care Fund is 20%, meaning that the average holding period for a typical stock is five years. If someone ran a portfolio analysis on the Vanguard Health Care Fund (VGHCX), they would see that the P/E ratio is 33x earnings. Ordinarily, you would think holy cow–why would I want to buy something that looks that expensive?

Well, the strategy involves buying drug companies with promising pipelines using a basket approach so that the rapid earnings growth from the winners will drive returns so great that it easily dwarfs the performance of the healthcare stocks that do not deliver. For instance, the signature holding of the the Vanguard Health Care Fund (VGHCX) is Allergan PLC. At the time of purchase, it traded at 44x earnings. But here is why the strategy works: It has grown earnings at 19% annually since its inclusion in the Vanguard Health Care Fund and delivered 17.31% annual returns over that time frame.

Since 1984, the Vanguard Health Care Fund has returned: 17.28% annually compared to the 11.30% annual returns of the benchmark health-care index and 9.94% annual returns of the S&P 500 Index Fund. It is the best performing Vanguard Fund of all time, turning a $10,000 initial investment at the May 23, 1984 launch into $1,236,988 today before expenses. The expense ratio is 0.34%, meaning you would have to subtract $17,200 over the past twenty-seven years to adjust for Vanguard’s take which would leave you with $1,219,788 in reality (though some retirement accounts have negotiated lower bulk rates from Vanguard than the 0.34% used in this example).

The conventional wisdom of retirement planning among financial professionals is to eschew sector-specific funds like Vanguard Health Care. But I don’t understand how someone can have a blanket opinion on that since not all industries are equal. If you are scrolling through your menu of 401(k) offerings and see an aluminum or shipping-sector specific fund, then yeah–follow the conventional advice of the industry and avoid the heck out of those funds. Since 1900, aluminum stocks have only outpaced inflation by one percent annually and shipbuilders have only outpaced inflation by 0.7 percent annually from 1900 to 2013. The expenses measured against expected profits over the full course of the business cycle would almost never justify any of those stocks as the type of things to hold for the long run.

On the other hand, a fund that specializes in alcohol, consumer stocks, healthcare, or energy might make a lot of sense because these sectors of the economy have a century of data on their side denoting outperformance. This knowledge is usually only talked about among wealthy families and a sampling of academics, but they have high profit margins over the full course of the business cycle and little risk of bankruptcy due to friendly competition that makes it areas of the economy where nearly everyone builds wealth over the long haul.

In particular, what I like about the Vanguard Health Care Fund in particular is the manner in which it chooses to expose itself to the biotech sector. Biotech stocks are notoriously volatile and can experience 50% swings in a hurry in response to changes in sentiment. And given that biotech investments are high risk due to the number of bankruptcies in the sector, it makes a lot more sense to take a basket approach rather than investing in firm-specific biotechs because the costs are drastic if you are wrong (i.e. if you think GlaxoSmithKline will perform well and it doesn’t, no big deal, you only have to put up with years of 3-4% annual compounding. But choosing wrong in the biotech sector often involves bankruptcy risk because a typical biotech stock derives its value from one drug that is in the early stages of commercialization).

What makes the Vanguard Health Care Fund (VGHCX) unique is that balances a commitment to long-term biotech investing against those firms with diversified operations and high single digit earnings growth. In other words, you have Allergan blending with Abbott Labs, Becton Dickinson, and CVS Health within the fund. The successful biotechs drive the returns over the long haul, but the stable earnings growth from the likes of Becton Dickinson limit some of the short and medium term volatility of the fund by acting as an important offset against the biotech holdings when they are out of favor. I have found that retirement investors care about volatility quite a lot, and the Vanguard Health Care Fund (VGHCX) is the best way to get biotech exposure without feeling the full effects of the ups and downs.

Since Christmas, the price of the Vanguard Health Care Fund (VGHCX) has fallen 13%. It has provided a fair entry point for a fund that has delivered 19% annual returns over the past five years, 11% returns over the past decade, and roughly 17% annual returns since the inception thirty-two years ago. It benefits from the long-term wealth building characteristics of the health-care sector in general, and the distinguishing characteristic of management is that it buys a collection of biotech firms and holds them through their period of rapid earnings growth to deliver superior returns. Vanguard Health Care Fund (VGHCX) is on the short list of the best mutual funds I have ever come across.

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