THQ: Investing In A Healthy Future

As I approach my 65th birthday in a couple of days my thoughts turn to my own health (which is still good, fortunately!) and the state of global healthcare since the end of the global Covid-19 pandemic. Although the pandemic caused a lot of damage and forced everyone to think about the importance of good healthcare even more than they did before the pandemic, it has also sparked a flurry of innovation and medical research that was unheard of prior to 2020. And although the healthcare sector of the stock market did not perform very well in 2023, it appears that prospects for outperformance in 2024 are looking encouraging. In fact, so far in January, the healthcare sector is the most bullish of all according to a recent BofA global fund manager survey. In the second week of January, the healthcare sector saw the largest amount of net buying in the past five months, according to Goldman Sachs.

For investors with a longer-term horizon, the healthcare sector shows promise with an aging population that is living longer in both developed countries and in many developing nations leading to an ever-growing demand for improved healthcare. According to this recent insight from fund manager, abrdn, the cell and gene therapy industry offers especially promising growth opportunities:

The cell and gene therapy industry is set to grow at a compound annual growth rate of 34% from 2021-2027. The US Food and Drug Administration predicts that it will be approving some 10 to 20 cell and gene therapy products each year by 2025, compared to a total of just 21 as of September 2021.

One example of this recent innovation and a promising growth opportunity is represented by the introduction of the new GLP-1 class of drugs to treat obesity and diabetes. The initial results have been truly remarkable and offer a whole new class of drugs to potentially impact a wide area of diseases beyond weight loss due to the cardiovascular and renal benefits of the incretin drug therapy. In fact, some Wall Street analysts predict that the market size for this class of drugs could exceed $100B.

Today, GLP-1s are used by around 10-12% of T2D patients in the U.S. “We model GLP-1 usage expanding to around 35% of diabetics in the U.S. in 2030 and would not be surprised to see upside to this number, especially as outcomes data continues to emerge,” Schott noted. “In addition, we forecast that around 15 mn obese patients will be on GLP-1s by the end of the decade.” Overall, total GLP-1 users in the U.S. may number 30 mn by 2030 – or around 9% of the population.

The GLP-1 market is currently dominated by 2 players – Eli Lilly (LLY) and Novo Nordisk (NVO). And while the current drug pipeline is fully stocked and increasing net sales for both companies, new AI-based drug discovery methods offer the potential to further enhance the research and development of safer and more effective new drugs. In fact, the success of the GLP-1 drugs led to LLY becoming the largest drug maker by market cap (currently $565B), surpassing JNJ last year.

Healthcare CEFs

Trying to pick one or two strong healthcare stocks to invest in can be challenging. As a long-term investor interested in income-producing investments along with some capital appreciation, I have found that well-managed CEFs can offer outstanding returns when purchased at an appropriate discount and when the fund is actively managed to respond to market whims.

For those long-term investors interested in achieving an attractive return on a healthcare fund, a closed-end fund that invests in healthcare companies may be a good option. Investors in CEFs may be familiar with the name abrdn, but if you were not already aware, the 4 healthcare funds formerly managed by Tekla Capital Management were acquired by abrdn in October 2023. Those four funds are shown in the table from the press release, and although the names changed the ticker symbols did not.

While each of the four funds has its pros and cons, THQ and THW offer monthly dividends while HQH and HQL pay quarterly. In this article, I will focus on abrdn Healthcare Opportunities Fund (NYSE:THQ), which I feel is well positioned for the future with its top holdings in healthcare and the promise of strong returns in the sector, while the fund trades near its historic discount.

Here are some key facts about the fund from the website:

The THQ fund is currently trading at a discount of -13.75% as of market close on January 19. That is close to the widest discount that the fund has seen in the past five years. That discount has just started to narrow over the past few weeks even as the NAV has begun to rise again from its October 31 low.

While THW offers a higher yield (about 11%), the total return from THQ has been even better than THW over the past one-year period with a positive 2.5% total return compared to -5.5% for THW, as well as over the past 3 years at 7.9% for THQ vs -2.3% for THW. However, for new investors who are looking to the future, past returns are only helpful in knowing what previously happened but do not predict what will happen. Let’s take a closer look at the portfolio holdings for THQ to try to determine what the future returns might look like.

THQ Top Holdings

According to the fund’s Annual Report, THQ employs a versatile growth and income strategy across all sub-sectors of the healthcare industry and across the full capital structure (both equity and debt). The investment philosophy of the fund is explained:

As of 11/30/23 the top 10 holdings in the fund represent nearly half of the total portfolio and include many leading companies in the healthcare industry.

As of the end of November, LLY was the fund’s top holding which makes sense given the stock’s momentum and growth prospects from the GLP-1 drugs described above. UnitedHealth (UNH) is another top holding that has performed very well over the past 5 years and delivered solid results for Q423 when it reported earnings last week.

Managed care bellwether UnitedHealth exceeded Wall Street forecasts with its financials for Q4 2023 on Friday as the group’s quarterly earnings per share rose ~16% YoY despite rising costs in its insurance arm and Optum business.

JNJ is next up on the list of top holdings at nearly 6% of the portfolio value. At a market cap of nearly $390B it is a Dividend King and gets mostly Buy ratings from analysts despite struggling over the past year due to lawsuits over talc-based baby powders.

Merck & Co. (MRK) is another $300B market cap pharmaceutical company with good potential for strong returns. In fact, 17 Wall Street analysts rate MRK a Strong Buy, while 6 rate it a Buy and 6 give it a Hold rating.

The fifth-largest holding at nearly 4.5% is AbbVie (ABBV). With a market cap of about $290B, ABBV is also highly rated by Wall Street analysts with 8 Strong Buy, 8 Buy, and 13 Hold ratings.

Looking at results for the top 5 holdings over the past 5 years, only JNJ has a total return of less than 90% over that time frame. The recent jump in LLY stock has propelled that stock to generate the highest return with most of that jump coming in the second half of 2023.

Distributions and Coverage

Similar to other CEFs that I have recently written about, the Tekla funds employ a managed distribution policy that offers a level distribution to shareholders regardless of the net income or capital gains received from the fund’s investments. In the case of THQ, the monthly distribution has remained the same since the inception of the fund in 2014 (except for a special dividend paid in December 2015).

From the latest section 19 notice issued on January 10, 2024, this is the explanation for that policy:

Each Fund has adopted a distribution policy to provide investors with a stable distribution out of current income, supplemented by realized capital gains and, to the extent necessary, paid-in capital.

Unfortunately, in the case of THQ the amount of ROC (return of or “paid-in” capital) is nearly 100% YTD since the end of the previous fiscal year on 9/30/23.

Where the estimated amounts above show a portion of the distribution to be a “Return of Capital,” it means that Fund estimates that it has distributed more than its income and capital gains; therefore, a portion of your distribution may be a return of capital. A return of capital may occur for example, when some or all the money that you invested in a Fund is paid back to you. A return of capital distribution does not necessarily reflect the Fund’s investment performance and should not be confused with “yield” or “income.”

For at least the past 3 months, the fund has not been earning the 7% distribution that it has been paying out and that is a concern going forward. That concern may also explain why the discount has continued to remain historically wide if investors fear a dividend cut is forthcoming. This is not an encouraging trend and is especially unfortunate given the recent strong performance of the fund’s top holdings during that time.

Although a distribution cut may not be the worst outcome, it would likely have the effect of causing an even bigger increase in the discount and a big drop in the price of the fund. That is essentially what happened last year with the RA fund from Brookfield when that fund cut its distribution after paying the same monthly amount for the 7 years up until it cut last year. The price of the RA fund dropped dramatically and has not since recovered.

Summary and Conclusion

While the healthcare sector struggled to keep pace with the rest of the market in 2023, the THQ fund that was managed by Tekla until October when abrdn took over also had a difficult time covering the steady monthly distribution as evidenced by a large amount of ROC in the most recent distributions.

Changes to the top holdings can be seen when reviewing what the top holdings were as of 9/30/23 from the fund’s Annual Report, compared to what the top holdings are now (as of 11/30/23, which is the latest that I could find). For example, Pfizer is no longer a top holding where it was more than 4% of net assets back in September. Furthermore, there is less concentration in the biggest holdings with no single holding representing more than 7.5% now compared to UNH making up more than 10% of net assets previously.

As 2024 unfolds and the healthcare sector is demonstrating a strong recovery with good prospects going forward it remains to be seen whether THQ can continue to pay out the same monthly distribution of $0.1125 that it has paid for nearly 10 years now.

I am cautiously optimistic about the future of THQ given its strong position within the healthcare industry as represented by the fund’s top holdings and abrdn has proven to be a good fund manager. But I rate the fund a Hold given the large amount of ROC in the most recent distributions and would like to see the fund performance improving for a few more months before being motivated to start a new position. If one currently holds shares of THQ, the price, and NAV trends are encouraging and I would not be looking to sell shares at this time, especially as healthcare shows signs of recovery in 2024.