"A core tenet of our philosophy is the importance of using a longer-term horizon to evaluate secular themes and health care trends as well as individual companies on a global scale." – Manager Jean Hynes in the Vanguard Health Care Fund (Trades, Portfolio)'s Annual Report for 2016
It may seem odd to see a mutual fund – the Vanguard Health Care Fund – on the list of investing gurus, but it’s simply a bit of a turnaround. After all, many gurus run funds of one kind or another. In this case, the fund has had two notable managers backed up by teams of professional researchers.
Edward P. Owens was the fund’s original manager and won praise from all quarters for delivering outstanding returns throughout the more than quarter-century he ran it. Jean M. Hynes took over the top spot at the beginning of 2013 and has mostly continued the winning tradition.
Undoubtedly, both managers have been influenced by the iconic founder of Vanguard, John Bogle. He pioneered low-cost, passive mutual funds and gave all investors a new way to think about investing for the long haul.
As with the other gurus we’ve profiled – David Tepper, Prem Watsa, Bill Ackman and Chuck Akre – there are lessons to be learned from the gurus who run and have run the Vanguard Health Care Fund.
What is the Vanguard Health Care Fund?
This fund is part of the Vanguard stable of mutual funds, and Vanguard is the company founded by Bogle in 1975. It is advised by Wellington Management Co. LLP (Bogle is a former chairman of Wellington); Owens and Hynes are Wellington advisers.
It is one of two nearly identical funds:
- Vanguard Health Care Fund Investor Shares 0.36% MER, $3,000 minimum.
- Vanguard Health Care Fund Admiral Shares 0.31% MER, $50,000 minimum.
We will focus on the first, the fund with the lower ($3,000) entry threshold and the slightly higher MER.
According to the Fund Fact Sheet from Vanguard, the fund offers:
- Low-cost exposure to domestic and foreign companies in the health care industry.
- Exposure to firm types such as pharmaceuticals, medical supply and research.
- Geographic diversity; 21% of its capital is invested outside the U.S.
- A relatively low turnover ratio.
- Narrow scope, and hence may be more volatile than more-diversified firms.
- Investments that should be considered complementary to an already diversified portfolio.
Following up on that last point, Vanguard is essentially saying this fund should be a relatively small proportion of any portfolio because of its concentration on this one industry.
It is rated as an Aggressive fund, carrying the highest risk level among Vanguard funds, as explained in this excerpt from the Fact Sheet:
At the end of February, the fund contained 75 stocks with a total net asset value of $46.2 billion – a big fund in other words. Of that total, the biggest chunk, 46.8%, was in pharmaceutical companies, and the second-largest holding was in biotech companies at 14.9%.
The biggest holdings in individual companies were:
- Allergan PLC (AGN, Financial).
- UnitedHealth Group Inc. (UNH, Financial).
- Eli Lilly & Co. (LLY, Financial).
- Merck & Co. Inc. (MERCK, Financial).
- AstraZeneca PLC (AZN, Financial).
- Medtronic PLC (MDT, Financial).
- Regeneron Pharmaceuticals Inc. (REGN, Financial).
- Incyte Corp. (INCY, Financial).
- Mylan NV (MYL, Financial).
Pharmaceuticals has long been known as a sector that can deliver big rewards to investors willing to take big risks. That’s the case here with the company rating the fund as Aggressive. As we’ll see, despite the risk factor, the company has a solid history of positive returns.
The fund’s managers
During its more than 30-year existence, the fund has had only two managers.
Owens managed the fund from its inception in 1984 until his retirement at the end of 2012. He was widely recognized as a leading fund manager, and a company press release says that on at least two occasions he was a finalist for Morningstar’s Fund Manager of the Year award. The release also reports Owens was named to the Fortune magazine “mutual fund dream team” in 2003; the magazine cited his "performance over varying market conditions, consistency of returns, disciplined approach and low costs."
Hynes succeeded Owens and has followed much the same investment path since taking over. The press release says Hynes joined Wellington Management Co. LLP in 1991 and has been part of the Health Care Fund management team for more than 20 years (based on information from a company news release). She specializes in pharmaceutical and biotechnology companies, and she is Wellington’s lead pharmaceutical analyst.
Investment philosophy
According to the same company press release, the Health Care fund has two strategic thrusts. First, it diversifies its exposure across five primary subsectors:
- Health services.
- Medical products.
- Specialty pharmaceuticals.
- Major pharmaceuticals.
- International markets.
Second, the management team employs fundamental research that focuses on certain types of companies:
- High-quality balance sheets.
- Strong management.
- Potential for new products that will lead to above-average growth in revenue and earnings.
A Barron’s article from 2015 reports that the fund is driven by four major secular themes:
- Aging of the global population.
- Changes in the delivery of health care.
- Growth in emerging markets.
- Genomics, which is driving innovation.
The magazine also says Hynes and her team are driven by deep research; she reads medical journals as well as financial reports and meets with scientists, physicians and other health officials to help value health care companies.
Of course, we can’t forget to say a few words about the boss at Vanguard, Bogle, who practically reinvented the mutual fund industry with his emphasis on low-cost passive funds. There are many different lists of Bogle’s investing rules; here’s the essence of the one at Investopedia:
- Keep it simple; for example, don’t rebalance your portfolio too often.
- Minimize the costs and expenses associated with investing.
- Focus on the long term.
- Rely on rational analysis and avoid emotions in investment decisions.
- Indexing is an appropriate strategy for individual investors.
Bogle's influence can be seen in the work of Owens and Hynes, who have kept their portfolios and management relatively simple, who trade infrequently (helping keep costs down) and who thoroughly research the issues before making investment decisions.
How has the fund performed?
This excerpt from a GuruFocus table shows annual results for each of the past 10 years (note the Fund's Annual Report lists a positive 2.71% return for 2016; over 10 years there is agreement on a 10% return):
In commenting on the fund’s underperformance in 2016, Hynes writes, in the Annual Report,
“Our stock selection was weak in the large-cap biopharmaceutical subsector. In addition, our underweighting of medical technology and our cash position (roughly 3% of assets) pulled down relative performance modestly.
“Within large-cap biopharmaceuticals, relative results were most hindered by our positions in Allergan, Bristol-Meyers Squibb and Mylan and our avoidance of Johnson & Johnson (JNJ, Financial) (a strong performer in the benchmark).”
Despite the disappointing return in 2016, the fund had enough good years over the past decade to post an average annual gain of 10.2%.
What can we learn from the fund?
In a paper on its web site, Dodge & Cox makes a case for active investing, as opposed to passive investing through indexes, but it concedes that not all active managers can expect to beat their benchmarks and lists six practices that successful managers use. One is what it calls having a high "active share," meaning managers are not afraid to deviate from the holdings of the benchmark.
Vanguard benchmarks its health care fund against the MSCI All Country World Health Care Index, which is based on large-cap and midcap segments in 23 Developed Market countries. The extent of the divergence is brought home by the benchmark’s positive 3.27% return in 2016 (while the Vanguard fund suffered a loss).
Over the past 10 years, the benchmark has returned an annual average return of 8.8%, 1.4% below that of the Vanguard Health Care Fund. That difference, compounded, will be a material difference after a decade or longer.
The Vanguard fund also emphasizes (again, looking at Bogle’s influence) low fees and expenses as well as low turnover; GuruFocus puts the fund’s quarter-over-quarter turnover at 4%.
The Dodge & Cox paper also argues that a common trait among successful managers is risk avoidance, through a focus on fundamental value, which is seen with the Health Care Fund as well. Hynes is a believer in "deep research" and goes beyond financial statements in assessing companies and trends.
Although the Dodge & Cox paper may not be definitive on the secrets to active investing, the fund has been on a similar path for more than 30 years and enjoyed success with it.
Conclusion
Individual investors might take several lessons from the Vanguard Health Care Fund including a willingness to look beyond index stocks and weightings, keeping costs down and focusing on high quality companies (strong balance sheets, good management and new product potential).
The fund’s performance, or more correctly, the managers’ performance, is strong enough to rank it sixth among all GuruFocus gurus over the past 10 years. That level of performance obviously suggests there are lessons to be learned from the managers.
Finding value has been at the heart of this success coupled with a willingness to look beyond the usual names and being disciplined on costs.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
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