HQH: Healthcare Fund With 11% Income And A High Discount

Summary

• abrdn Healthcare Investors is a healthcare sector-specific closed-end fund that invests in a portfolio of common stocks in the healthcare industry, heavily weighted in biotechnology.
• The HQH CEF currently provides a very high yield of 11% plus a high discount of -15% to NAV.
• HQH has a solid long-term record of nearly 37 years, nearly matching the performance of the S&P 500. However, the recent near- and mid-term performance has been lackluster.

Introduction:

abrdn Healthcare Investors (NYSE:HQH) is a closed-end fund, or CEF, that was incepted nearly 37 years ago in April 1987. The fund was formerly known as Tekla Healthcare Investors with the same symbol HQH. Recently, all of the Tekla funds (four healthcare funds) were acquired by the Aberdeen group along with all of the management staff. So, in essence, the management and objectives of the fund have not changed except the umbrella group.

The Aberdeen Group is a U.K.-based investment firm managing over $600 billion of assets for institutional and retail clients worldwide. The fund [HQH] invests in the equities of healthcare companies all over the globe, but mostly in the companies based or listed in the U.S. The fund's primary objective is to provide high income, mostly by means of capital gains. It generates very little income by way of dividends, which are consumed by the expenses, including management fees.

As per the fund's literature:

"Abrdn Healthcare Investors is a non-diversified closed-end healthcare fund traded on the New York Stock Exchange (under the ticker HQH). HQH primarily invests in healthcare industries and will emphasize both large, established companies and smaller, emerging companies, with a maximum of 40% of the fund's assets in restricted securities of both public and private companies. The Fund's investment objective is to seek long-term capital appreciation by investing primarily in securities of healthcare companies. In addition, the Fund seeks to provide regular distribution of realized capital gains."

Other salient features of this fund are as follows:

• The fund is focused on providing regular and high distributions by using the realized capital gains.
• The fund uses zero leverage, which is definitely an advantage during a high-interest rate regime.
• The fund has a reasonably good past record of performance when we look at the long term. The more recent performance has been rather dismal. Since its inception nearly 37 years ago until Dec. 31, 2023, it has returned 9.84% annualized on NAV (net asset values) basis, compared to 10.17% from the S&P500. Also, the fund has returned 6.32%, 8.56%, 0.39%, and 4.43% for the 10, 5, 3, and 1-year periods, respectively, on the NAV basis. These results assume that all distributions were reinvested.
• The fund follows a "managed" distribution policy and pays quarterly. It pays 2% of its NAV (net asset value) every quarter, which roughly equates to 8% of NAV on an annual basis. This has been increased to 2.5% of NAV every quarter as of Feb. 9, 2024. Due to this policy, the distribution amount can vary from quarter to quarter. At times, the fund may pay the distributions as ROC (return of capital) when the et-investment income and realized capital gains are not sufficient to meet the net distribution amount.
• As per its mandate, the fund can invest globally, but 80% of the fund's assets are invested in healthcare securities based or listed in the U.S.
• HQH is a sector-specific fund, so by nature, it is concentrated. However, it is invested in roughly 125 securities, and its top 10 represent 45% of the total. Nearly 87% of the assets are invested in common stocks, out of which more than 60% are in the biotechnology sector. So, in that sense, it is a rather concentrated fund.
• As of Jan.31, 2024, the fund under its management had roughly $1 billion in net assets (as well as total assets).
• The fund is an actively managed fund and has an expense ratio of 1.18% (including 1% of the management fee) based on the managed assets.
• As of Feb.27, 2024, its distribution yield on the market price was 11.19% and 9.55% on the NAV.
• As of Feb.27, 2024, HQH's market price offered a nice discount of -14.58% to its NAV. However, on a 3-year average basis, it has traded at a smaller discount of -7.83%.

Financial Outlook:

Let's look at the Fund's Financial health and performance. The most recent detailed report that is available to investors is the annual report for the period of Oct. 2022 – Sep. 30, 2023.

Net Investment Income:

The net investment income (or NII in short) is the net income that a fund earns from its investment in the form of dividends, distributions, and interests or derivatives like options, minus all of the fund's expenses, including management fees, operating expenses, commissions, and interest on leverage. For equity-based funds, especially in high-growth sectors like technology, the NII is not very relevant. However, for fixed-income or bond funds, it is very relevant.

The HQH fund is between 85-90% equity and the rest in convertible preferreds or cash equivalents. Also, more than 50% of its assets are invested in biotechnology companies, some of which do not pay much dividends. So, whatever income is generated it is all consumed by the expenses, and in fact, all of the distribution has to be supported by the realized capital gains. This is okay when markets and the healthcare sector are doing good. However, during the downturn, the fund may not have sufficient capital gains to pay the distribution, and it has to pay as ROC. It may not be a problem in the long term, but a prolonged downturn can really hurt the NAV.

Here is what it looks like in terms of NII, Distributions, and Net Assets at the beginning and end of the statement period.

(all amounts are in US $ (except Shares Outstanding) for the 12-month period; negative amounts are shown inside parentheses, per the annual report, 12 months ending Sep.30, 2023. We also provide the data for the year 2022 for comparison.

Table-1:

Distributions:

In the most recent quarter, HQH increased the distribution amount to $0.48 a share (from $0.38 the previous quarter), which is a sign of improving NAV during the last quarter.

So, is the distribution covered?

Table-2: Distribution (from 2020-2023)

We can observe from the above table that distribution varies from year to year, but no more than 20%. We also observe that nearly 40% of the dividend in the last four years has been paid as ROC. Distributions in the form of NAV itself are not bad, but they are bad when accompanied by a declining NAV. This may be a temporary period of difficulty; as we know, the healthcare sector was hammered pretty badly in 2022 and 2023. However, the sector is showing signs of recovery right now.

Discount/Premium:

The fund is currently trading at a discount of -14.58% to its NAV. But if you look at its 3-year history, it has traded at a discount of -7.83% on average. At the same time, the recent discount has been higher in the last six months, with an average of -16.30%. If we look at the 5-year chart below, the majority of the time, it has traded at roughly -10% discount. All that said, we should always look at both the premium/discount and the overall valuation of the fund within its sector. Right now, generally, stocks are quite expensive, but not the healthcare sector.

Chart-1: HQH – Premium/Discount Chart

Funds Holdings:

The fund is sector-specific and heavily weighted towards the biotechnology sector with the broader healthcare sector. It has nearly 100 equity positions and a total of 127 positions as of Jan.31, 2024. The top 10 holdings, which are mostly equity positions, make up about 45% of the total assets, which makes it a concentrated fund.

Some of the top holdings are Vertex Pharma (VRTX), Regeneron Pharma (REGN), Amgen (AMGN), Gilead Sciences (GILD), AstraZeneca (AZN), Biogen (BIIB), Eli Lilly (LLY), and AbbVie (ABBV).

The top holdings and asset composition as of Jan.31, 2024, are presented below.

Table-3: Holdings as of 01/31/2024

Chart-2:

Performance and Valuation:

The fund's big attractions are its current high yield of over 11% and nearly -15% discount to NAV. However, if you are looking for market-beating performance, this may not be the fund. Though the long-term performance has been solid, the recent and mid-term performance of this fund does not inspire much. However, the healthcare sector in general, and biotech in particular, has underperformed the broader market heavily in the recent past.

Table-4:

In the above table, the performance since inception stands out as it has nearly matched the S&P 500 Index (SP500) over a period of 37 years. But the short or near-term performance has been dismal, especially if we compare it with the S&P 500. As such, the S&P 500 is not an appropriate benchmark for this fund. The closest benchmark may be the "NASDAQ Biotechnology Index."

Since HQH fund is 87% equity (with nearly 56% allocation to biotechnology), its performance will naturally be heavily impacted based on how the biotech sector does in the future. The fund uses no leverage, so the movement of interest rates has no direct impact on the fund, but certainly, it has an impact on the securities that the fund holds.

Let's see how the fund compares over the last 20, 10, 5, and 3 years with the S&P 500 and a hypothetical blended fund (to mimic HQH allocations).

Blended Fund 1 (hypothetical):

• SPDR S&P Biotech ETF (XBI) 56%
• Health Care Select Sector SPDR Fund ETF (XLV) 34%
• Fidelity Convertible Securities Fund (FCVSX) 7%
• Cash 3%.

Blended Fund 2 (hypothetical):

• iShares Biotechnology ETF (IBB) 56%
• Health Care Select Sector SPDR Fund ETF (XLV) 34%
• Fidelity Convertible Securities Fund (FCVSX) 7%
• Cash 3%.

Table-5: (Data - period as specified, if not specified then as of Jan.31, 2024)

Note: Some of the data (e.g., number of holdings and leverage) may not be current as of Jan.31, 2024.

Now, we can observe that in the last 17 years, the blended fund (from broad Biotech and Healthcare ETFs) sometimes performed better than HQH but other times worse. What we see is that the healthcare sector, and especially the biotech segment, has performed very poorly during the last five years. HQH, being in that space, could not have done much better.

At the same time, HQH offers a very high yield of 11% in addition to a deep discount of -15% on its NAV. The healthcare sector has been in a down cycle for quite some time, and the biotechnology sector is especially highly cyclical. When a closed-end fund like HQH is in a down cycle, the discounts tend to get larger. So, we can hope that when the cycle turns positive and NAV starts improving, the discount should start getting narrower. However, investors will need patience for this to play out.

Risk Factors:

Investors need to be aware of certain risk factors that are associated with this fund and CEFs in general. Risk factors could be summarized as follows:

• HQH is a healthcare sector-specific fund. It is also heavily weighted towards the biotechnology segment. If this segment is impacted by any adverse macro conditions, HQH will be impacted as well.
• The general risks such as the geopolitical situation.
• The possibility of occurrence of a recession in 2024, though most market participants are expecting a shallow one if that happens.
• Market risks: The S&P 500 recently crossed its previous all-time highs, and since then, it has been making new highs. The broader market certainly is expensive in many areas, especially due to some bubble-like actions with the AI (artificial intelligence) hype. Even though the healthcare sector is not directly related to these events and is generally undervalued, a significant correction in the broader market will bring down all sectors with it.

Concluding Thoughts:

HQH fund currently offers a deep discount of nearly -15% and a high distribution yield of 11% plus. The distribution yield is 2.5% of NAV every quarter (increased from 2% recently); hence, it is variable. The healthcare sector and the biotech segment are showing early signs of recovery (from a down cycle), but it may take time for it to show substantial progress. Patient investors can profit by playing abrdn Healthcare Investors right while being paid for waiting. For existing investors, it is a "hold."