Fidelity Select Health Care Portfolio Q2 2024 Review

Performance Summary

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Market Review

Health care stocks returned -1.28% in the second quarter of 2024, according to the MSCI U.S. IMI Health Care 25/50 Index, behind the 4.28% gain of the broad-based S&P 500® index. The broader U.S. stock market shook off a rough April and rose steadily due to resilient corporate profits, a frenzy over generative artificial intelligence and the Federal Reserve’s likely pivot to cutting interest rates later this year.

However, excitement about high-growth megatrends – fanned by AI fervor and reflected in the roughly 14% gain for the information technology sector of the S&P 500® Index – continued to captivate investors at the expense of other sectors. As a result, health care stocks lagged the broad market in Q2.

Among industries within the MSCI health care index, health care technology stocks (-20%) – a relatively small benchmark weight – lagged the broader sector the most. This was largely the result of idiosyncratic factors weighing on medical tech companies such as Veeva Systems (VEEV, -21%), a cloud solutions company focused on life sciences. The stock dropped in April, following the departure of the firm’s CEO, and in May when Veeva lowered its Q2 revenue guidance despite better-than-expected Q1 financial results.

Health care utilization and costs continued to ramp higher in the second quarter of 2024, as patients who delayed surgeries and treatment during the pandemic continued to seek services in hospitals, doctors’ offices and ambulatory care centers in increased numbers. This weighed on the health care services (-13%) group. In addition, in April, the U.S. government reported that Medicaid Advantage payments would not increase to the degree that the industry had hoped for. As a result, large health care services stocks, such as CVS Health (CVS, -25%), underperformed.

The only health care industries to advance this period were biotechnology (+3%), as well as pharmaceuticals and managed care (+2% each). Within these industries, individual stock performance was mixed. For example, pharma giant Eli Lilly (LLY, +17%) gained strongly on the back of the excitement surrounding glucagon-like peptide 1 agonists – the innovative new class of treatments for diabetes and obesity. However, legacy pharma companies such as Bristol-Myers Squibb (BMY, -23%) and Johnson & Johnson (JNJ, -7%) underperformed, in part due to sluggish quarterly sales.

Performance Review

Largest contributors vs. Benchmark

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Largest detractors vs. Benchmark

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For the quarter, the fund returned -2.46%, underperforming the MSCI sector index.

Stock choices in biotechnology and life sciences & tools detracted from the fund’s performance versus the sector index the past three months, as did positioning in health care services and health care technology. Among individual stocks, the fund was hurt the most by its overweight in health care equipment firm Penumbra (PEN, -19%). Shares of the neuro/vascular device maker were hurt by disappointing Q1 earnings-per-share results. Still, we remained excited about the firm’s product cycle and future growth prospects. Therefore, it remained the fund’s No. 7 holding at the end of June.

It also hurt to overweight 10x Genomics (TXG), a gene sequency technology company, because the stock returned -48% during the past three months. The company released mixed Q1 2024 financial results this period, with earnings in line with Wall Street’s expectations, but revenue falling short due to a rise in operating costs and a decrease in the firm’s consumables revenue. Still, the company recently launched four promising products, which should support its growth. We continue to hold the position on June 30.

On the positive side, a large overweight in Boston Scientific (BSX, +12%) was our top individual relative contributor. The stock rose in late April when the maker of medical devices reported quarterly financial results that topped Wall Street’s expectations, along with an increase in its annual profit forecast. The firm noted particularly strong demand for its heart devices, including pacemakers and stents, which comprise most of Boston Scientific’s revenue. Though we trimmed our stake, Boston Scientific was the fund’s largest overweight and holding on June 30.

It also helped to overweight Alnylam Pharmaceuticals (ALNY, +63%). The stock surged in late June 24, on news the maker of RNA interference therapeutics achieved favorable top-line results in a late-stage clinical trial for its cardiovascular treatment, vutrisiran. Management noted the drug’s potential to address the needs of patients with a steadily progressive, debilitating and ultimately fatal disease. We added to our position, making it a top-15 holding.

Outlook and Positioning

We’re optimistic regarding our outlook for health care stocks over the long term and maintaining patience in the short term. We’re also positive on the fund’s holdings as of June 30, and we only made some slight shifts this quarter. Utilization continues to weigh on the managed health care industry, and Medicare advantage companies grapple with lower pricing capabilities and higher costs. We modestly added to the fund’s weighting in managed care this quarter on attractive valuations, and the fund is slightly overweight the industry at period end. Notably, we increased our position in UnitedHealth Group (UNH), which went from our No. 4 holding at the end of Q1 2024 to our No. 2 position on June 30. Our long-term thesis on the group has not changed and we think firms here exhibit strong long-term fundamentals.

We are positive on health care equipment names Boston Scientific and Penumbra; bioprocessing firm Danaher (DHR); biotech company Regeneron Pharmaceuticals (REGN); and Insulet (PODD), maker of the Omnipod device for diabetes. These were the fund’s five-largest overweights at quarter end.

Health care equipment stocks have benefited from the recovery in health care utilization in 2023 and early 2024, and we expect it to continue. Our expectation is that utilization will begin to moderate in 2025. In this industry, our largest positions are in Boston Scientific and Penumbra – the fund’s largest- and seventh-largest holdings at the end of June. Boston Scientific is in the midst of two key product cycles, with one already going strong. The fund is also invested on Glaukos, a maker of iDose TR, a small ophthalmic device to treat glaucoma that was approved by the FDA in December, and Procept BioRobotics (PRCT), which produces a device to treat prostate cancer.

We’re also interested in bioproduction stocks. Bioprocessing companies make the tools (e.g., bioreactors, fluid bags and cellculture media) used to produce complex drugs, such as monoclonal antibodies (mAbs), and cell and gene therapy.

The stocks of bioprocessing firms appeal to us, given their relatively stable business models and the multiple long-term tailwinds that could drive long-term sales growth. The bioprocessing industry is expected to hit the bottom of its COVID inventory in the first half of 2024. From there, the stocks should see better growth and a material cyclical snap back. Danaher is our largest position in this space and the fund’s fourth-biggest holding, though I’ll note we trimmed our position in Q2.

Elsewhere, we expect to see more M&A activity in the biotech space, as capital raising in the sector has increased and companies have become more realistic about their valuations. As big pharma stocks face looming patent cliffs stretching out into the late-2020s, we think more of the large-cap pharma firms will try to fill these gaps by acquiring innovative biotechs. We’re especially bullish on the small- to mid-cap area of the biotech market, where we are finding opportunities with attractive risk-reward dynamics.

Exuberance around the new-generation GLP-1 treatments for diabetes and obesity have created an environment of “have” and “have nots” regarding the innovative drugs. We are skeptical on the sky-high numbers analysts and companies are projecting for these drugs. As a result, the fund is underweight Eli Lilly (LLY) and we do not own Novo- Nordisk (NVO), given high valuations, lack of clarity on how much optimism is already priced into the stocks, and our view on the high earnings momentum ahead. Additionally, we expect that by next year we will see peak data on the effectiveness of GLP-1 drugs. We plan to look for opportunities to further reduce the fund’s weight in Lilly.

In terms of risks, the upcoming elections in 2024 election may cause turbulence for the sector, especially as the rhetoric around drug pricing ramps up. It may also be a choppy environment for health care services stocks that provide of Medicare/Medicaid coverage. While we can’t make explicit predictions on potential election outcomes, we are keeping our eye on some of the prospective drug regulations making their way into Congress.