This health care fund has delivered top-notch returns -- without excess volatility. And the sector is dirt-cheap. By Steven Goldberg, Contributing Columnist November 23, 2011 I usually steer clear of sector funds. After all, when you invest in a mutual fund, you're paying a manager a handsome sum to pick stocks. Why tie his or her hands to one industry or sector of the economy? SEE ALSO: Our Special Report on Investing in Volatile Markets T. Rowe Price Health Sciences (symbol PRHSX) is a sparkling exception. Why? Start with the returns. Over the past ten years through November 22, the fund returned an annualized 7.1% -- an average of 4.7 percentage points per year better than Standard & Poor’s 500-stock index. Just as important, the fund has been less volatile than the S&P 500. That has paid off in bear markets. In 2008, for instance, the S&P plunged 37.0% while the health fund lost only 28.8%. Advertisement Health care is, almost by definition, a low-risk sector. If you’re ill, you’ll likely seek medical care even if the economy is ailing. Because of the sector’s defensive characteristics and the weakness of the economy, it’s surprising how cheap most health-care stocks are just now. For example, biotechnology stocks, on average, trade at 11.5 times estimated earnings for the coming 12 months, according to FactSet Research. That’s more than 50% below the group’s average price-earnings ratio over the past 15 years and close to its lowest P/E -- a bit more than 11 -- over that period. Pharmaceutical stocks are likewise a bargain. They trade at an average P/E of 10.1, almost 50% lower than their average P/E of 18.8 over the previous 15 years. The lowest P/E during those years was 9.3. Stocks in other health care subsectors are cheap, too. Health care providers and services (a grab-bag category that includes everything from hospitals to insurers) trade at about 10 times earnings, and suppliers of health care equipment sell for just below 12 times earnings. Advertisement Demographics and new medical technology are driving a boom in health care. The Labor Department estimates that from 2008 to 2018, half of the 20 fastest-growing occupations will be in health care. The field will generate 3.2 million new jobs during that period, “more than any other industry,” the Labor Department predicts. President Obama’s reform program has added a dose of uncertainty. But over time, as insurance coverage kicks in for all Americans, reform will likely result in more health care usage. That development should offset the likelihood that Uncle Sam will mandate reductions in the prices that health care companies can charge for their goods and services. Kris Jenner, who has run the T. Rowe fund since 2000, owns stocks in a variety of health care sectors, including biotechnology, drugs, devices and insurance companies. Jenner, 49, credits his success not to picking the right industries within his sector, but to picking good stocks. He tends to keep about one-third of the fund in biotech, including many smaller biotech companies. Advertisement When he finds a good company, he’s not afraid to back up the truck. That’s especially true of biotech. Jenner was early in buying Alexion Pharmaceuticals, which saw its share price skyrocket with the approval in 2007 of Soliris, a treatment for a rare genetic blood disorder. At last report, Jenner had more than 8% of his fund’s assets in Alexion, although he has been trimming the position lately. Jenner employs options, both to leverage his bets and to hedge his positions. Over the years, he says, the options have added less than one percentage point per year to the fund’s return. “Stock selection is what drives the fund’s performance, not options.” Jenner says his search for attractive companies begins with two “enduring themes.” The first is to invest in companies that are developing “important new medicines and new medical devices.” The second is to invest in “businesses that can improve quality and don’t add costs.” Health reform, imposition of stricter safety standards by the Food & Drug Administration and a scarcity of new blockbuster drugs have hurt the sector, Jenner says. Advertisement In the 1990s, drug companies turned out a number of remarkably successful products, such as Prozac and Lipitor, and investors expected the pattern to continue into the new century. It didn’t. Breakthroughs in science come at an achingly slow pace most of the time, Jenner says, but every so often they arrive in droves. Those fertile periods are devilishly hard to predict. Right now, we’re between leaps. Still, there have been big advances in drugs for Hepatitis C and multiple sclerosis. Trials are underway for two potential blockbusters in Alzheimer’s treatment, but so far the effectiveness of both drugs is unproven. I think that Jenner’s background as a medical doctor is a big plus in analyzing drugs and medical devices. He completed the course work to be a surgeon and was working as a resident when he had a change of heart. He recalls the moment he realized he was in the wrong field: “I was walking down a hospital corridor, and I saw one of the senior physicians in my field with a medical journal under his arm. I was carrying the Wall Street Journal.” Jenner, who successfully traded stocks through medical school, decided to switch careers. Shareholders are fortunate that he did. As much as I like him, though, it’s important not to go overboard with T. Rowe Price Health Sciences. No sector fund should account for more than 5% to 10% of your stock holdings. Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.