By Lewis Krauskopf
NEW YORK (Reuters) - When it comes to investing in the U.S. healthcare sector, it has paid off big to bet on smaller stocks.
So far this year, the healthcare sector within the small-cap S&P 600 <.SPSMCA> has gained about 14 percent as investors point to a boost from an expected pick-up in deal-making. Those gains far outpace the 1.5 percent decline for the healthcare sector within the S&P 500 <.SPXHC>, the benchmark for large-cap U.S. companies, as of Monday's close.
While small-cap stocks in general have fared better than large-caps this year, the edge has been slight - with the overall S&P 600 <.SPCY> up 0.8 percent versus a 0.6 percent dip for the S&P 500 .
An expectation for increased acquisitions in healthcare has benefited small stocks, with deal premiums and improved valuations leading to higher share prices, investors say. The anticipation of more consolidation has gained steam as investors began anticipating the federal tax-reform package that paves the way for larger companies to bring back money from overseas.
Healthcare analysts also point to relatively strong innovation among smaller companies as helping their shares, while some investors cite the potential for smaller stocks to be more immune to concerns about regulatory pressures in healthcare.
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"A lot of it is all the M&A and consolidation that has been going on. You are seeing it across medical devices, you pretty constantly see it in pharma and biotech, now you are seeing it in large cap deals in the insurance and (pharmacy benefit) side of things," said Jeff Jonas, a portfolio manager focusing on healthcare for Gabelli & Co. "That has given the big boost."
Over the past three years, small-cap healthcare has also beaten large-cap - 65 percent to 11.5 percent - with small-cap outperforming large in the four biggest industries: pharmaceuticals, biotechnology, equipment and supplies, and providers and services.
Graphic: Small cap health stocks' performance over three years - https://reut.rs/CMWc3c
The top small-cap healthcare stock gainers this year include diagnostics company Abaxis Inc , biotech Enanta Pharmaceuticals and HealthEquity Inc , which provides health savings accounts.
Among large healthcare companies, shares of biotech firms Celgene Corp and Biogen Inc have stumbled in 2018 amid product setbacks, along with shares of Cigna Corp , following its planned purchase of pharmacy benefit manager Express Scripts .
The stock price of the largest healthcare company by market value, Johnson & Johnson , is down about 9 percent in 2018.
"Big-cap healthcare is generally dominated by major pharma, and they have done nothing ... Same thing with big biotech," said Les Funtleyder, healthcare portfolio manager at E Squared Capital Management. "The interesting science has all happened at the small-cap therapeutic level."
Graphic: Smallcap health stocks in 2018 - https://reut.rs/CqO2GS
Money flows suggest a small-cap strategy within healthcare gaining favour. The Powershares S&P Smallcap Health Care Portfolio ETF has seen its assets grow to $392 million, more than double than at the end of 2016, according to Lipper data.
While more than $3.8 billion has flowed out of healthcare ETFs and mutual funds this year, $66 million has flowed into the Powershares smallcap ETF, according to Lipper.
Similarly, the SPDR S&P Biotech ETF , which weights large, mid and small-cap biotech stocks relatively equally, has drawn $276 million in net inflows this year. The Ishares Nasdaq Biotechnology ETF , which is more heavily weighted to large-cap stocks, has had net outflows of $822 million.
"There's certainly more innovation in the small-cap space and I don't think it's any big secret that the pipelines of the larger companies are kind of looking boring at this point...," said Terry Smith, director of life sciences research at Emerald Advisers, a small-cap investment firm in Leola, Pennsylvania. "So they do need to buy innovation."
Another factor that could be propelling smaller stocks, including biotechs, is the potential for them to be less in the crosshairs of any concerns over drug pricing, an issue that has clouded the healthcare sector since the run-up to the 2016 presidential election, investors said.
Smaller biotech companies typically work on fairly innovative therapies or those that address new markets, said David Heupel, a healthcare analyst for Thrivent Investment Management.
"Typically that is not where we're so worried about price," Heupel said. "It's been more in the areas of, 'I've got five diabetes drugs that do the same thing, why are we allowing them to price up 6- to 8-percent every year?'"
Greenwood Capital has an overweight position on healthcare in its small-cap portfolio, but not in its large-cap fund, according to Walter Todd, chief investment officer for the Greenwood, South Carolina, firm.
"We felt like in healthcare you had a lot of opportunity with much less risk than the large-cap space," Todd said.
To be sure, betting on individual small-cap stocks is still a very risky endeavour. For example, biotech companies banking on one product can see huge share swings on single events.
"It is better to have a basket of them, so if one or two of the pharma or biotech companies fail, it doesn't ruin the entire portfolio," Gabelli's Jonas said.
(Reporting by Lewis Krauskopf; Editing by Alden Bentley and Dan Grebler)