Drug Store Stocks Good For Staples ETFs (CVS, WAG, RAD, XLP)

It has been a good year to own drug store stocks. The group's behemoth, CVS Caremark CVS, is up 17 percent. Rival Walgreen WAG has surged 28 percent while Rite-Aid RAD, often viewed as the more speculative member of the drug store sub-sector, has more than doubled.

Favorable demographics and looming implementation of the Patient Protection and Affordable Care Act are seen as catalysts boosting drug store stocks.

"We think drug retailers are well positioned to benefit from increased volumes as implementation of the new healthcare law results in a significant increase in the number of people covered by health insurance," said S&P Capital IQ in a new research note.

S&P Capital IQ has a five-star rating on CVS and a four-star rating on Rite-Aid. The research firm has a three-star rating on Walgreen.

"We expect traffic to retail drugstores to rise significantly in 2014, with about 30 million people expected to gain healthcare coverage on January 1, 2014. We believe drugstores have advantages over alternative formats (including supercenters, supermarkets, warehouse clubs and mail order pharmacies), such as being conveniently located close to people's homes, offering a faster in-and-out experience with smaller parking lots and building footprints, and a more personalized one-on-one pharmacist experience," said the research firm.

Upside for drugstores could be good news for consumer staples ETFs, including the group's largest fund, the Consumer Staples Select Sector SPDR XLP, according to S&P Capital IQ. Previously high-flying staples ETFs do feature some exposure to drugstore stocks.

For example, CVS is a top-10 holding in XLP and combines with Walgreen to represent 8.5 percent of that ETF's weight. The Vanguard Consumer Staples ETF VDC also features CVS among its top-10 lineup as well as allocations to Walgreen and Rite-Aid. S&P Capital IQ rates both of those ETFs Overweight.

The First Trust Consumer Staples AlphaDEX Fund FXG devotes almost six percent of its combined weight to CVS and Walgreen. Although FXG has outperformed XLP and VDC by a wide margin over the past year, S&P rates the ETF Marketweight.

"We think traffic will also be aided as an aging U.S. baby boomer generation, with 10,000 people turning 65 years old every day, results in increased demand for retailers' prescription drug offerings. We think national chains are well positioned as their pharmacy departments continue to gain in importance, with prescription sales contributing over 70% of total sales," said S&P Capital IQ in the note.

However, there is a cautionary tale with staples ETFs. After being a leadership group for three years, staples funds, along with other low-beta sector ETFs such as utilities funds, wilted in May. Speculation about rising interest rates and a cyclical rotation are among the issues that have taken some of the wind out of staples ETFs' sails.

While not as bad as the almost eight percent loss taken by the Utilities Select Sector SPDR XLU this month, XLP finished May down more than one percent. VDC finished down a similar amount. More downside could be on the way and the weights drugstore stocks represent in staples ETFs probably will not be enough to prop the funds up.

"Given that the movement in 10-year UST has been a strong proxy for Staples' relative valuation, the recent underperformance in Staples is not surprising. We also find it instructive to assess the implied downside to the group based on the rate move relative to the move in dividend yields. Our analysis shows that XLP should be down another 6% to ‘catch-up' to the rising rates," according to an excerpt from a Goldman Sachs note published in Barron's Friday.

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