Polar's Daniel Mahony and Gareth Powell on the secular growth story emerging in the healthcare sector
Healthcare is unloved and out-of-favour, which would suggest fundamentals for the sector have deteriorated significantly.
This could not be further from the truth. Demand for healthcare is set to grow for at least the next 20 years driven by an aging population in the Western world (over 60s have greater need/demands for healthcare) and increasing GDP in the emerging markets (GDP per capita is correlated to healthcare spend per capita).
While there is a debate over how governments can pay for this increasing demand, the global market for healthcare products and services is set to grow for the foreseeable future.
The risks are behind us
Investors have shunned healthcare stocks over the last 15 months – the prospects of US healthcare reform created uncertainty about long-term growth for the entire sector. However, the risks of US healthcare reform are now behind us as the Patient Protection and Affordable Care Act was passed into law.
This new legislation is more about healthcare insurance reform than a broad-based re-shaping of the US healthcare system. While many healthcare companies have made pricing concessions to the government, the major effect of the new law should be an additional 30 million individuals with healthcare coverage in 2014. This expansion of patient access should be neutral to positive for most healthcare companies.
We would expect the “reform discount” to dissipate over the coming months as there appears to be little political appetite for any new efforts to reform US healthcare.
The patent cliff
The other major issue for healthcare, in our view, is that the market is unwilling to look past the pharmaceutical sector’s upcoming patent cliff. The 2010-15 EPS growth rate of nearly every major pharmaceutical company will be affected by patent expirations.
It is interesting to note there has been a changing of the guard over the last two to three years, with new senior management teams now in place at most of the large pharmaceutical companies. These management teams not only understand the issues but also have begun to implement strategies to take these companies back to growth.
Perhaps the biggest change, in our view, is a greater focus on shareholder returns and the allocation of capital. Pharmaceutical companies are not simply throwing huge amounts of cash at R&D hoping to find the next blockbuster drug.
The biggest change in healthcare over the last five years has been the concept of “value for money” in healthcare. This is one of the reasons why the low-risk pharmaceutical business of developing “me too” products is now out of date. All of the stakeholders in the healthcare value chain – patients, doctors, hospitals, insurance companies, and governments – have incentives to make more informed value-decisions than they may have done 20 years ago.
This focus on value means the way healthcare products and services are developed and commercialised is set to change radically over the coming years. This gives rise to a secular growth story driven by three key themes – the three “I”s of healthcare investing, namely inefficiency, innovation and infrastructure.
Inefficiency
Inefficiency is a major problem in healthcare systems around the world. There are many companies that offer products and services to improve “the utilisation of healthcare resources” – that is to deliver improved patient care for less – and given the need to cut costs these companies should deliver strong growth over many years. This includes companies from the pharmacy benefit managers (PBMs), hospital, generics, clinical research organisations (CROs), and diagnostics sub-sectors.
The healthcare IT sector also fits the inefficiency theme – delivering products such as electronic patient records. President Obama’s stimulus package signed into law at the beginning of 2009 has allocated $20bn to the creation of healthcare IT infrastructure over the next five years – even on conservative estimates many healthcare IT companies should deliver 20% EPS growth over this period.
Innovation
Innovation affects all aspects of healthcare, in general it means identifying “breakthrough” products from drug, device or diagnostics companies. The key here is not only to identify companies that address unmet medical needs (ie the next cure for cancer) but also to find companies that improve clinical outcomes and reduce costs (such as novel robotic surgery).
The latter is most important in terms of the overall value proposition of healthcare. For example, the next wave of “personalised therapies” are set to utilise diagnostic tools that will enable healthcare to be “rationed”. That is, only patients who are likely to respond to a treatment will receive it.
While these innovation opportunities tend to be small- or mid-cap names, and higher risk, such stocks often have the potential to double or triple on a two- to three-year timeframe.
Infrastructure
Infrastructure is evolving in developed and emerging markets. In developed countries, infrastructure is evolving to take advantage of the efficiencies created by outsourcing certain healthcare services. Germany looks set to increase the number of hospital beds in for-profit hands from 10% to 20% of total capacity over the next five to 10 years. Clearly, there are political risks to this and the outsourcing opportunities vary between countries.
In the emerging markets as GDP increases, we would expect healthcare spending per capita as a percent of GDP to approach levels seen in the developed countries over the long-term. A number of governments have made commitments to building infrastructure in the near-term – for example, China plans to build 5,000 hospitals over the next five to 10 years.
There are a number of ways of investing in healthcare in the UK depending on the risk appetite. Clearly an investment in an individual stock carries significant risk but may be a reasonable strategy as part of a diversified portfolio. However, with only a handful of large healthcare companies listed in the UK (and most of these in the pharmaceutical sector) it is difficult to get exposure to the key themes we describe above.
Investment advisers also have a wide range of collective funds to choose from with different risk profiles depending on the investment strategy. These range from funds focused on the biotechnology sector, to broader pharmaceutical or healthcare funds with a growth mandate to closed-end funds that pay a dividend yield.
We believe the healthcare sector is significantly undervalued on a P/E basis, is at a greater than 20% discount to the market and at a Ï low on a relative valuation basis. It is under-owned by most generalist investors and this provides opportunities for both advisers and their clients.
Daniel Mahony and Gareth Powell are healthcare managers at Polar Capital
