US Equities: Healthcare - A healthy prognosis

Recent developments in market structures and biotechnology augur well for the recovery of ailing US healthcare stocks

Healthcare is probably the sector ripest for productivity improvements after its recent poor performance. Such a bounce back should both drive outperformance for the winners in the new environment and also act as a boost to overall GDP growth. 

The sector faces several challenges. Michael Gregory, head of healthcare investment strategies at Highland Capital Management points out that 70m American baby boomers will turn 65 between 2011 and 2029. Over the past three decades, the population over age 90 has tripled, and is expected to quadruple over the next three decades. Annual healthcare spending per head is 2.6 times higher for persons aged 65-84 compared with adults less than 65 years old, and 5.7 times higher for persons aged 85 and over. The Centers for Disease Control and Prevention (CDC) estimates 35% of Americans are obese and another 34% are overweight. These figures have tripled since the early 1960s.  

Healthcare prices have risen by about 6-8% annually since 1970, almost double the baseline GDP growth rate. Increased access to insurance continues to drive utilisation rates higher to primarily high-cost medical procedures, rather than use of routine preventive services like frequent visits to the doctor. 

The current US fee-for-service payment system does not reward efficient providers, with little incentive to get a patient healthy while keeping costs down. An estimated $750bn (€660bn) of US healthcare spending, or a quarter of the total, is wasteful. The number of beneficiaries of the Medicare social insurance programme is expected to climb to 75m in 2026, up from 55m in 2015. Against this backdrop of increasing demand, with severe cost constraints in an inefficient sector with strong vested interests in a politically charged atmosphere, there will be plenty of winners and losers in healthcare-related stocks. 

“When pharma moved from chemical patents to biological patents it was like manna from heaven. The patent queue became less of an issue. These were more dependable patents with a longer life”
Matthew Benkendorf

One extreme is the now collapsed Valeant with its unique business model of buying companies, ripping out research and development (R&D) expenditure before ramping up prices. “It is one of those strategies that works until it doesn’t work. Everyone knew what the business model was. It was very clear. Some people were critical of it early on, including Warren Buffett,” says Matthew Benkendorf, CIO of Vontobel Asset Management. 

It is alleged that what brought Valeant down was not its own activities but the actions of Martin Shkreli, a former hedge fund manager who is now chief executive officer of Turing Pharmaceuticals. His emulation of Valeant’s approach brought him under fire for boosting the cost of decades-old medicine by 50-fold and then declaring it was still good value. 

Hillary Clinton responded to this by posting a tweet declaring she was going to try to control the cost of skyrocketing prescription drugs. That tweet acted as a catalyst for a collapse in the Nasdaq biotechnology index. As Connor Browne, a portfolio manager at Thornburg Investment Management says, it has reopened questions on drug pricing. “Frankly, we go through this every election year. Interestingly, on average, global drug companies increase prices less in a US election year than in other years.” 

For several years Valeant capitalised on the fact that return on R&D investment lagged expectations. As a result, large-cap pharmaceutical R&D spending was viewed quite negatively, says Browne. But he adds that the industry has entered a new cycle where targeted therapies, particularly in cancer treatments, means there are some good returns on R&D.

Benkendorf agrees. “When pharma moved from chemical patents to biological patents it was like manna from heaven. The patent queue became less of an issue. These were more dependable patents with a longer life.” New drugs are starting to come on line in areas such as cutting-edge treatment in cancer. That benefits some of the big players like Bristol Myers with its strength in oncology and Cellgene, with a 25% earnings growth forecast for the next five to seven years.  

Where there is more uncertainty is in small and mid-cap biotech stocks: “Biotech is just rife with speculation – that is not what we do,” says CT Fitzpatrick, CEO of Vulcan Value Partners. As Highland’s Gregory points out, the Biotech equal-weight index was down 56% over the 12 months to mid-May. Yet the opportunities arising from industry dislocations are high. “The US spends $90bn on cancer therapies annually and about 75% of that fails to provide the intended clinical benefit of prolonged patient survival.” Genomics provides the ability to identify and target genetic drivers of disease.

What is exciting about the US healthcare market is that, post the US election, there will be massive changes arising, which creates opportunities. Gregory sees key areas as: 

• The slowly transitioning market structure from a fee-for-service payment model to one of bundled and value-based payments. The  the goal is to reward providers based on the value they provide to the patient. It will be measured by outcomes and patient satisfaction rather than the quantity of services they perform.
• Moving large numbers of patients away from expensive hospitals to lower-cost settings of care.
• The use of biotech to provide precision medicine for targeted therapies.
• Freestanding inpatient psychiatric care, as mental health spending doubled during the period 2003-14 to $239bn annually, with a widening supply/demand imbalance.

A combination of politics and market sentiment has hit US healthcare stocks badly over the past year. But after the US elections it may well be the sector with the most opportunities for those managers with the expertise to exploit them.