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The healthcare sector has bounced back in 2017, with returns running well ahead of the S&P 500 in the year-to-date, as Richard Saldanha* explains.

While recent attention has focused on gains for US technology, the US healthcare sector has had an equally strong 2017, delivering a total return of 21% so far this year, almost double the 11% year-to-date return of the S&P 500, according to Bloomberg data.

This partly reflects the fact that some of the negative sentiment from 2016 has begun to dissipate. The US healthcare market is the largest globally, and patients often pay more there for treatment than in other countries. There was plenty of focus on the pharmaceutical industry’s overly-aggressive pricing during the last US presidential election race; at that point, parties on both sides of the political spectrum suggested that it might be time for action to end “price gouging”.

In fact, with concerted pressure from major healthcare buyers, many global pharma companies have taken it upon themselves to moderate their pricing strategies, both in the US and elsewhere. With these steps towards self-regulation, the tone of political rhetoric has moderated. The pharma industry drives a significant amount of research and development, and with a number of unmet medical needs, governments seem to acknowledge the threat of intervention is not the most effective way to manage priorities.

Meanwhile, the healthcare market continues to expand to meet the growing needs across the globe and treat complex health conditions. Diabetes, obesity and various forms of cancer are all becoming more prevalent, creating specific health challenges. For example, sales of cancer treatments are expected to grow around 13% each year over the next seven years, according to EvaluatePharma.1

There are also new opportunities to develop treatments for rare health conditions, using personal health data better for earlier diagnoses, and to treat patients in a more tailored and effective way, sometimes remotely. Medical device companies, as well as pharma companies, are well-placed to benefit.

Despite the recent gains, we believe there is still value to be found in the sector. For investors seeking lower volatility, there are a handful of global companies with diverse sources of revenue, generating significant free cash flow and paying attractive dividends. These companies have very different earnings profiles to more volatile early-phase companies, which are often cash flow negative, and highly reliant on individual research outcomes.

In either case, monetizing research involves uncertainty, which even the larger players cannot insulate themselves from entirely. Setbacks are almost inevitable in rapidly evolving fields like immuno-oncology.

Research in areas like this has become a race for success, with trials underway of new drugs; either on their own or in combination with other established treatments. Multiple trials exploring various combinations of drugs may take place, with potentially binary outcomes; meaning significant gains for the winners, but setbacks for treatments that fail to deliver. Weighing up the value of drugs in a company’s development pipeline and adjusting earnings expectations based on the probability of success or failure is critical.

In an increasingly competitive and closely regulated environment, trends to watch include companies scaling up through mergers and acquisitions and working more collaboratively in order to spread risk and development costs.

While the strong performance of healthcare stocks year-to-date has passed without much fanfare, we believe investors should look more proactively at the sector as it offers some attractive characteristics, including strong free cash flow, solid balance sheets and attractive dividends. With the rapid development of new drugs in areas such as immuno-oncology, finding companies with the most attractive pipelines to tap into this growth potential will be the key to investment success.

A version of this article first appeared on Investment Adviser.

1 “World Preview 2017, Outlook to 2022”, EvaluatePharma, June 2017. http://info.evaluategroup.com/rs/607-YGS-364/images/WP17.pdf

* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").

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