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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 stocks - particularly Facebook, Amazon, Netflix and Google - the US healthcare sector has had an equally strong 2017, delivering a total return of 21 per cent so far this year, almost double the 11 per cent return of the S&P 500.

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 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. Sanofi, for instance, which produces the insulin treatment Lantus, has promised to cap price increases to below healthcare inflation. Allergan, better known as the manufacturer of Botox, has also pledged to limit annual price increases to single-digits.

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. Sales of cancer treatments are expected to grow around 13 per cent each year over the next seven years, for example.

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, monetising research involves uncertainty which even the larger players cannot insulate themselves from entirely. Shares in AstraZeneca fell 15 per cent in July, for example, wiping more than £10 billion pounds off the value of the company after disappointing trial results for a new, combined lung cancer treatment. These kinds of 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. Recent examples of M&A in the sector include Johnson & Johnson’s acquisition of Swiss biotech company Actelion, as well as Becton Dickinson buying medical device maker C.R Bard.  The importance of collaboration was evident in AstraZeneca’s agreement to partner with Merck on its breast cancer treatment Lynparza, allowing it to pair with Merck’s leading cancer drug Keytruda. AstraZeneca has $8.5 billion at stake, to be paid if the appropriate hurdles are met. These moves are designed to improve efficiency and mitigate some of the risks of pipeline failure. 

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

REFERENCES:

Market returns source Bloomberg as at 1st August 2017

http://uk.reuters.com/article/us-sanofi-usa-idUKKBN1851HA

Sanofi pegs U.S. drug price rises to below healthcare inflation

Allergan took its pricing pledge last fall about as literally as it gets http://www.marketwatch.com/story/allergan-took-its-pricing-pledge-last-fall-about-as-literally-as-it-gets-2017-01-03

http://info.evaluategroup.com/rs/607-YGS-364/images/wp16.pdf

Certain therapy areas are also set to continue to increase rapidly, adding to the strong overall growth forecasts for the industry. Oncology remains the sector’s powerhouse, clocking up compound annual sales growth of almost 13% over the next seven years, driven by recent advances in immunotherapy that have facilitated the launch of drugs such as Keytruda, Imbruvica and Tecentriq. Johnson & Johnson to buy Swiss biotech company Actelion for $30bn https://www.ft.com/content/b3b98348-e396-11e6-8405-9e5580d6e5fb

https://www.bloomberg.com/news/articles/2017-07-27/astra-s-imfinzi-combination-fails-to-check-lung-tumor-growth

AstraZeneca Plunges After Setback in Crucial Lung-Cancer Drug Trial

https://www.bloomberg.com/news/articles/2017-07-27/astra-s-imfinzi-combination-fails-to-check-lung-tumor-growth

https://www.actelion.com/media/media-releases?newsId=2113719

JOHNSON & JOHNSON COMPLETES ACQUISITION OF ACTELION

Becton Dickinson to acquire Bard for $24 billion

 http://uk.reuters.com/article/us-cr-bard-m-a-bd-idUKKBN17P0ZS

AstraZeneca, Merck team up on Lynparza combos in collaboration worth up to $8.5B

http://uk.reuters.com/article/us-cr-bard-m-a-bd-idUKKBN17P0ZS

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 4th August 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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