The various challenges facing the healthcare sector today have been brought to light recently with media headlines highlighting the pressures at play in a very competitive industry. The cost of healthcare in the US is a key challenge for providers and consumers of healthcare, where we have seen companies such as Amazon announce their intention to find alternative ways to provide more affordable healthcare to their employees, with consequences for US healthcare companies.
Other challenges the sector has experienced in the last few years include:
- Generic drug manufacturers have struggled with increasing price competition.
- Repeated attempts to repeal Obamacare throughout 2017 created apprehension among health care providers.
- Health care expenses continue to rise, and hospitals and providers are under pressure to lower costs and drive efficiencies.
- There has been increasing regulatory and political scrutiny around drug pricing.
While these pressures are not new, they have intensified in the US with the increased powers in the hands of commercial players.
With regard to branded-drug pricing, our view is that market forces have and will continue to dominate in exerting pricing pressure, especially in the competitive-drug category. This is why investors should favour stocks with valuations that are discounting significant competitive pressures, as well as companies whose products have limited competition or clearly demonstrate advantages over existing alternatives.
We believe that the health care industry will rise to these challenges, but it remains vital that innovation, both in product and services, is designed to benefit clinical outcomes and take out cost in the system rather than adding new cost. Those that fail to innovate will be subject to commoditisation and margin pressure.
Investors must capture as much of the earnings up-cycle as possible. At the same time, consider a company’s earnings duration. With pharmaceutical companies, the earnings cycle is driven by innovation. Duration comes from patents, and marketing and distribution is also crucial to successfully commercialise new products.
In our experience, the real winners are the stocks whose price-to-earnings (P/E) ratios are heavily discounting future growth. Also we look at various other fundamental metrics such as free cash flow, yield and balance sheet strength.
Investors should focus on opportunities that fall into one of three categories:
- Businesses with tangible revenue streams that are mispriced due to near-term pressures or competitive threats.
- Innovative companies with pipeline optionality and overlooked research and development (R&D) that is meaningfully undervalued.
- Companies positioned to unlock value through effective restructuring i.e., cutting costs to improve earnings.
Overall, health care continues to be an attractive sector characterised by high barriers to entry, favourable margins, attractive long-term industry growth and strong innovation potential. We believe investing in unloved and unappreciated quality businesses will be rewarded over time.