Our Healthcare Sector Diagnosis: A Touch of Pre-Election Anxiety, but Vital Signs Appear Strong

10.04.2016 - Amy Kong, CFA

In this Q&A, senior portfolio manager Amy Kong, CFA, offers insights into the changing dynamics of the healthcare sector, how the November elections are influencing our views, and why healthcare is one of our top investment themes.

Q: In general, why do you consider healthcare a top investment theme?

AMY: The most important reason is that it appears to offer stronger growth potential than many other market sectors. Earnings are projected to grow approximately 11% in 2016 and 8% in 2017. These are consensus projections from FactSet as of July 30th, but they’re close to our internal expectations.

Q. How are the November elections influencing the sector?

AMY: In the short and intermediate term, we think the market could show some choppiness in this election year, depending on who takes office in January. Both major candidates have their own healthcare agendas. For example, Hillary Clinton has indicated she wants to maintain and improve the Patient Protection and Affordable Care Act (i.e. Obamacare) while Donald Trump wants to dismantle it.

Both candidates have shown an interest in controlling drug pricing to one degree or another, which we think makes investors nervous and puts pressure on stock prices. Although we do expect to see changes in the way drugs are priced, we don't anticipate a complete overhaul. The government is legally prohibited from interfering with drug prices, at least directly, although it has been able to exert pressure on drug companies through its reimbursement policies for Medicare.

Over the longer term, we are encouraged by the new level of transparency within the FDA and the demand created by aging populations, both domestically and internationally. Finally, we have seen that the healthcare sector is usually less sensitive to geopolitical events than other sectors of the market. Whether the European economy heats up or slows down, or China’s economy grows at 3% or 7% are obviously concerning to us, but they are less likely to affect the healthcare sector than, for example, industrials. Historically, the healthcare sector tends to run its own course.

Q. What qualities do you look for in healthcare innovators?

AMY: Our fundamental research includes looking through the company’s balance sheets at its debt and cash flow levels. Bringing a new drug into the pipeline and on to the market is an expensive proposition, including R&D costs, setting up clinical trials, etc. Occasionally, we see startup firms establishing partnerships with larger, well-established companies to share those startup costs.

Of course, we want to find companies with a track record of successful launches, but we also want to make sure they are financially strong enough to survive a setback if they have trouble getting FDA approval right away. We also look for companies with strong dividend yields, which demonstrates fiscal responsibility and shows that they can be more defensive when the market hits turbulence. 

Q. Do regulatory pressures make investing in healthcare complicated?

AMY: Yes, they do. However, the FDA has become more predictable in recent years and the approval process for new medications is a bit more transparent today. So I think investors are more comfortable buying into healthcare knowing that a drug will probably be approved if it fits the FDA’s profile.

Understanding the complexities of the FDA approval process is important. For example, the FDA has been paying a lot of attention in recent years to hematology and oncology-related drugs, so those types of drugs often receive “fast track” approval.

A drug that has the right safety profile and level of effectiveness can also be assigned “breakthrough therapy” status, which usually moves it through the review process more quickly. Therefore, we look for healthcare companies that are not only innovative but also financially healthy and focused on unmet needs and new treatments that are in high demand.

We also look carefully at the reimbursement rates health insurance companies are willing to pay for certain medications. It’s difficult for a drug company to be rewarded financially if insurance companies don’t add the medication to their formulary (essentially, a list of recommended drugs). 

Q. How do you measure a healthcare firm’s competitive positioning?

AMY: If a company is competing against five or six others in any particular area of the market, it is probably less attractive to us. In addition, if there is already a drug on the market treating that particular disease it becomes even less attractive (unless the new drug has a much higher safety or efficacy level).

But the big question is: How good is this company when it comes to bringing a drug all the way to the finish line? A lot of the companies we own today have high success rates bringing products to market. 

Q. Are there specific segments within healthcare you find particularly appealing?

AMY: Our portfolios hold a fairly high concentration of innovators—companies that create and manufacture new drugs. However, we also have exposure to med-tech firms that make products like defibrillators, artificial joints and the equipment used for procedures like Transcatheter Aortic Valve Replacement, which is a newer, less invasive alternative to open heart surgery.

The role of technology in modern medicine really is amazing. Minimally invasive procedures allow patients to come into the hospital in the morning and go home the same day. And because hospitals are under great pressure to reduce costs, we favor technology firms that can help them run more efficiently.

Q. Are there any areas of the healthcare market you avoid?

AMY: Generally companies that have not been innovative but instead have relied on price increases to remain profitable. From a subsector perspective, the area that comes to mind is Specialty Pharma, which has done very well in recent years because of M&A activity and tax-reduction measures. This approach has worked well for these companies financially but it has proved unsettling for many investors because of the aggressive price hikes that typically follow these acquisitions.

So basically what we're recommending to our portfolio managers is to stick with companies that are focused on traditional R&D, have a strong pipeline of drugs, pay dividends that appear sustainable and have shown the ability to be defensive when the market is stressed.

This communication is intended solely to provide general information. The information and opinions stated are as of October 4, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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