Healthcare had been increasingly considered a sweet spot for portfolio exposure due to the tailwinds of an ageing population. This is true at a global level, but has been especially impressive in the United States. US healthcare has experienced significant price growth over the past twelve years and commensurately attracted investors that were willing to pay higher premiums for the privilege of accessing the market.
The challenge in a forward-looking context is to understand whether this superiority remains valid or whether the price has moved too far relative to the fundamentals. An effective means of assessing this is to look back at the underlying revenue and profitability growth of the sector at both a US and global level.
This is undoubtedly having an impact on the outlook for the industry and is beginning to draw critics that believe the ‘quality growth’ may be deteriorating. In order to comprehend this from a broader perspective, one should consider the underlying earnings.
The fact that the US has historically achieved superior growth rates in both revenue and earnings would typically comfort an investor that wants ‘quality growth’ exposure. However, the earnings superiority has dampened in the past five years and global healthcare is now the more profitable exposure. This raises eyebrows in an environment where regulatory pressure is beginning to mount.
Deep Dive of US Healthcare
We can see that the US healthcare story is largely a pharmaceutical and biotechnology story, with the two sub-sectors growing substantially over time and now accounting for 57% of the healthcare market.
By investigating both the return-on-equity and profit margin numbers above, we can also see that the two sub-sectors flaunt very impressive profitability metrics. This will have an important role to play for ‘quality’ focused investors, especially when we consider the exceptional dividend growth rates and the impact rising payout ratios may have on the regulatory risks faced by the industry.
The fact dividend growth rates have been increasing in the US while earnings growth rates have been deteriorating is a cause for some concern. On face value, it potentially implies that there are challenges in innovation and an acknowledgement by management that the return-on-investment is in structural decline. However, to fully comprehend whether this may be a structural or cyclical phenomenon, we need to examine the productivity of the current pharmaceutical and biotechnology pipeline.
A Decline in Growth Rates
Specifically, we find that while overall pricing regulation is an industry-wide uncertainty, pricing power of patented drugs remains strong, with mid-single-digit net price increases to continue for most branded franchises in the areas of cancer, immunology, multiple sclerosis and vaccines. In this regard, we find that the development of new technologies has actually led to optimism amongst many healthcare analysts and researchers. However, on the other hand, historical pricing pressure in diabetes, hepatitis C and the respiratory market has shown that a lack of differentiation can be problematic and there are limited benefits from incremental innovation.
Therefore, the industry’s ability to successfully innovate remains segmented despite the broad shift in business models to “externalise” research and development through partnerships and acquisitions.
M&A Deals Important
Mergers and acquisitions have also played an important part in the development of the healthcare industry. While consolidation can generally be seen as a positive for the industry, as it can lead to higher return-on-equity and higher profit margins, it does depend on the sub-sector as to the impact it will have.
Furthermore, as we reflect on recent developments, we note there have been a lot of deals in both volume and size over the last five years, some of which were at elevated valuations. These elevated valuations would typically be a perceived concern, however, we note that it is hard to draw inference off a small sample as the statistics are skewed by a couple of large deals. If we apply perspective and look at the longer-term, the majority of recent deals are not outside of what has been paid in the past – which is largely consistent with the prevailing valuations and therefore less of a concern.
Regulatory Threat is Real
It is also imperative to review the regulatory threat to pharmaceutical profits, as this would seem to be a secular threat to US drug prices. With the US government responsible for over a third of drug sales globally, changes to drug-pricing policy under a Donald Trump administration would be expected to affect pharmaceutical and biotechnology fundamental valuations.
The biggest issue in this regard would be to tackle the largest recipients of healthcare – individuals who qualify for both Medicare and Medicaid; so-called dual eligibility.
This could have a significantly negative impact on the intrinsic value of healthcare stocks, where our Morningstar equity analyst colleagues estimate a 5% fall in earnings-per-share. It is also worth noting that any regulatory change would likely have a meaningful benefit for managed-care insurance companies, as they benefit from reduced taxes and become a beneficiary of future penalties related to a lack of coverage, although this may be somewhat offset by lower numbers of insured people.
Therefore, while the regulatory proposals are undoubtedly a threat, we need to acknowledge that we cannot predict such outcomes as the probability of success in any effort to reform Obamacare is difficult to assess. This reinforces our need to apply a margin of safety in our valuation assessment.
Overall Conviction
By weighing up all of the above factors, and considering the valuation-implied returns offered by the sector, we consider the US healthcare sector to be a ‘medium’ conviction opportunity in an environment where most asset classes look expensive. Healthcare stocks still offer a higher quality real return of 3.7% over the coming 10 years, and even if the intrinsic value is impeded by regulatory change, our stress testing still offers a small positive return in real terms. This provides a reasonable level of comfort and warrants further analysis on the most appropriate means of gaining exposure at a portfolio level.
