Westwood Holdings Group, Inc. (NYSE: WHG), an asset management firm based in Dallas, Texas, has released a “Perspectives” piece looking at opportunities for investment in the health care arena.

The firm believes that 2014 will be another strong year in the sector, but after strong returns in 2013, cautions that downside risk will be a more important consideration than it may have been in the last year.

Within the sector, the firm believes that pharmaceuticals are “poised for continued strength,” based on strong pipelines, emerging markets exposure, and the lessons learned after the mid-2000s “patent cliffs.”

Medical devices continue to look “strong and stable,” and with “sticky” business revenues and other “strong competitive advantages,” Westwood “prefer(s) companies in the medical device industry over other segments of the health care sector because we foresee more compelling reward/risk opportunities in this area.”

Lastly, the team sees a “mixed outlook” in health care services and biotechs, having run in 2013, look “overheated.”

Perspectives on Health Care

Health Care continues to be a topic of interest to many investors, whether it’s examined from the standpoint of the world’s aging population or from the perspective of the Affordable Care Act (ACA). At Westwood, our U.S. equities research team continues to focus on identifying companies in the industry that we believe meet our criteria of having:

  • Solid long-term business fundamentals with strong free cash flows,
  • High-quality, profitable franchises which provide for downside protection in case of market weakness or a change in investor sentiment, and
  • Persistent earnings growth that exceeds expectations.

As we’ll discuss in more detail, there are several areas of the Health Care sector that we believe are promising in 2014, including Pharmaceuticals and Medical Devices. On the other hand, we continue to have concerns about the upside potential within Biotech and Health Care Services. Additionally, we anticipate that the ACA will be neutral for the overall industry. We have a positive outlook on the overall sector but will continue to be very focused on downside risk.

Pharmaceuticals Poised for Continued Strength

Pharmaceuticals have recently come back into favor after experiencing a rough patch during the mid-2000s driven by concerns over patent cliffs (i.e. when a patent expires and a firm’s revenue falls dramatically due to generic versions becoming available) and fears that their business models had become permanently impaired. Since coming out of this slump and addressing patent concerns, we believe pharmaceutical companies have improved fundamentals and good valuations.

Our portfolio holdings in the Pharmaceuticals industry possess attractive new product pipelines and product cycles that should support long-term earnings growth. These companies have learned from the experiences of patent cliffs and have diversified their businesses. They have also focused on areas of the market where it’s not as easy to develop generic versions, such as in biologics and/or vaccines. Additionally, some pharmaceutical companies are looking to emerging markets for long-term growth potential.

Exposure to emerging markets and non-U.S. developed markets helps diversify risks created by the ACA. Further, our favored pharmaceutical companies have moved their attention from the family doctor and generalist practice to focusing on medical niches like oncology or immunology. Pharmaceuticals have also streamlined their sales and marketing infrastructure by focusing research and development (R&D) efforts in areas of expertise and monitoring productivity. Cash flows are used prudently to make small strategic acquisitions or are returned to shareholders via dividends or share repurchases.

Medical Devices continue to be Strong and Stable

Within the Medical Devices industry, we favor companies with low exposure to reimbursement (i.e. Medicare) risks, that have reasonable pricing power, and that have a strong and/or growing presence in emerging markets. Device business revenues tend to be a lot more “sticky” than those of pharmaceutical businesses and do not have the classic patent cliff risk that is associated with drug companies. Expanding one’s market share within this industry takes longer since doctors and other care providers must be trained and often have strong preferences for the products they use, which leads to strong competitive advantages for the best firms. Additionally, device companies do not rely heavily on one single patent for their devices. For these reasons, all else being equal, we prefer companies in the medical device industry over other segments of the health care sector because we foresee more compelling reward/risk opportunities in this area.

Health Care Services Outlook is Mixed

Broadly speaking, the Health Care services industry is more exposed to government reimbursement risk compared to other Health Care industries. The implementation of Health Care reform will benefit hospitals due to a decrease in their substantial bad debt expense allowing for a multi-year tailwind.

However, the positive effects are somewhat tempered by the much-publicized start-up issues faced by the new, ACA-mandated, federal Health Care exchanges. We also expect managed care companies to benefit from a slowing medical cost inflation trend due to the increasing prevalence of high-deductible health care plans and other factors, such as the increasing use of generic drugs. Drug distributors and Pharmacy Benefit Management (PBM) companies should be relatively unaffected by Health Care reform and are expected to perform well in the current environment. Finally, we expect the independent lab providers to continue to face reimbursement headwinds in 2014.

Biotech is Overheated

Biotech was a significant driver of performance within the Health Care sector in 2013 and was among the best performing industry groups out of ALL industries in the S&P 500, up 75.2% for the full year. As Figure 1 shows, in the past few years, we have seen a spectacular rally in Biotechs, relative to their larger more profitable peers within the Health Care space and the broader S&P 500.

Nasdaq Biotech Index health care Westwood

The Health Care sector is not immune to this type of cycle – in fact, we saw this first in the late 1990s and again in the mid-2000s. The key factors that cause these outcomes are 1) successful drug approvals and 2) an increase in investor risk tolerance. However, investing in these stocks (most of which are “story” stocks with little to no earnings) can be risky since they sell off quickly when sentiment turns and/or there are disappointments on the drug approval front. For these reasons, we did not participate in the 2013 rally in these stocks, but instead focused on the companies that exhibit our core, high quality characteristics. Going into 2014, we continue to be disciplined and selective in our exposure within this segment of the market.

ACA Impact on the Health Care Sector appears to be Neutral

The ACA continues to be an area of interest and we are paying particular attention to:

  • Enrollment trends within ACA,
  • Reimbursement levels at service providers,
  • Utilization trends, and
  • Potential pressure on drug reimbursement either through narrow formularies (allowed list of drugs) or through direct rebates.

We believe that the ACA is positive for drug and device company volumes, as more people will now be insured. There will be some pricing challenges, but companies should be able to successfully navigate through these situations and offset lower pricing with either higher patient volumes or new product launches. We doubt pricing for these businesses will become severe enough to discourage innovation, which has been a source of competitive advantage for the United States. A negative pricing environment in the U.S. would be a disincentive for innovation in the

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