Healthcare Sector: A Health Warning? by Mikhail Zverev, Head of Global Equities, Standard Life Investments
Global healthcare has been a good place to invest. MSCI All Country Healthcare index had outperformed global stock market by over 60% over the past 5 years, although this outperformance had slowed down during last 12 months.
There are good reasons for that outperformance. It is a defensive, yet growing and cash generative sector – features that investors like. US healthcare reform, which once caused uncertainty and fear, had proven to be a positive – expanding coverage of the US population without adverse changes to how healthcare is delivered and paid for. US market is a key driver for the industry – for most healthcare segments US is up to 50% of the value, and companies tend to achieve higher prices and margins in the US.
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But there are limits to the US opportunity. US now spend 16% of GDP on healthcare, and is the most expensive healthcare system in the world, spending a lot more per capita than even prosperous European countries.
Healthcare costs had seen relentless growth in recent years. This cost trend was temporarily helped by the so called “generic wave” – major drugs, such as Lipitor, anti-cholesterol medication, were substituted by cheaper generic versions as their patents expired. This helped US healthcare system save costs.
But most of that generic benefit is now over, and new generation of drugs tend to be complex biologic molecules, with higher cost. Recent breakthrough Hepatitis C drug, Sovladi, was launched with an $84,000 price tag, causing a lot of controversy. Political sentiment is turning against healthcare as politicians cite excessive price increases. US presidential candidate Hillary Clinton citing healthcare cost control as key point of her political agenda.
Even essential day-to-day medications, such as insulin for diabetes treatment, are seeing pricing pressure – its leading manufacturer, Novo Nordisk, had recently downgraded its outlook as a result.
So what are the implications for the investor?
Change is often a source of opportunity, even in what looks like an adverse industry environment. But investors need to be careful and selective.
One interesting area of change is how the healthcare is administered and procured in the US. It is to a large degree a private system, managed by insurance companies (also called HMOs) and benefit management companies. These companies essentially are gate keepers for healthcare spend, acting on behalf of their corporate, public sector and individual clients. And some of them are adopting innovative solutions to save money for their clients while also delivering returns to their shareholders.
CVS is a combination of the largest pharmacy chain in the US with a benefit management organization that administers prescription drugs for its patients. It had launched a number of initiatives over the past several years – introducing low-cost physician clinics in their pharmacies, to save money on doctor’s visits; consolidating buying of drugs to improve procurement costs; striking “exclusive” deals with the suppliers, where only one supplier of similar drugs is allowed in, in exchange for price discounts; and even setting up low-cost infusion centers for more advanced drugs, avoiding expensive hospital visits.
All this saves money for their clients, but also adds to CVS’s own margin profitability. This led to a strong multi-year performance and is increasingly appreciated by investors.
On the other end of the spectrum are medical devices companies. These companies had lived with a pricing pressure for a long time – single digit price declines each year for their products is often the norm. They have adjusted their business models to this environment, and invested in innovation to reaccelerate their revenue growth. They are a relatively smaller part of the US healthcare costs, 3%-5% of the total spend, so are much less in the cross-hairs of the political pressure. It is also an economically cyclical business – people are more likely to postpone elective medical procedures during tough economic times, so when growth and employment improves – as they have been doing in the US – there is pent-up demand.
One such company is a US listed CR Bard – it has diverse product set, strong record of innovation driving growth in multiple market segments, and an opportunity to take their best in class medical devices to emerging markets, including China, where standards of care– for example in cancer treatment – are likely to trend towards international best practice.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
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