Weekly Global Market Commentary – 16th November 2015

The Healthcare Opportunity – By Bryan Dooley, CFA

Download the full article here

Healthcare may be the most controversial sector of the global economy right now. Stocks in this industry have recently suffered broad price declines due largely to the actions of a couple of bad players, but that could spell opportunity for those with a longer term investment horizon.

It all began with a tweet from American presidential candidate Hillary Clinton in late September. The socialist political hopeful with a long history of lashing out against the healthcare industry, ranted about pharmaceutical profits after a small drug company aggressively raised a price on one of its drugs. Shortly thereafter, Canadian-based Valeant Pharmaceuticals saw its stock price crash after news broke concerning a federal investigation surrounding some of its more dubious operating practices.

Renewed pricing concerns and the threat of increased government regulation tumbled healthcare sector equity prices in late September. Since then, the stocks have rebounded somewhat but still lag the overall market’s strong October rally. After several years of outperformance, the once high flying group has fallen back to earth and is now trading well off its highs for the year. Near term, the outlook remains a bit cloudy but patient investors should hang on and consider buying more.

Despite the risk of further negative news stories brought out by the popular media, ‘short selling’ hedge fund managers and political candidates jockeying for position in the 2016 American elections, several positive factors are likely to persist above the noise. Favorable demographics, industry consolidation and an ongoing improvement in the number and quality of products are key positive trends.

To begin with, demographics are clearly working in the industry’s favor. Without exception, the world’s largest countries continue to see a steadily increasing longevity of their populations. This means more and more citizens will need increased healthcare services as they live out their extended golden years en masse. In the United States alone, the number of older people is projected to increase by 135% from now until 2050 while the size of the population over 85 year old is projected to increase by 350%.

The demographic effect is already beginning to show up in economic data reports. Due also in part to enactment of America’s Affordable Care Act (ACA), spending on health-related goods and services is once again on the rise. The latest U.S. gross domestic product (GDP) report showed spending increased at an annualized rate of 4.7%, more than twice the level of overall GDP growth.

Total spending now amounts to $3.1 trillion, or $9,695 per person. That represents an increase of 5.5%, according to federal estimates and the first time the rate exceeded 5% since 2007 and the trend is expected to accelerate over the next decade.

In addition to favorable demographic trends, innovative products are hitting the market at an accelerated pace and new therapies filling unmet needs are having success in this environment. According to the Food and Drug Administration (FDA), the number of ‘novel drug therapies’ approved each year has more doubled over the past decade. These products provide solutions for serious diseases including cancer, hepatitis C and diabetes. Fast track approval for life threatening diseases has also helped reduce development costs and time to market.

Another factor which could continue to help healthcare stocks is the ongoing consolidation of the industry. So far, this year has seen 324 pharmaceutical deals amounting to $204.9 billion, a staggering 149% increase over last year’s tally. Healthcare deals typically increase bottom line earnings as costs are taken out of the combined entities. Overlapping sales forces and research and development staff are usually pared back, improving earnings growth and creating certain economies of scale. Also, tax planning can be part of the strategy.

Earlier this month pharmaceutical heavy weight, Pfizer Inc. made a bid for Ireland-based Allergan in a move designed to cut the company’s taxes and unlock overseas cash. The proposed deal, valued at over $100 billion makes for one of the largest mergers ever. If it goes through, the merger will dramatically reduce Pfizer’s tax bill after the company moves its domicile to the Emerald Isle. Ireland’s top corporate tax rate of 12.5% compares favourably to the U.S. rate of 35%.

While the healthcare sector is likely to remain volatile in the face of increasing political headwinds, the current negative sentiment belies strong fundamentals and reasonable valuations. Within the broad category, we recommend avoiding expensive, smaller biotech companies banking on the success of a single drug or a buyout offer. Instead, the more diversified, larger capitalized pharmaceutical and medical supply companies look more enticing.

Veteran industry analyst David Bianco of Deutche Bank recently commented that healthcare is trading at about a nine percent discount to the overall market as measured by the price/earnings ratio applied to next year’s expected S&P 500 earnings levels, despite having better prospects. “We expect 6% sales growth from (the healthcare sector) in 2016, well above nominal GDP and S&P sales growth. Healthcare has margin risks, but also upside potential. We expect 6-9% EPS growth. We doubt the S&P delivers better growth.”

With overall corporate earnings progress now more at risk as the Fed likely looks to tighten monetary policy, the traditionally defensive and faster growing healthcare group looks like a good bet.

The information contained in this article is for information purposes only, and represent the views of the author. It is not intended as specific investment or financial advice, or a recommendation or solicitation to buy or sell any security. Any investments or strategies listed in this article may not be suitable for all investors. Past performance is not indicative of future performance, and as with any investment, prices may fluctuate. It is recommended that advice is sought from a qualified investment professional prior to implementing any financial plan. LOM has made every effort to ensure that the contents herein have been compiled from sources believed reliable, however LOM does not warrant the accuracy, adequacy, timeliness, or completeness of this information expressly disclaims liability for errors or omissions in this information.