Healthcare looks fit for action again

A marked outperformance among biotechnology stocks indicates that the healthcare sector is recovering from its recent lethargy and offering better prospects for investment this year.

Although 2007 was another poor year for healthcare stocks, the sector did not have only itself to blame. Indeed, the subprime crisis and its fallout were behind much of the sector’s poor performance during the second part of the year. So much so that healthcare stocks have started modestly to outperform, possibly marking the beginning of a shift of investor preferences from cyclical to defensive industries.

The outperformance is most marked for biotechnology stocks, which possess the strongest set of fundamentals among the different healthcare industries. This could therefore be a better year for healthcare stocks, and five themes will be particularly relevant in 2008.

We should see large pharmaceutical stocks start to emerge from the doldrums, with improved earnings per share (EPS) growth and revitalised pipelines, while the broader market’s EPS growth should contract, primarily as a result of the subprime crisis and high commodity prices.

One telling statistic is the rate of EPS growth for American pharma versus the S&P 500. In the past few years the overall market’s EPS growth has been about 8% a year on average, while big pharma has barely managed 5%. As of this year, however, pharma should increase its annual EPS growth to 8-10%, while the broader market should see its EPS growth trend south of the long-term average of 8%. With that, we see no reason for the 10-15% discount applied to pharma (and healthcare) to be sustained.

America will move towards universal healthcare coverage and a centrally managed healthcare system, irrespective of who wins the presidential election. Indeed, with healthcare spending continuing to rise at a rate exceeding that of GDP growth, massive budget deficits, tens of millions of Americans not having access to basic healthcare goods and services and mounting political pressure, the outcome is a foregone conclusion. In fact, some states – California and Massachusetts, for example – are leading the way. Therefore, pricing power is a declining function of time, as there is simply not enough money to pay for the increasing demand.

While this is detrimental to the healthcare industry overall, there are losers and winners in this game, too. The losers are first and foremost the suppliers of “me too” solutions and poorly differentiated products – in other words, much of big pharma. The winners are suppliers of affordable medicines such as generics and of products with a high benefit-to-cost ratio. In other words, there is still a premium for innovation. In this context, a preference should be given to companies with high innovation power, such as biotechs and selected medtechs. Pharmaceuticals with a high American exposure and above-average patent expirations over the next five years should be avoided.

There are the first concrete signs that spending on drugs and healthcare services is seriously taking off as disposable income increases in emerging economies. The most dramatic examples are in Eastern Europe and China, but the rest of Asia should follow shortly. The immediate beneficiaries are suppliers of affordable medicines, in line with the income levels of those countries, but spending on high-priced drugs will also start to increase in the years to come.

In the immediate future, generic companies, selected speciality pharma companies and large pharmaceuticals with a relatively large presence in Asia are ways to capitalise on this trend. Longer term, this theme will also represent a growth opportunity for bio-tech companies.

The resistance of bacteria to commonly used anti-bacterial agents has long been on the worry list of international health organisations and academic institutions. With the recent dramatic rise of MRSA (and VRSA) resistant organisms in public and private hospitals, the topic is taking on a socio-economic dimension. Strong market uptake of recently launched antibiotics further highlights the case. With several new products slated for approval over the next 12-24 months, this theme will be relevant for investors in 2008 and beyond. Selected biotechs and pharmaceutical companies are the way to go hereAnother theme is the rise of predictive medicine and molecular diagnostics. Whether through chip companies, diagnostic companies, large pharma or biotech offering personalised medicine approaches, there are several ways to capitalise on the fact that gene-based testing is starting to acquire clinical utility.

Despite all the challenges ahead, not least the overall market environment, 2008 stands a good chance of being rewarding for healthcare investors, in both absolute and relative terms. The innovation-rich industries are well placed and companies with biotechs and medtechs will lead the way. Pharma is attractive, based on its EPS turnaround potential and low valuation, but large exposure to America and the headline risk from the presidential election is significant.

Lastly, generics and specialty pharma are a good way to capitalise on emerging pharmaceutical markets such as Eastern Europe and Asia, as well as emerging generic markets like Japan.