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Why the unloved healthcare sector deserves a closer look

Healthcare has been one of the most unpopular areas of equity markets for the better part of two years, but one where opportunities for sustainable growth continue to be found.

To better understand the current situation and what the near-term future holds, it is helpful to review the bull and bear markets the sector has experienced over the last six years.

From 2011 through to the summer of 2015, healthcare significantly outperformed the broader market, with particular strength in biotechnology and pharmaceutical stocks.

This bull market was driven by four trends: the end of the patent cliff of branded drug expirations, increasing optimism about innovative drug therapies and technologies, a more favourable regulatory environment for new drug approvals and robust prescription drug pricing power.

US presidential hopeful Hillary Clinton’s tweets on the campaign trail about the high prices of certain branded drugs coincided with the end of the rally. Since then, biopharmaceutical stocks have endured above-average volatility, with negative sentiment overshadowing resilient fundamentals.

From July 2015 through to March this year, the Nasdaq Biotechnology index of large-cap biotech stocks lost more than 20 per cent, while the S&P 500 index was up 14 per cent.

Innovation alive and well 

Despite recent weakness, three of the four trends that powered the healthcare bull market remain in place today. The patent cliff is still not an issue, with no major patent expirations expected until the middle of the next decade. Regulators remain supportive of new drug treatments, having approved seven new therapies in March.

We are also optimistic that changes at the FDA under President Donald Trump will allow new compounds to get to market faster.

Perhaps most importantly, innovation is alive and well. Biopharmaceutical companies are making meaningful progress in the areas of immuno-oncology, where the four drugs now on the market are generating $8bn in annual sales with the potential to reach $15bn in the future.

Gene therapy and personalised medicine remain important trends for growth.

Meanwhile, late stage clinical trials for new treatments for cholesterol and rare diseases like cystic fibrosis have been positive.

Drug pricing remains a headwind but not all therapeutic companies will be affected equally. For drugs in competitive markets like diabetes, respiratory and hepatitis C, commercial payors will continue to extract price concessions and favour lower priced choices.

Pricing power

In contrast,  innovative companies like Amgen, which is researching new, more effective treatments for widespread health conditions such as high cholesterol, and Vertex Pharmaceuticals, which is designing combination therapies for rare forms of cystic fibrosis, work in areas that face less competition, allowing them to better maintain pricing power.

Few of these positive catalysts are being recognised by investors as share prices have yet to catch up with business fundamentals. Profitable biotech stocks are trading at their biggest discount to the overall stockmarket in more than 20 years.

Current valuations assign little to no value to companies with rich research and development pipelines. Being invested in biopharmaceutical stocks since 1983, we have seen several of these business cycles unfold where a segment of healthcare or the entire sector falls out of favour. A recent example, analogous to what is happening now in the therapeutics sub-sector, was the sell off in managed care companies on the eve of Obamacare in 2009.

The stock price of UnitedHealth Group fell into the $20s during a period of extreme fear of a single payor government system. But in spite of losing money in the public exchange market (which it has since exited), the company recently hit all-time highs in revenue, earnings, and free cashflow. It now trades near $170 per share.

Over the long term, the value of quality biopharmaceutical assets will be realised through a re-rating of share prices or a significant wave of industry consolidation. In the meantime, investors should use short-term periods of volatility to add to healthcare exposure.

Evan Bauman is manager of the Legg Mason ClearBridge US Aggressive Growth fund

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