Healthcare Stocks: Invest in Business, Not Science

Written by: Vinay Thapar

Healthcare stocks served as powerful painkillers during last year’s market declines. Yet the sector offers much more than just downside protection for investors who focus on business potential and resist the urge to predict scientific breakthroughs.While the MSCI World Index fell by 8.7% last year, healthcare stocks advanced by 4.8%. But healthcare’s reputation as a defensive haven understates the sector’s attractions. Pharmaceutical groups, medical device manufacturers and healthcare providers are benefiting from big trends that can fuel returns for investorswho are skilled at deciphering the complex forces shaping the sector.

Three Big Trends

Three forces are stimulating change in healthcare today: innovation, pricing structures and policy. However, these dynamics often clash and complicate the investment outlook for a product or company. Will people pay more for a revolutionary treatment if it isn’t covered by a healthcare system? Is a government likely to provide meaningful subsidies for a new diagnostic technology? Are current prices sustainable over the long term? Questions like these vary from country to country, based on government policies, national economics, and spending or cultural preferences.Despite these challenges, we believe there are ways to make informed judgments across the industry that can lead investors to solid sources of profitability and investment returns. The first step is to avoid a common fallacy: don’t make predictions about drug trials. Even the best scientists in the world cannot reliably forecast drug-test results, so why should investors gamble? Instead, develop a clear picture of how innovation, pricing and policy dynamics could affect a company’s profitability and growth rate.

Medical Innovation

Scientific innovation has underpinned healthcare advances for decades. Yet in many ways, the technological revolution in healthcare is still in its infancy. Investors need to look beyond cutting-edge equipment or biotechnology research to understand how innovation will reshape the industry. For example, although the use of big data is still relatively limited in pharmaceutical development, over time, it will probably become an integral tool in improving the efficacy of drug trials.New developments will make an impact across many areas. Robotics are already changing surgical procedures. Treatments for Alzheimer’s disease and cardiovascular disorders will help combat the physical and economic costs of demographic change. The development of solutions to age-old problems from the common cold to cancer is just a matter of time.

Pricing Disruption

Still, powerful innovations don’t always make economic sense. Understanding how pricing points are determined for a new product or service is essential to gauge a company’s earnings potential.Innovation and pricing have a curious relationship in healthcare. In technology, it’s well known that innovation drives performance improvements and pushes down costs exponentially. The IBM mainframe computers that powered NASA’s Apollo spacecraft in the 1960s, which cost millions of dollars each, had a fraction of the memory and processing capacity of an iPhone. But in healthcare, the opposite happens: innovation tends to drive prices up ( Display, left). For example, 20 years ago, cancer patients paid about $200 a month for chemotherapy, and success was limited. Today, some chemotherapy treatments can cure cancer with fewer side effects, but at a cost of $100,000.In many cases, investors must ask whether prices are realistic. For example, Mylan’s EpiPen is a popular product that can avert death in cases of extreme allergic reactions. Its price has surged more than sixfold since May 2007 ( Display above, right), when Mylan bought Merck’s generic drug unit, which included the EpiPen. Is this sustainable? While high-priced products may flatter a company’s earnings and margins, they could prove to be a weakness if the price is forced down by market dynamics or policy decisions.

Policy Dynamics

Government policies about healthcare are a key determinant of whether a business will succeed or fail. Healthcare spending per capita differs dramatically from country to country, and the quality provided doesn’t always reflect the price paid. For example, the US spends more on healthcare than almost any country in the world, yet the quality of healthcare provided ranks lower than in the UK and Germany, which both spend much less ( Display).Policy decisions can make the difference between life and death, by determining which costs and treatments are covered. Around the world, healthcare systems are feeling the strain of rising costs, and workers are responsible for meeting more healthcare costs. At the same time, demand from emerging economies is growing, and spending is likely to increase amid efforts to upgrade the quality of healthcare. These trends will reshape price points for treatments, technology and services.Related: Why Play Defense in Rising Emerging Markets?

Business Fundamentals

Taking these three forces into consideration, investors can evaluate a healthcare business. In our view, innovative healthcare companies that are positioned for long-term success amid pricing pressures and shifting policy sands should demonstrate the following attributes:

High or improving returns on invested capital (ROIC)

Strong reinvestment rates

Healthy balance sheets

Businesses with durable competitive advantages

Be wary of companies that pursue earnings growth at the expense of profitability. Highly acquisitive companies should also be scrutinized closely, especially if they have a lot of debt and/or sales concentrated in a small group of products. And companies that rely on a single successful drug test to drive future growth should be handled with extreme care, in our view.Intuitive Surgical is a good example of a company that scores high on our criteria. The company is a leader in medical robotics, with proven technology in an industry that has high barriers to entry for competitors. Global adoption of robotic surgery is increasing, with about 1 million procedures performed in 2018, a year-over-year increase of 18%. And Intuitive Surgical’s strong ROIC provides it with the financial means to self-fund its expansion, as well as new opportunities in areas such as natural orifice surgery, which reduces the risk of procedures and doesn’t create scarring.In contrast, we believe that drug distributors and hospitals are often problematic investments. For many drug distributors, pricing models are unsustainable, as companies charge based on the value of the cargo, contrary to pricing models for other distribution companies, that price based on size, weight and distance travelled. Hospitals are also facing pressure on profitability as new technological advances pull patients away from hospitals for many types of treatments.Investing effectively in healthcare stocks requires a unique set of skills. It’s not about scientific insight. By applying a disciplined investment process that integrates the diverse factors that affect healthcare businesses, investors can access sources of strong return potential that can invigorate an equity portfoliofor the long term. Vinay Thapar is Portfolio Manager and Senior Research Analyst—US Growth Equities and International Healthcare Portfolio at AllianceBernstein (AB) The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.