Nothing is certain but death and taxes. To this Benjamin Franklin might have reasonably addended ‘but people’s desire to avoid both should not be underestimated’. Putting aside the morality of the latter the desire to maximise one’s health speaks to us all.
It is this desire which has helped the healthcare sector to deliver enviable multi-year returns. Globally the sector has generated a total return of 9% p.a. since 2005, outperforming the broader market by over 2% p.a.
Source: Bloomberg, world = developed markets
But fortunes have not been evenly distributed. Beneath the surface the drivers of growth are shifting. Since the late ‘80s cash earnings for the broad healthcare space have exhibited a rising trend against the market, illustrating the unique secular demand underpinning the sector. However, the beneficiaries of this demand have rotated. Large cap pharma, often a heuristic for the sector, continues to dominate the market cap spectrum, but better growth is to be found elsewhere. This is reflected in starkly contrasting stock performance. Despite representing some 50% of the whole, pharma gained only 46% since 2012 (a CAGR of 6%) against the sector up 112% (CAGR: 13%).
Distributable Cash Earnings – US Healthcare vs S&P 500, Source: Valu-Trac
But if traditional pharma is no longer generating growth, to whom has the baton passed? The answer lies in a broad church of businesses, from medical technology, to managed care, to healthcare IT. The myriad solutions these businesses offer directly, or indirectly, coalesce around the central issue facing healthcare today: a lack of affordability. There will necessarily always be a role for innovative drug discovery. However, prescription drugs represent only a small fraction (9%) of the total annual US healthcare spend of some cUS$3.3tn. With US healthcare cost inflation set to continue to run at over double CPI there is a significant opportunity set for innovative companies in reducing the 91%.
Technology has the potential to revolutionise the entire healthcare model. It is no coincidence that the number of healthcare companies included in the Nasdaq composite have risen from 606 in 2015 to 703 today.
Valuations meanwhile remain undemanding with PE multiples in all markets are towards the low end of their historical range. Indeed, despite historical outperformance and the opportunity set, the sector in the US continues to trade at an attractive discount to the broader market. In Europe, the sparsity of healthcare stocks has kept the sector at a premium.
Source: BB Healthcare Trust
One side effect of internal sector rotation may be that healthcare will no longer exhibit its traditional ‘all-weather’ role within portfolios. Historically big pharma’s inelastic demand profile has acted to bulwark sector earnings through general volatility; from September 2008 global healthcare declined 30% and took 14 months to recover its losses against -46% and 19 months for the global index.
Global pharma will continue to play a role within the industry sector but the greater opportunity lies in niches where medical care is expedited by technology with benefits to patients and health care systems.
Within Cerno clients’ portfolios, we own companies in orthopaedics (Zimmer Biomet), pharma & technology (Johnson & Johnson and Waters), post-operative care (Coloplast) and newer, disruptive technologies represented in the Baillie Gifford Global Discovery Portfolio.