By Vinay Thapar, manager of the AB International Health Care Portfolio
Even the best scientists in the world cannot reliably forecast drug-test results, so why should investors gamble? Drugmakers don’t have to dominate a healthcare portfolio – investors should cast a wide net to find innovation and growth.
Pharmaceutical companies often grab the limelight in the healthcare sector, attracting investors with the promise of a potential blockbuster drug to eradicate an intractable illness – and a healthy flow of profits.
Quality businesses are key for healthcare stocks, which often serve as powerful painkillers during market declines. Yet the sector can offer much more than downside mitigation.
While the MSCI World index fell 18.1% in 2022, healthcare stocks dropped by only 5.4%. 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 help fuel long-term returns for investors skilled at deciphering the complex forces shaping the sector. The sector’s lacklustre 2023 returns suggest much of this potential is yet to be realised.
Big pharma companies rank among the largest healthcare weights, often dominating sector positions in a global equity portfolio or a stand-alone allocation. Yet focusing too much on pharmaceuticals could limit a portfolio’s potential. Companies that manufacture diagnostics, technology and equipment to address the world’s most pressing medical issues have become increasingly important for progress in the healthcare sector.
Changes to the healthcare benchmark over the last two decades reflect this shift. The weight of pharmaceutical companies in the MSCI World Health Care index has fallen from 82% in 2000 to 41% today. Other industries have become more prominent, offering equity investors a broader array of opportunities in areas such as life sciences tools and services, technology, and equipment.
Diagnostics and life sciences tools and services
These areas are just as important for medical processes as treatment. Advanced testing and imaging can help medical professionals detect disease much earlier, improving treatment efficacy and recovery outcomes. And the power of sequencing the human genome will only create more opportunity.
Pharmaceutical companies typically outsource clinical trials when testing new drugs. Luxembourg-based Eurofins Scientific is one of the largest diagnostic companies outside the US, offering services from clinical trials to environmental and food testing. Japan’s Synnex sells diagnostic equipment to analyse blood, from simple tests to identify a patient’s blood type to liquid biopsies for cancer and detecting Alzheimer’s disease.
In biotech research and development, innovative drug-development processes in areas like gene therapy have historically been very capital intensive, with companies needing many tanks to manufacture biologic drugs in multiple locations. Germany’s Sartorius Stedim Biotech has developed a reusable system for the steel tanks used by biotech firms that saves money and is more environmentally friendly.
Technology and artificial intelligence (AI)
Compared to other sectors, healthcare has been a laggard in our high-tech society. But things are changing, and companies that can successfully adopt new technologies could dramatically change care provision and delivery.
The US’s Veeva Systems and Ireland’s ICON, for instance, are introducing AI via commercial tools. As AI improves and become more widespread in disease diagnostics, we believe companies that offer SaaS for healthcare will enjoy greater demand. Japan’s Veeva and M3 offer a range of SaaS, from clinical trials to home health monitoring and marketing software for pharmaceutical sales.
Equipment and supplies
Across the sector, the equipment and tools used to deliver healthcare products and services are constantly changing. Innovative equipment used in lifesaving procedures can improve outcomes for patients. Consider Edwards Lifesciences, which manufactures a transcatheter aortic valve replacement (TAVR) that helps solve a major heart ailment with a minimally invasive procedure. The global market for TAVR equipment is poised to grow from $7bn in 2024 to $10bn in 2028, according to company reports.
For surgeons, a technological revolution is rapidly unfolding. An increasing number of procedures use robotic tools, allowing surgeons to access hard-to-reach spots inside the body with high-precision, minimally invasive incisions, fewer complications and faster recovery times. The US’s Intuitive Surgical manufactures a robotic surgery system that is popular in American operating rooms and is gaining momentum globally, with significant growth opportunity in Europe, Japan and China.
Three attributes to define healthy growth
While each industry has different dynamics, investors should look for three attributes to identify attractive healthcare businesses.
First, the product or service should improve healthcare outcomes for patients. Second, companies helping cash-strapped healthcare systems save costs are likely to benefit from strong demand drivers. Third, products that improve outcomes and save costs must generate a profit for the business.
Companies that possess these three attributes are operating in a virtuous ecosystem. The dynamics of a healthy ecosystem provide a foundation for companies to profitably reinvest cash flows, which helps support consistent earnings growth over time. Equity investors should always stay focused on business fundamentals when choosing healthcare stocks, rather than trying to predict scientific success.
Pharmaceutical companies meeting the criteria of a healthy ecosystem should be included in a diversified allocation of healthcare stocks. But instead of having drugmakers anchor a portfolio, the starting point should be a search for high-quality business models – wherever they may be.
