Health Care Sector Outlook: Inflection Points Ahead

Posted by Dana Funds Investment Team on Aug 10, 2021 4:30:02 PM

Editor’s note: Our health care sector outlook is part of a regular series sharing our views on various sectors. It’s part of our efforts to increase communication with investors at a time of economic and market uncertainty. While the sector outlooks provide a short overview of our thinking, we invite you to contact us if you are interested in a deeper discussion.

In a sector as large and diverse as health care, only one sweeping statement can be applied across the entire investable universe: Fundamentals are at an inflection point.

Each industry within health care finds itself at a crossroads. For pharmaceutical companies, a patent cliff is emerging. Medical Technology companies could see a sharp uptick in demand as patients schedule elective surgeries delayed during COVID. Managed care faces its own inflection, as those delayed surgeries turn into increased costs. And within the biotech industry, every emerging company faces its own distinctive turning point as the passage — or failure — of a clinical trial could weigh heavily on the stock.

Our second half outlook shares a closer look at what’s changing for each industry within the health care sector, and how Dana is navigating each of these junctures:

Pharmaceuticals

Over the next five years, 2022 will be the worst for the pharmaceutical group in terms of patent expirations. Valuations reflect the trough in the research and development (R&D) cycle. The price to earnings (P/E) ratio for the pharmaceutical group trades at a 28% discount to the S&P 500,* which is quite attractive for a group of stocks whose multiple has generally been on par with the broader index over the last 32 years.

As long-term investors we view this as an opportunity. While patent expirations are peaking in the near term, investors should remember pharmaceutical companies have a 50-year track record of productive and innovative R&D engines, have huge competitive moats around their business, and have maintained a high degree of pricing power. With valuations offering an attractive entry point, we continue to see long-term opportunities among individual pharmaceutical companies who either a) do not face near-term patent expiration for major therapies, or b) have drugs that offer more revenue upside than the market is currently giving them credit for.

*based on 12-month forward earnings estimates

Medical Technology (medical devices)

Among health care industries, the medical technology group enjoys the largest tailwind, benefiting from society’s “reopening.” Elective procedures and surgeries that were curtailed during COVID are back in high demand in the U.S. Internationally, the recovery varies due to ongoing coronavirus cases in select geographies.

While volumes should continue to trend upward, investors have flocked to medical technology stocks as a reopening trade, and pushed relative valuations above their long-term averages. We still see opportunity in the sector, but only where we have a differentiated view on specific products.

Managed Care

As society reopens, the managed care industry faces an inflection point opposite that of medical devices. These companies pay for health care, so as health care consumers go in for the procedures and surgeries they delayed at the height of COVID, costs for managed care companies have the potential to go up.

Another cloud for the industry is Biogen’s new Alzheimer’s drug. While not an issue in 2021, managed care companies could find themselves in a difficult position … Who will get access to a $50,000+ drug that has only marginal benefits, but which millions of patients and families are desperately seeking?

While we have a less sanguine outlook for managed care, an improving labor market could mean more insured individuals, which is generally positive for the industry. Any legislative effort to expand the Affordable Care Act could also result in millions of new customers for managed care companies.

Given uncertainty in the space, we have generally tried to invest in companies that are more diversified. For example, a managed care company that owns a retail pharmacy chain could benefit from vaccine distribution and increased foot traffic in the stores. The tailwinds within that business could offset some of the headwinds facing a pure managed care business.

Biotechnology

While not exclusive to the current environment, biotechnology stocks are always at risk of a binary outcome: the success or failure of a clinical trial for a developing drug. Within our small cap strategies, we are approaching the sector by taking smaller positions in individual companies so that the broader portfolio is less affected by a potential failed trial. Also, we see potential in companies where expectations are too low, or in companies that don’t face near-term clinical trial results.

Finally, we seek companies that we believe will age well with time. For example, companies with innovative technologies that will help other companies with established therapies be more effective or more tolerable. Such companies benefit from broad innovation within the sector, and aren’t subject to the risk of a single clinical trial.

Interested in hearing more? Download our short Q&A to learn more about our investment team and the differentiated approach we take to equity investing.

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The Dana Funds are distributed by Ultimus Fund Distributors, LLC. There is no affiliation between Ultimus Fund Distributors, LLC. and the firms referenced in this blog post.