We are seeing a wave of innovation in the healthcare sector globally. Last year alone, the US Food and Drug Administration (FDA) approved 41 new drugs, the highest number in 16 years. In addition, the seven largest biotech companies are all in the early stages of major new product launches and these products generally have long patent lives (10+ years) that could drive improving profitability for the industry for many years to come.
The increasing pace of innovation in healthcare – and the associated opportunities for investors – are driven by a number of trends globally, one of which is the dramatic reduction in the cost of genetic analysis. DNA sequencing is the evaluation of the genetic code, or genome, which is the book of life for all organisms. The first genome was sequenced in 2000, it took 13 years to complete and cost $3 billion (£2.02bn). Today a human genome can be sequenced in just a few days for a few thousand dollars. Improved genetic analysis allows for a better understanding of the underlying basis of disease, enabling faster development of more targeted therapies.
Greater cost-consciousness permeating the system is a second driver. In the US the Affordable Care Act has led to reimbursement cuts, implying that everyone will have to make do with less. As a result, there’s a higher bar for getting new therapies reimbursed. Insurers and other payers in the US and elsewhere are no longer paying for ‘me-too’ treatments, such as new formulations of existing therapies. Now, companies are more focused on addressing unmet medical needs and that is improving the productivity of their research and development.
A third driver is demand from an ageing population. The ageing babyboomer generation means that healthcare spending has grown faster than GDP for the last 30 years in all developed markets. This also opens up great opportunities for investment in the life sciences sector. People over the age of 65 spend more than three times as much on pharmaceuticals than any other age group. This may be expected to continue for many years to come and in developing markets we believe the spread of wealth should lead to higher healthcare spending as well.
In response to these trends, savvy investors should be looking to companies that are addressing high unmet medical needs, identifying companies that make the healthcare system more efficient and help to lower costs, and investing in companies that are superior allocators of capital. Given the high number of mergers and acquisitions in the sector, it is paramount to identify management teams with established track records of successfully allocating capital via highly accretive deals. With these themes, investors are positioned well to capture future growth and generate significant outperformance versus the broader markets.
Last year was exceptionally strong for the healthcare sector broadly, but it’s important to remember that healthcare underperformed in seven out of eight years leading up to 2010, and so the strong performance over the last few years came off a low base. Valuations are only now getting back to historical averages and are still well below their prior peak in 1999. The sector’s (and especially biotech’s) improving earnings profile likely will begin to be reflected in valuation multiples and the upside potential of share prices could still be substantial.
However, healthcare stocks are prone to extreme outcomes; for instance, for every 10 therapies that go into clinical testing, generally only one is approved and makes it to market. This is why deep fundamental research is critical to differentiate between the sector’s few winners and numerous losers.
Looking ahead, there are a number of richly-priced early-stage firms, and also an IPO pipeline packed with unproven companies capitalising on elevated investor enthusiasm. So, while it seems unlikely that the extreme outperformance of the sector will continue, there is certainly solid return potential.
Key takeaway: The healthcare sector is awash with opportunities for investors, however an investment approach rooted in both fundamental analysis and scientific understanding is essential in identifying both winners and losers.
Andy Acker is portfolio manager of the Janus Global Life Sciences fund.
Date: May 7, 2015