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  • Sagar Shah, CFA

Healthcare: from Hero to Zero?

Politics and profit taking are souring the sentiment towards the healthcare sector

  • Drug transparency legislation is unlikely to affect long-term profitability

  • “Medicare-for-all” sounds good but is highly unlikely to ever become reality in the US

  • Record new FDA approvals bode well for the pharma sector

  • We remain constructive on Healthcare, especially because of the secular demographic tail-winds

Usually, when investors want to defensively position their portfolios, they rush into non-cyclical sectors such as utilities, consumer staples, and healthcare. These sectors are known for their stable cash flows and earnings consistency. After a stellar 2018, healthcare is the worst performing S&P500 sector year to date. Why one may ask? Politicsand investor sentiment.

The Department of Health and Human Services has been pushing for more transparent and lower drug pricing. This is pressuring pharmaceutical companies and their margins. There has been a public outcry over drug prices increasing year after year, and the government has made it their priority to solve this crisis. Legislation such as showing drug list prices on advertisements and applying point of sale rebates has already been under thorough consideration.

Some drug price transparency rules have already been passed. Ensuring that patients (not the insurance companies) receive the discounts from pharmaceutical rebates is becoming a hot-button topic. In our view, passing along the rebates shouldn’t hurt the profits of health insurance companies. Usually, they retain a portion of rebates in order to help subsidize customer premiums. If all rebates are passed along directly to the end patient, this will lead insurers to hike premiums to offset the lost revenues.

To illustrate our point, let’s look at an illustration from a Milliman research report:

As shown above, if all rebates were passed through to patients, over half of patients would see increases to their premiums. This policy would only benefit those with high-cost medications. Source: Milliman Research Report.

Headline risks also abound for this sector and they are likely to last until the next presidential election. Many Democrat presidential candidates are running on the platform of ‘Medicare for All’which would markedly decrease reimbursement rates to managed care organizations and health care facilities. In our view, the likelihood of the US converting into a single payer system and eliminating private health insurance is extremely low. There would be far too much disruption to the industry, and patients would not receive optimal healthcare. The question of how the government will pay the massive bill also begs to be answered. We believe that changes that would make The Affordable Care Act (“Obamacare”) more comprehensive are much more likely to be passed. With all of this rhetoric being thrown around, investors have been fleeing the sector. Large insurers such as Anthem and United Health have been shunned. Should you be dumping your healthcare holdings?

We’d answer with a resounding no! Most of the pharmaceutical manufacturers and healthcare insurers are stable, blue-chip companies producing consistent cash flows. We feel that patient investors have a chance to buy these companies at a discount amidst this fundamentally unwarranted sell-off. There have also been a record number of new drug approvals by the FDA within the past two years, as shown by the graph below. This should solidify the revenue stream for many pharmaceutical companies for at least the next decade. Many of these companies sport double-digit earnings growth, and may be able to provide market beating shareholder returns over the next three to five years.

Source: FDA CDER

Last but not least, the secular demographic trends (aging population) in the developed economies remain very supportive for this sector.

We remain constructive on the healthcare sector in general, especially on Big Pharma and the Health Insurers.

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