After an extremely challenging 2023 for healthcare equities, the sector has performed better so far this year. However, it still lags the broader market, which has been dominated by the momentum in stocks related to artificial intelligence (AI). Even so, we believe that over the long term the drivers and beneficiaries of healthcare innovation will outperform the broader market.
Healthcare’s relative performance has waxed and waned alongside investor sentiment on the US economic outlook, inflation data and the path of long-term interest rates (see Exhibit 1).
As inflation finally approaches the Fed target and monetary policy becomes less restrictive, macroeconomic factors should become less dominant. Idiosyncratic factors such as company fundamentals and the changing political landscape will have an increasingly significant impact on stock prices.
We believe the outlook for stock picking in healthcare is becoming brighter, especially in light of the significant innovation we see in the sector.
Recent healthcare fundamentals
In our last piece we highlighted several headwinds which depressed healthcare equity performance in 2023. Many of these headwinds have since abated, although some persist.
We noted that small and mid-cap (SMID-cap) biotechnology stocks had struggled during most of 2023 due to rising long-term interest rates and limited access to capital. The 10-year US Treasury yield is now around 125 bp lower than the 2023 peak level and that decline has improved sentiment, enabling stocks to move higher on the heels of clinical and regulatory successes.
In contrast to previous years, healthcare companies with these successes have been able to raise capital via public follow-on or private placements despite non-existent initial public offering activity (see Exhibit 2). Meanwhile, mergers & acquisitions (M&A) activity has been more sluggish than in 2023. This is likely a by-product of large-cap biopharma companies integrating recent deals and cost restructuring efforts ahead of patents expiring in the near term (see Exhibit 3). Given the significant patent cliffs ahead for large-cap biopharma and the lack of sufficient pipeline depth, we expect more M&A activity ahead.
We are finding ways to generate idiosyncratic returns within SMID-cap biotechnology and we remain overweight these stocks, while we remain underweight large-cap biopharma.
A shift to biologics
In contrast to SMID-cap biotechnology, the outlook for life science tools and contract research organisation stocks is mixed. Demand from China remains depressed, SMID-cap companies are spending more cautiously, and large cap biopharma companies are focusing more on margins and near-term pipeline initiatives than on preclinical research and capital investments.
However, coming out of the second quarter reporting season, it seems that customer destocking is nearly complete, particularly bio-production of clinical stage and commercial products. Longer term, it is apparent that two legislative issues will drive further secular bioproduction demand.
First, due to the differential treatment under the Inflation Reduction Act of biologics (which get 13 years’ patent exclusivity) and small molecules (which get nine years’ exclusivity), companies are increasingly shifting their pipelines towards biologics.
Second, companies are shifting incremental bioproduction and genetic research work to companies residing outside China due to the Biosecure Act, which seeks to prohibit government entities from contracting with Chinese companies for this work. As a result, we see opportunities to invest incrementally in bioproduction within developed economies.
Fallout from the adoption of obesity medication and investor anxiety around the impact of obesity medication adoption on medical procedural volumes hit its peak during the summer of 2023 and then began to ease heading into the end of the year.
Since then, medical procedural volumes have remained strong and this has bolstered returns for healthcare providers while hindering managed care stocks. However, returns within medical technology stocks have been much more mixed, with any positive performance concentrated among a few secular winners.
Negative sentiment continues to cloud the group and it will likely take several quarters of solid performance for bearish investors to be convinced of the sustainability of positive volume growth (see Exhibit 4). This negativity has hindered broad industry returns and prevented a rebound in small-cap initial public offerings (IPOs). With utilisation trends remaining solid and M&A activity showing some signs of life, it seems only a matter of time before the group’s performance improves.
Obesity drug market enthusiasm may be peaking
Obesity drugs have been all the rage for some time now – becoming a social media phenomenon and poised to become the biggest drug class in history.
There has been a continued stream of clinical data validating the medical benefit of these drugs. Fuelled by the perception of significant competitive barriers to entry, investors have exceptionally high forecasts for the drug class. Stock valuations for the two leading obesity drug companies are elevated.
We are becoming increasingly concerned that market enthusiasm is peaking. We see several long-term risks to market expectations. These include:
a) Potentially high discontinuation rates resulting from gastrointestinal adverse events: data shows that people discontinuing the regime regain most of the weight they had lost.
b) The high price of these medicines. This makes it difficult for payers to generate a pharmacoeconomic return on reimbursement and becomes even more problematic when taking drug adherence into account.
c) The potential for within drug-class competition: Many large cap pharma companies are developing competing agents, which could bring prices down.
d) Competition from novel drug classes in development. It should be noted that the leading obesity drug companies have deep pipelines with multiple novel agents, but their dominance in these emerging drug classes has not yet been established.
While we have investments in stocks of the leading obesity companies, we are becoming more cautious. We prefer to look for companies that could potentially disrupt what has become a duopoly market.
Healthcare innovation remains robust
We have long argued that healthcare is one of the most innovative sectors. We also believe that, over the long term, this innovation will lead to outperformance of the healthcare sector versus the broader market.
Some of the most salient innovative trends we are currently investing in or evaluating are:
- Robotic technologies for minimally invasive surgery: These systems enable surgical outcomes to be standardised across a diverse physician base. They also offer the potential for improved outcomes based on the ability to use artificial intelligence to analyse data from its installed base of instruments.
- Pulsed field ablation for atrial fibrillation (AF): Ablation, with either radiofrequency (hot) or cryotherapy (cold), has been used for years to prevent the abnormal electrical signalling that causes atrial fibrillation (a leading cause of strokes). However, these approaches can be sub-optimal in terms of safety and/or efficacy. Pulsed field ablation represents a new ablation energy source offering better efficacy without compromising on safety. Doctors indicate that the technology appears to offer better clinical outcomes and works more quickly. They expect AF ablation procedures to grow significantly as a result of the introduction of this new technology.
- Next generation obesity targets: Current obesity drugs can give rise to muscle loss. It is estimated that approximately one-third of weight loss derived from the new medications is attributable to muscle loss. This muscle loss reduces patients’ core caloric needs. If patients discontinue the treatment they regain the fat but have a hard time regaining lost muscle, which puts them in a worse metabolic state than before. There is therefore an unmet medical need for next-generation drugs which either do not generate muscle loss and/or increase muscle.
- Resetting the immune system to manage autoimmune diseases: Many autoimmune diseases result from a patient’s own memory B cells (cells that have encountered an antigen and persist in the host after the resolution of infection), as part of an accidental learned response, inappropriately producing antibodies that attack the patient’s own tissues. Hypothesising that depleting these memory B cells could reset the immune system, immunologists are exploring the use of engineered T cells and T-cell engaging antibodies to deplete these memory cells, thus restoring the immune system to its state before the accidental learned memory.
Political backdrop
While the US presidential election outlook turned on a dime this summer with Joe Biden’s simultaneous announcements that he would not be seeking re-election and that he was endorsing Kamala Harris, we view the overall landscape for healthcare as unchanged.
There is bipartisan distrust of the biopharmaceutical industry in the US. However, since the Inflation Reduction Act has only recently given Medicare the power to directly negotiate drug prices, it seems unlikely that any new legislation will be passed that targets pricing.
In our opinion, the election’s biggest potential impact for healthcare relates to the outlook for Medicare Advantage, Medicaid, and the Affordable Care Act’s (ACA) health exchanges, and any developments could impact health insurers and providers.
If Republicans gain control of the government, the uninsured rate will likely rise because
a) ACA health exchange membership is likely to fall as Democratic initiatives that boosted enrolment are allowed to lapse, and
b) it will be increasingly likely that the government will allow states to impose work requirements for Medicaid eligibility.
If Democrats maintain control, enrolment in these programmes would probably remain stable. Since our fund is predominantly focused on the more innovative areas within healthcare, we do not see these variables as presenting any material risk for the fund.
Current backdrop and implications
Healthcare stocks have rallied alongside the broader market in 2024. However, with the exception of a few leading secular winners, the sector’s relative valuation has not changed. While SMID-cap biotech stocks have moved up significantly from recent trough levels, they still trade substantially below their peak from more than three years ago, and we believe we are in the early/mid stages of a recovery.
SMID cap med-tech valuations are even more depressed due to concerns about the sustainability of strong volume growth. Overall, we believe this creates a very compelling setup for investing in healthcare.
