Key takeaways
For any investor constructing a portfolio of health-care stocks, a major benefit is the diversity of the subsectors. Health care spans a wide range of industries globally, each with a unique set of opportunities. The sector continues to play a defensive role in investment portfolios, but many of its industries also offer compelling long-term growth potential. From biotechnology companies focused on personalized medicine to drug giants looking for innovative ways to combat the patent cliff, there are many reasons to be optimistic about investment opportunities in health-care stocks. At the same time, there are many challenges, not the least of which is investor uncertainty about cuts in government spending on health care worldwide.
While stocks in the sector have remained relatively strong, we have seen a notable diversion from past patterns of health-care utilization. Following the downturn that began in 2008, doctor visits, elective surgeries, hospital admissions, and lab tests all declined (Figure 1). While such declines in utilization are not unusual during economic slowdowns, they have been more pronounced in recent years. Whats more, we have observed this trend even among those who remained employed and had health insurance coverage. While lower utilization puts pressure on some health-care industries, it can be beneficial for other subsectors. Managed care, for example, has been the
strongest-performing area in 2011, as lower utilization helps HMOs keep expenses under control. Low utilization has the opposite effect on device makers, drug companies, and hospitals, all of which face challenges when fewer people are spending money on health care. We expect utilization to remain at these relatively low levels while macroeconomic uncertainty persists. Trends could improve when we see more positive indications of an economic recovery and a better employment picture. Over the longer term, as the Patient Protection and Affordable Care Act takes effect, we anticipate that millions more people will have access to health insurance, which should also boost utilization.
Figure 1.Do I really need that surgery? Fewer people sought health-care services after the downturn Patient visits to physicians offices, change from prior year
6%
3%
0%
-3%
-6%
2008
2009
2010
2011
6/30/10
Source: Putnam. The S&P 500 Index is an unmanaged index of common stock performance. You cannot invest directly in an index. Past performance is not indicative of future results. Performance shown is not representative of any particular investment. Investing in the health-care sector involves more risk than investing more broadly.
for truly innovative products, but it is unclear how long this will continue, given the United Statess own deficit challenges. Combating the cliff For many pharmaceutical companies, the most significant headwind in recent years has been the so-called patent cliff. In 2011 and 2012, the patents on many of the worlds leading drugs are expiring, paving the way for lower-cost generic drugs. The loss of exclusivity for these branded drugs many of which are top sellers could result in significant revenue losses for their makers. It is important to note, however, that the patent cliff threat has been widely analyzed and anticipated by investors and businesses. It has been priced into the stocks for some time, and the effects of the patent expirations have played out as expected. At this point, the most important observation to make about the patent issue is that it has prompted companies to find new ways to sustain their long-term growth. We have been analyzing the strategies that companies have implemented to combat the effects of patent expirations. In some cases, cost-cutting measures introduced as a result of the recession have meant leaner, more efficient firms that continue to generate profits. Attractive valuations are also helping to mitigate the negative impact of the patent cliff. For many companies in the pharmaceutical sector, we are seeing historically low P/E ratios along with strong cash flows and attractive dividend yields.
Progression in the pipeline of truly innovative drugs, attractive valuations, and some good news with late-stage clinical trials for high-profile companies have all brought positive momentum to pharmaceutical stocks.
Whats in the pipeline? A key driver of growth for pharmaceutical firms is the pipeline new drugs that are in development, testing, or clinical trials. An important component of our analysis is the quality of a companys pipeline, and particularly the late-stage pipeline drugs that have progressed through the rigors of clinical trials. Recently, the early FDA approval of several truly innovative drugs has brought positive momentum to the industry, and we are optimistic that pipelines are shaping up to help drug companies combat the patent cliff. Another way for drug companies to enhance late-stage pipelines is by collaborating with biotechnology companies either by partnering to develop new products or through mergers and acquisitions. Today, many large pharmaceutical companies have healthy balance sheets and strong cash flows, and we expect some will put that
cash to work by either acquiring or forming partnerships with biotechnology companies with promising pipelines. In recent years, pharmaceutical M&A activity has been slow, due in part to the uncertainty of the macroeconomic environment. In the long term, however, the drive to make acquisitions and expand business may help pharmaceutical companies become more diversified and create more stable sources of income. Worldwide expansion Many of the large, global drug companies are increasing their focus on emerging markets to improve their topand bottom-line growth as U.S. and European sales slow. Emerging markets offer significant growth potential, and even as pharmaceutical companies cut jobs in the United States, they are adding to their head counts in emerging markets to capture growth opportunities.
Figure 2.Health-care valuations are near historic lows Valuations for companies in the health-care sector have become more attractive in recent years and have approached historic lows.
S&P 500 Index P/E ratio 40
P/E ratio (forward 12 months)
35 30 25 20 15 10 5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Biotechnology: High-growth potential in small and mid caps One of the most exciting aspects of the health-care sector is the remarkable innovation of biotechnology companies. Rigorous research and development is leading to more technologically advanced products that offer vast improvements in the way illnesses and diseases are treated. As with the pharmaceutical industry, the power of the pipeline is a key driver of growth in biotechnology. While pharmaceutical firms develop more traditional chemical-based products, biotechnology companies work with living organisms to develop drugs and therapies. Biotech companies tend to devote more time and resources to research and development than traditional drug manufacturers. Many biotechnology companies, particularly in the small- and mid-cap space, are not yet profitable. As a result, they are more vulnerable to market volatility and have struggled in the recent macroeconomic environment. While robust pipelines of innovative compounds may offer considerable longterm growth potential for biotech companies, investors recently have been less willing to take a risk on the outcome of clinical trials. For large-cap biotech companies, we expect growth to remain slow over the near term, as there is a scarcity of promising late-stage compounds and an overall lack of M&A activity. For small- and mid-cap companies, a wider array of high-growth product opportunities makes these stocks more attractive in our view in part because many companies have become appealing targets for acquisition.
Drug development gets personal The future of product development in pharmaceuticals and biotechnology lies in personalized medicine which, put simply, is to tailor a drug or compound based on a persons genetic makeup. A recent example, approved by the FDA, is a compound that targets lung cancer patients with a rare genetic abnormality. While these patients represent a small portion approximately 5% of the lung-cancer patient population, directly targeting a specific gene mutation has boosted the products efficacy. The product, which is in pill form, has tested extremely well in shrinking and stabilizing tumors in these patients. We are seeing more evidence that pinpointing specific patient populations helps to improve R&D productivity. Although such personalized products offer benefits for fewer patients, their higher success rates can enhance pricing power for the companies that develop them.
From biotechnology companies focused on personalized medicine to drug giants looking for innovative ways to combat the patent cliff, there are many reasons to be optimistic about investment opportunities in health-care stocks.
Drugs representing $86 billion in sales will have lost patent protection by 2020
$17 billion
$45 billion
$24 billion
Medical technology: Managing product life cycles Declines in utilization trends have dampened the performance of medical technology stocks those of companies that develop devices such as coronary stents, artificial heart valves, and replacement hips and knees. As volumes have slowed, these companies have struggled with pricing pressure as they compete for market share. We believe most medical technology companies will continue to struggle with slower growth until utilization trends pick up. For device companies, rather than the threat of generic competition, the challenge is product life cycle management ensuring that their devices do not become obsolete. While medical technology firms dont roll out brand-new products as frequently as biotech companies, they must continually improve the features of their devices to gain market share and pricing power, and to ensure that their products continue to offer a competitive edge.
Managed care: A beneficiary of lower utilization The global economic downturn and the resulting decline in utilization of health-care products and services has been most beneficial for managed-care companies. HMO earnings exceeded estimates in 2011, and all managed-care companies raised their guidance for the full year, driven mainly by lower-than-expected cost trends a measure of how much businesses are paying to provide medical services for their employees. When fewer people visit the doctor, elect to have surgery, or otherwise cut back on health-related spending, the result is lower expenses for health insurers. A recent challenge for managed-care companies was the effect of the health-care laws medical loss ratio (MLR) provision. The provision requires companies to spend 80% to 85% of premium dollars on medicalcare and health-care quality improvement. While still a concern, it appears that the provision may not be as big a burden for these companies as initially feared. Another segment of the health-care services industry hospitals has not fared as well in the lower-utilization environment, as declines in patient volumes hurt hospital revenues. Hospital stocks have also been pressured by investor worries over potential cuts to Medicare reimbursements.
For device companies, rather than the threat of generic competition, the challenge is product life cycle management ensuring that their devices do not become obsolete.
Figure 3.In the United States and many emerging markets, health-care spending is expected to grow faster than GDP
Projected GDP growth, 20102020 Projected health-care spending growth, 20102020
167% 57% 100% USA China India 45% 62% 140% 115%
38%
Brazil
nation in the world. At the same time, the IDF estimates that more than 60% of these diabetics are undiagnosed and untreated. Also worth noting is the prevalence of cancer in China. The disease is now the leading cause of death in Chinas urban and rural areas, followed by cardiovascular and cerebral vascular diseases.1 From 2003 to 2008, the number of cancer patients increased by 56.6%. There is a clear need for prevention and treatment strategies for these diseases, and as wealth in China grows, so do the opportunities for companies that provide health-care products and services.
While higher income levels are prompting individuals in China to spend more on health care, government spending is providing an additional boost. In recent years, the government of China has significantly increased its spending in the health-care sector (Figure 4) and has implemented system reforms to greatly expand health insurance coverage. These reforms should lead to higher expenditures, particularly in areas such as pharmaceuticals and devices, which bodes well for health-care companies with exposure to China.
500
300 200 100 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 (through 9/30)
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Large multinationals have low exposure to emerging markets Compared with other industries, health-care companies have relatively low exposure to emerging markets. For example, if you look at sales data for leading global consumer goods companies, you will find a significant portion of sales in some cases more than 50% are from emerging markets. Within the health-care sector, that concentration is much lower. A French pharmaceutical giant with one of the highest exposures, for example, derived only 30% of its 2010 sales from emerging markets. And most other global health-care companies have significantly less exposure. Challenges for investors Investors can gain exposure to emerging markets by targeting developed companies with exposure to these regions, or by investing in companies that are based in emerging markets. Investing in large, established healthcare companies offers many advantages. Their larger market capitalizations mean their shares are easier to trade. In addition, most of these companies have solid corporate governance policies and lower regulatory compliance risks. On the other hand, they may have lower growth potential than companies based in emerging markets. In many cases, valuations and growth potential are attractive for emerging-market health-care companies. However, these stocks pose volatility and liquidity risks, and they can present greater regulatory compliance risks because the health-care industry is not as strictly regulated in these markets. The investable universe of emerging-market health-care companies is relatively new; many publicly traded companies have only been listed in the past five years or so. Ideally, a diversified health-care portfolio should gain exposure to emerging markets through a range of developed and developing market stocks.
Kelsey Chen holds an M.B.A. from the Wharton School of the University of Pennsylvania, a Ph.D. from the University of Texas Medical School, and a B.S. from Wuhan University in Wuhan, China. She joined Putnam in 2000 and has been in the investment industry since 1999. Christopher J. Stevo has an M.B.A. from The University of Chicago Booth School of Business and a B.S. from the Wharton School of the University of Pennsylvania. A CFA charterholder, he has been in the investment industry since he joined Putnam in 1999.
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