Healthcare: A new bull market?

Sponsored by Polar Capital Global Healthcare Trust

Written by Gareth Powell, Head of Healthcare, Polar Capital

Going back over the past 30 years, healthcare, while outperforming significantly over the long term, seems to go through periods of positive performance, typically for 7-8 years, followed by periods of underperformance, again, typically, for 7-8 years. Looking back seven years to Q3 2015, healthcare has since underperformed the market at the broader index level, so we are hopeful things will turn and we will see an extended period of outperformance.

What seems to be critical in driving these 7-8-year periods is policy risk in the US, the largest healthcare market, particularly drug pricing policy. The sector is very much out of favour when policy risk is high and a significant overhang lifts when that policy risk is cleared. One example is the fear over changes in healthcare under the Clinton administration in the 1990s that ultimately did not happen and we saw a bull market in the sector over the following few years. Another is the spike in outperformance in 2008, with mega-cap healthcare showing its defensive attributes, followed by Obamacare which derated the sector until late 2010, then another bull market as we moved past those policy concerns.

Over the past 7-8 years, healthcare has underperformed the broader market though, more recently, we are seeing signs of change. In the US, the Inflation Reduction Act has just been signed by President Biden, passed by the Democrats without Republican support using a process called ‘reconciliation’ so they were able to achieve the healthcare policy they wanted. We see this as major clearing event and think this could be a peak in healthcare policy risk, justifying our view of a period of outperformance for a number of years.

A multi-cap opportunity

Looking up and down the market cap scale, the decade-long outperformance for small and mid-cap stocks peaked in a bubble for the most speculative stocks in 1Q21. Since then, the scale of the move downwards makes small and mid-cap stocks that were not in the bubble areas, in our view, much more interesting from a risk/reward perspective.

We still like large and mega-cap healthcare, particularly given their defensive attributes in today’s stagflationary environment. The larger companies have top-line strength and, critically, margins that give them the ability to offset inflationary pressures and still deliver on earnings growth, valuable for investors in this kind of environment.

The S&P 500 Healthcare (large cap) Index has pulled back a little recently, though is still at a 10-15% discount to the broader market. Mega-cap healthcare has outperformed by even more due to the stagflationary environment, thus we feel these types of company are likely to outperform.

If you go back to the 1970s when we had stagflation, large-cap healthcare outperformed significantly, both in the US and Europe. Looking at the other end of the spectrum, again if you go back to the 1970s, after the first peak in inflation there was a period of significant outperformance by small-caps over the following decade.

Long-term themes

While demographics are a major positive driver of growth, the cost of healthcare is huge and, particularly in developed markets, the delivery of healthcare is incredibly inefficient. We need innovation to make healthcare much more cost effective and the way we think about investing is in products and services that keep patients out of hospital as this is the most expensive setting for delivery care. For those who do go into hospital, we look at products and services that help them avoid open surgery through minimally invasive approaches that enable patients to leave much more quickly than has been possible historically. We have exposure to them all, to differing degrees, across the range of healthcare products we run at Polar Capital.

Healthcare delivery disruption: shifting where healthcare is delivered, to the home or surgery centres, with the aid of technologies such as telehealth and robotics.

Innovation: you would expect exposure to innovation through investing in healthcare, particularly in biotechnology and medical devices. In five years’ time, we hope to be talking about potential cures for major diseases through the use of novel therapies such as cell therapy and gene editing.

Consolidation: this is a major theme for healthcare, the most fragmented industry there is. We expect to see M&A continue as the industry tries to become more efficient, particularly with small and mid-cap stocks looking so attractive now, alongside pharma companies looking to improve their revenue growth for the 2025-30 period.

Emerging markets: the graph below shows healthcare expenditure per capita across different countries. On the left are the US and Switzerland which spend the most but need to become much more efficient and productive; on the right are emerging markets where healthcare expenditure is especially low. One of the big surprises is India, where we have some direct healthcare exposure. The US, for example, spends 50x more than India on a comparative basis, an extreme difference that we expect to narrow over time.

Outsourcing: outsourcing was absolutely critical in the development of the Covid vaccines and is a key way for the industry to become more efficient.

Prevention: again, the pandemic highlighted the value of diagnostics and vaccines and how powerful they are in preventing negative healthcare outcomes.

The key focus point for us is that we are able to find opportunities across the market cap scale and across the healthcare subsectors. The fundamentals for large/mega-cap healthcare are extremely attractive and the stagflationary environment is where these types of company really shine. At the other end of the spectrum, small and mid-cap stocks – which have been hit hard and is where stock-picking is crucial – look attractive on a number of metrics.

We are optimistic about healthcare and there is the potential for the sector to do very well over the coming several years. Driven by what is happening in the US, we are hopeful that we will now see a number of years where policy is not a major headwind that could lead to an expansion in valuation for the healthcare sector and potentially be a new bull market.

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