The delivery of healthcare varies in its model around the world, from the free at the point of delivery government-funded National Healthcare Service in the UK, to the private insurance-based system of the US, the world’s largest healthcare market.
Whatever the funding model, there are a multitude of elements needed to deliver the whole service. We have taken a closer look at the sector to see what opportunities and risks it poses.
The elements that most readily come to mind are the pharmaceutical companies that discover, develop, manufacture and market drug-based treatments, from relatively simple pain relief tablets to complex oncological therapies.
Companies such as Switzerland’s Roche and the UK’s GSK take on risk as they put novel therapies through the research and development process and can be rewarded should their efforts prove to be efficacious.
The pandemic served to underline the importance of medical testing
Patent protection on the new treatments grants a period where the company can reap the rewards by selling it exclusively, but these are limited in time and the company must replenish its pipeline. The patent cycle is designed to spur on and reward innovation, while ultimately leading to treatments being made at low cost.
As such, the drug development business is not without risk – it is expensive to put a new molecular entity through the phases of development, and if it fails then there will be no market for it at all. But when successful, they can become blockbusters like Sanofi’s Dupixent, a wonder drug for allergic diseases which is forecast to have peak sales of €13bn per year.
A second area of healthcare is medical and surgical devices. This covers another broad range of products, again from the relatively simple such as stents, to highly advanced surgical robots. The product development dynamics have similarities to the pharmaceutical sector in that approval must be given by healthcare regulators for new products, and there is a significant research and development requirement.
Over the past year the sector has underperformed, being flat versus a rising market
Innovation is key, although the reliance on “blockbuster” products is less given vast product diversification. Medtronic makes products across multiple subcategories such as pacemakers, stents, defibrillators, spinal implants, insulin pumps and glucose monitoring systems to name just a few. There can be high switching costs for these products due to the training needs of the physician and patient familiarity, which extends product lifecycles.
Multinational Australian business Sonic Healthcare and US-focused Quest Diagnostics operate the laboratories where samples from patients are analysed. If you are in the UK and had a PCR test for Covid-19, it may well have been sent off to a Sonic Healthcare facility for analysis, and it reports back the results.
The pandemic served to underline the importance of medical testing and presented an acute load on the testing system, but during normal times these companies have shown the value of specialising in thorough analysis that can be done quickly, accurately and at a cost that makes sense.
Near-term concerns often turn up opportunities and looking at the valuations in the sector we see some evidence of this
In the US, much testing was historically done in-house at hospitals but often these labs were uneconomic as they lacked scale. There is therefore a growth opportunity for medical testing businesses from both the increased use of such services in general and in consolidating smaller, less efficient laboratories into more efficient and reliable operations.
The catch all term of “healthcare” can be seen from this overview to be quite diverse under the bonnet, and while patient outcomes and the efficiency of the health system are common driving forces across its different elements, there are different motivations and multiple ways for businesses to add value.
Health systems do not have unlimited budgets, so it is important there is a strong value proposition from any therapy, device or service being brought to the market. Total budgets might grow roughly in line with the global economy, perhaps a little more if health expenditure continues its trend of rising as a percentage of GDP, or a little less if it reverses.
Figures are attractive for income seekers, and the total return potential is backed up by our discounted cash flow valuations as well
The goods and services provided by portfolio healthcare companies are valued by the patients and systems they serve, but are they valued by investors?
Over the past year the sector has underperformed, being flat versus a rising market. The main culprits for this are the pharmaceutical companies Roche and GSK, which declined over the period.
Roche has one of the more diversified pharmaceutical portfolios of any of the large integrated players and has navigated its patents cycle well, but longer-term worries about the future pipeline have weighed on the stock price.
Near-term concerns often turn up opportunities and looking at the valuations of the companies in the sector we see some evidence of this. The free cash flow is flattered somewhat by the tail end of the Covid testing boom, but nonetheless the figures are attractive for income seekers, and the total return potential is backed up by our discounted cash flow valuations as well.
Ben Peters is a fund manager and Bethan Rose is a sustainable investment analyst at Evenlode Investment
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