US companies lead the world in discovering new drug and device therapies, and they are motivated to continue innovating.
That motivation is only growing stronger with time. The healthcare industry represents nearly 18 per cent of US GDP, and this figure is rising. As concern grows around the sustainability of rising healthcare costs, industry players must now prove their value to the system.
Only those that innovate and add real value over the long run will survive. This dynamic creates interesting opportunities for long-term investors.
Fear creates opportunities
We evaluate healthcare investments by looking for areas where the market is undervaluing a company’s long-term growth potential. Often, that happens when investors develop short-term concerns about regulation or competition.
We take a longer-term view. While sentiment swings, we do deep fundamental research to get conviction on companies’ growth potential. Where short-term concerns create opportunities, we are willing to take large positions. Historically, this approach has generally worked well across the web of US healthcare sectors.
We actually welcome the highly regulated nature of the industry. Being aware of the “fear cycle” around regulatory changes should be an important component of any fund managers research. Consider 2009-2010, when the US Congress was debating and passing the “Obamacare” healthcare legislation. At that time, US health insurers like Anthem were trading at extremely depressed valuations for fear they would be replaced by a single-payer system (like the UK’s NHS).
Our research gave us high conviction this outcome would not come to pass, in part because the insurers added considerable value to the healthcare system, and that the companies’ good growth prospects and strong cash generation would persist. In the end, the legislation recognised their important contribution and enshrined a central role for the insurers. These investments have performed well for the better part of a decade, and we believe selected health insurers can continue delivering value to the healthcare system—and to shareholders in the process.
Opportunities can also arise from fears about competition, particularly for pharmaceuticals. After getting a drug approved, a company receives a patent that lets them market the drug exclusively for a period of time. When the patent expires, other manufacturers can develop and market generic copies. This typically undermines pricing on the branded version, so investors fret when they see a “patent cliff” on the horizon.
Performance of S&P 500 - Healthcare over 5yrs
Source: FE Analytics
To follow that logic, the world’s largest drug might be the world’s tallest cliff. This seems to be the market’s concern with AbbVie. AbbVie is one of the world’s largest biopharmaceutical companies and also owns the world’s largest drug, Humira. Humira is approved to treat 10 different conditions, such as rheumatoid arthritis and psoriasis, and generated $16bn in sales in 2016.
The drug’s success has become a double-edged sword for AbbVie. It is driving considerable earnings and cash flow growth for the company, but it is also causing much consternation among investors about how AbbVie will grow once they lose patent protection on Humira.
We believe Humira will prove more durable than the market fears, because it is not a traditional drug. For a traditional drug, it is relatively quick (2-3 years) and inexpensive (<$5m) to develop a generic copy that works just as well as the original. This makes generics a potent threat. But Humira is a biologic. Biologics are made from living organisms, and their molecular size is 100-1000 times greater than those of traditional drugs. This makes them far harder to replicate: a so-called “biosimilar” might take 7-8 years to develop, at a cost as high as $250m. Even then, making drugs out of living things is tricky, so there is no guarantee that a biosimilar will work as well as the original. Recognising this, regulatory tests for biosimilars are more onerous than for traditional generics, and doctors are more reluctant to switch away from branded biologics.
The market’s level of concern about Humira is so high that AbbVie has the lowest valuation among its biopharma peers despite industry-leading earnings growth. That is OK with us. We are happy to underwrite the pessimism about Humira’s patent and potential biosimilar competition, and we believe the market is also ignoring AbbVie’s late-stage drug pipeline— one of the most active and promising in the industry. As these dual components of the investment thesis play out, we believe AbbVie can continue to grow earnings nicely. Should the market reward that growth with a higher valuation, the stock could deliver very attractive long-term returns.
Betsy Lind is US analyst at Orbis Investments. The views expressed above are her own and should not be taken as investment advice.