The delivery of health care varies in its model around the world, from the free at the point of delivery governmentally-funded NHS in the UK, to the private insurance-based system of the US, the world’s largest health care market.
Whatever the funding model, there is a multitude of elements that are needed to deliver the whole service. With the health care sector making up around 19% of the Evenlode Global Income portfolio, we’ve taken a closer look at the sector to see what opportunities and risks it poses.
Perhaps the ones 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.
Patent protection on the new treatments confers 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, whilst ultimately leading to treatments being able to be made at low cost, socialising the long run benefits of the developed technology.
As such, the drug development business is not without risk – it is expensive to put a ‘new molecular entity’ (NME) through the phases of development, and if it fails then there will be no market for it at all.
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. With that risk/reward profile in mind, we diversify the pharmaceutical risk both within and between companies.
A second area of health care is medical and surgical devices. This covers another broad range of products 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 health care regulators for new products, and there is a significant research and development requirement.
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’re 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 they report back the results.
The pandemic perhaps 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 high throughput analysis that can be done quickly, accurately and at a cost that makes sense.
In the US, historically much testing was 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 ‘health care’ can be seen from this overview to be quite diverse under the bonnet and whilst 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 don’t have unlimited budgets, so it is important that 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.
Is there value for investors?
The goods and services provided by portfolio health care companies are valued by the patients and systems they serve, but are they valued by investors? Over the last 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.
As noted above, developing drugs involves risk and the company did have some negative readings in trials in the pipeline of new therapies, but the company still has good medium-term visibility from its existing portfolio across oncology (the largest), MS, haemophilia and ophthalmology.
Near-term concerns often turn up opportunities and looking at the valuations of the companies in the sector we see some evidence of that. 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 and Chris Elliott are portfolio managers at Evenlode. The views expressed above should not be taken as investment advice.