By James T. Tierney, Jr.
Fears of price controls for drugs and the crisis at Valeant Pharmaceuticals have infected the US healthcare sector. But we believe that the sector isn’t fatally ill and that investors can still find companies that offer solid growth potential.
During the first quarter, healthcare was the worst-performing sector in the S&P 500 Index, falling by 5.5%, compared to the market’s 1.3% gain. At the same time, the iShares NASDAQ Biotechnology Index dropped by more than 20%.
Price Controls: Fact and Fiction
So what happened? Let’s start with the comical explanations. The presidential election cycle continues to be a source of peculiar promises. Donald Trump surprised investors on February 7 by saying that he would negotiate $300 billion of price concessions for the US government from drug companies. But the math doesn’t quite add up; total industry revenues from federal spending were only $143 billion in 2014. That didn’t stop the headlines, which spooked investors.
Some concerns were real. The Centers for Medicare & Medicaid Services announced a proposed rule that would change how they pay for drugs that are not self-administered. There will be a demonstration project to assess the impact of the proposed changes starting later this year, and it will probably run for a couple of years. The initial plan involves reimbursement changes for the providers (hospitals and physicians), rather than changes for the drug companies themselves.
These proposals have raised concerns that drug-price controls may be introduced at some point. In our view, the repeated price-control scares are a red herring. Investors need to focus on companies with products that can deliver meaningful benefits for patients. Those that can’t meet these conditions will have a challenged future—price controls or not.
Growth Stocks Lagged
Market rotation was also a driver of underperformance for the healthcare sector in the first quarter. Generally speaking, investors sold last year’s winners such as Internet stocks and biotech companies, and bought the underperformers, including utilities and energy. In addition, value-related industries in the US market performed better than growth-oriented sectors like healthcare.
But style winds can be deceiving. While we understand why more economically exposed cyclical sectors bounced back strongly as recession fears faded, in reality, the world is still in a slow-growth mode. So don’t expect all boats to rise—and growth will likely still be scarce. In these conditions, a sector like healthcare should be well positioned over time, given global demographic trends, as people are living longer and tend to need more pharmaceutical products as they get older. In addition, untapped treatment areas such as cancer and Alzheimer’s disease hold long-term promise for companies that can crack the code and discover effective treatments.
Valeant Crisis Shakes Industry
Against this messy backdrop, the troubles at Valeant Pharmaceuticals (NYSE:VRX) have shaken the industry. Valeant’s controversial business model was driven by acquisitions, cost cuts and aggressive price increases. This year, the company’s shares have tumbled more than 65% amid a series of scandals that put it in the eye of the drug-pricing storm, with company executives being called upon to testify before a Senate and House of Representatives committee. Valeant’s high debt levels have raised fears of default, after the company missed its filing deadline for its 10-K report.
The most surprising thing about Valeant’s predicament is how the fallout has spread over the rest of the healthcare industry. The increased focus on drug pricing—and negative sentiment around acquisitions—has been more profound than expected. We believe that this fallout will eventually diminish, and quality companies will prosper again, but the rebound will take time.
Prescription for Investing Success
So what should investors do? Don’t give up on healthcare stocks. It’s very easy to get distracted by the intense noise across the industry. But healthcare stocks offer equity investors defensive positioning and solid growth potential, even in a tough global economy.
Companies with solid fundamentals that aren’t really vulnerable to recent developments can be found. Equity investors should focus on identifying companies with solid earnings growth potential and drugs that offer a differentiated and meaningful medical benefit. It’s also important to make sure that drug-pricing structures are in line with the benefit delivered by the product, and that the company’s business model is based on volume growth rather than aggressive price increases. We believe that these guidelines are a prescription for success in the healthcare sector—where many stocks are currently on sale.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.