Have healthcare stocks been given the all-clear?

As sentiment changes, the number of new drugs approved this year is also approaching record levels, according to Benjamin Matthews, investment manager at Heartwood Investment Management. And, he says, valuations still look reasonable given the area’s long-term growth potential.

“The biotech sector’s price/earnings (PE) ratio has languished below that of the broader market for the first time in history,” he says.

“Globally, populations are rapidly growing, ageing and becoming richer. It is estimated that within 25 years the number of over 65s in Asia will exceed the total populations of the eurozone and US combined. When populations become older and wealthier, healthcare spending increases and pockets of new healthcare needs (in response to lifestyle changes) often emerge. The consequences of this includes a far greater reliance on the private sector to provide care.”

Increasing scientific and technological development is opening up new fields, with many companies looking to take advantage of scientific discoveries in areas such as immuno-oncology and gene therapy. International Biotechnology Trust (IBT) is one trust within the Association of Investment Companies Specialist: Biotechnology & Healthcare sector. It has increased its focus on companies operating within oncology; these now make up more than 40 per cent of its portfolio.

“Our increased interest reflects the advancement in the treatment of cancer over the past two decades,” explains lead manager Carl Harald Janson. “Scientists have significantly improved their understanding of this disease, which has led to an increase in both the number of ways to treat the disease and new drugs. In 1996, there were only four approved chemotherapy drugs approved. By 2016, 19 drugs had been approved covering five different therapeutic categories."

The potential for healthcare funds to meet the needs of different types of investors is growing and becoming more apparent. Biotech companies can offer high growth potential through drug development, while more established pharmaceutical companies can be good for income investors.

“Almost half of the MSCI World Health Care index is represented by the pharmaceuticals sector, which includes well-known companies such as Pfizer (PFIZER:NSI), AstraZeneca (AZN) and Roche (ROG:VTX), which are typically considered to represent relatively stable businesses offering attractive dividend yields,” adds Emma Bird, research analyst at Winterflood Securities.

Exposure to healthcare can also be a good defensive position for investors, especially if they are worried about how much further the equity market cycle has to run. For example, the healthcare sector outperformed the broader equity market during the 2007-08 crash.

“People don’t stop consuming drugs in a downturn, so healthcare tends to do better [than most other sectors] in that environment,” explains Sheridan Admans, investment manager at The Share Centre. “The sector also includes lots of quality businesses that give off lots of cash.”

Headwinds and risks

Despite these positives, as we saw in 2016 the sector can be vulnerable to political interference. It may have been US presidential candidate Hillary Clinton's comments on the level of drug pricing that caused the recent struggles, but the pressure to reduce these prices has not necessarily gone away, even though she lost the election. And this needs to remain a concern for investors.

In addition, the outlook for healthcare funds is strongly linked to the economic and political conditions of the US, as many biotech and healthcare companies are based there. For example, the US makes up 67 per cent of the MSCI World Healthcare index, followed by Switzerland with 7.5 per cent, Japan and the UK with 5 per cent apiece, and the remainder spread across a range of other countries. Although the US economy is powering ahead at the moment, there are some concerns about how long the bull run can continue.

Higher interest rates could be bad news for earlier-stage biotech stocks, and rates are rising steadily in the US and globally. Such companies tend to be valued using a discounted cash flow (DCF) model, which uses future free cash flow projections but discounts them to arrive at present value estimates, using the current interest rate.

“The valuation of companies that are not yet profitable (due to current product development) but will be profitable in the future are more sensitive to an increase of the interest rate,” explains Dr Janson. “The cash flow in 2025 would be discounted back to 2018 with a factor that includes the interest rate. Consequently, a company with more of the cash flow stream further into the future will suffer more from an increase in interest rates."

If long-term global interest rates were to rise above 4 per cent this could cause problems for these companies, he believes.

The complexity of valuing biotech companies alongside the binary nature of investing in them is something investors need to grasp. These companies can become highly valuable if their drugs pass clinical trials and make it onto the market. But a negative clinical trial can mean a sharp collapse in share price or the failure of the company.

“It’s often the case that smaller companies are working on just one or two drugs and therefore success or failure is paramount to the company’s survival,” says Helal Miah, investment research analyst at The Share Centre.  “There's no escaping the longer-term view that we would advise investors take when exploring healthcare-related companies.”

And although more mature biotech companies may not be so dependent on win-or-lose clinical trials, they could also face issues maintaining growth, particularly when their patents run out.

Getting exposure to the healthcare sector

For many, the pros outweigh the cons, but because of the risks involved investors should have no more than 10 per cent of their portfolio in health and biotech.

“Even though healthcare is defensive, whenever you are buying a single sector fund you take on the risk of owning just one sector,” Mr Admans says. “A broader tracker fund, such as iShares S&P 500 Health Care Sector UCITS ETF (IHCU), could give you pretty reasonable exposure at a competitive cost of 0.15 per cent. But when you are in an environment when things are a little bit more questionable, you probably want to be investing in active funds as managers can pick out the winners.”

For this reason, his firm is considering a move out of passive funds into active funds. He likes the look of Polar Capital Healthcare Opportunities Fund (IE00B3NLDF60), which aims for long-term growth by investing in global heathcare stocks. It is managed by Daniel Mahony and Gareth Powell, who have several years investing in this area. Mr Mahony also previously worked as a research scientist.

The fund invests in healthcare companies of all sizes, with a slight bias towards smaller ones, which currently make up 12 per cent of the portfolio. Almost 80 per cent of the fund’s assets are held within the US and its largest sector is healthcare equipment, with 28 per cent – more than double the allocation in the MSCI World Healthcare index. The fund is also significantly overweight biotechnology companies, which make up almost 20 per cent, compared with just 4 per cent in the index.   

It has a charge of 1.16 per cent. The fund is soft-closed to new investors buying directly from the asset manager, but can still be purchased by private investors through execution-only platforms.

Mr Matthews has been getting exposure to healthcare via both active and passive means. In the passive arena, he holds Invesco NASDAQ Biotech UCITS ETF (SBIO), which tracks all relevant companies listed on the Nasdaq exchange. Only liquid stocks are allowed and they are weighted by their market capitalisation: the largest five constituents are capped at 8 per cent, with the remaining constituents capped at 4 per cent. The exchange traded fund (ETF) has an ongoing charge of 0.40 per cent.

In the active space he holds a closed-ended fund, BB Healthcare Trust (BBH), which invests in global healthcare stocks. The trust is managed by the healthcare investment trust team at Bellevue Asset Management. The managers invest across the market capitalisation spectrum and across all regions, but the fund has a relatively high concentrated portfolio of 35 holdings, 93 per cent of which are based in the US. Medical technology and biotechnology are the fund’s two largest sectors, making up around 35 per cent of the portfolio.

The trust launched in December 2016, but has delivered the highest share price return within its sector over one year. It is trading at a premium to net asset value (NAV) of 1.7 per cent and has an ongoing charge of 1.36 per cent. It has a yield of 2.7 per cent.

Meanwhile, over five years, IC Top 100 Fund Worldwide Healthcare Trust (WWH) has been the top performing investment trust in the sector. It aims to grow capital by investing in pharmaceutical and biotech companies across the world and has a more diverse geographic exposure than most of its peers, with 75.8 per cent in North America, 9 per cent apiece in Europe and emerging markets and 6.2 per cent in Asia.

“OrbiMed Capital [the company that manages the trust] is a leader in the field of healthcare and biotechnology investment,” says Rob Morgan at Charles Stanley. “The depth of resource upon which it can draw in terms of medical and investment expertise, longevity of investing in the sector and network of industry contacts is extremely impressive.”

The trust is trading at around NAV, with a premium of 0.8 per cent. It has an ongoing charge of 0.91 per cent, but including its performance fee the total charge for the year ending 31 March was 1.73 per cent.

Fund performance

Source: Winterflood Securities as at 28/09/18. *The AIC, inclusive of performance fee. **FE Analytics.

This article has been amended to clarify Helal Miah's job title.