'Looking at numbers won't get you very far with healthcare stocks'

Stockpickers always need to understand the dynamics of the sectors their companies operate in. But some sectors are trickier than others. And in some, internal dynamics can matter even more than financial fundamentals in terms of driving share price movements.

Sven Borho, co-manager of Worldwide Healthcare Trust (WWH), says that healthcare investing is all about the science, but the science is hard to get. “Take the tech sector: everyone is an expert on the next iPhone," he explains. "Even artificial intelligence (AI) is quite intuitive. But when it comes to the next big antibody drug, for example, how do you understand it? The healthcare sector is special because the learning curve is steep. You typically need scientific expertise to be a good assessor of innovations in this area.”

Worldwide Healthcare, which invests in healthcare companies around the world through a growth-focused strategy, considers its team of scientist stockpickers one of its key strengths, with a number of them having a medical background. For example, the trust's other manager, Trevor Polischuk, holds a doctorate in neuropharmacology. “I came into this industry 30 years ago and I'm probably the last non-scientist,” Borho jokes.

One could argue that as much as the science matters, investing is about money, and fundamentals such as profit margins and valuations are crucial in every sector. But Borho doesn't entirely agree. “Valuations are important, financials are important, especially to the bigger, established companies,” he acknowledges. “But even the largest healthcare company in the world, Eli Lilly (US:LLY), is driven by its weight-loss drug and its Alzheimer’s drug. What's the most important skill for investing in Eli Lilly – financial analysis or correctly assessing the prospects of those drugs? How successful they will be and how big they will become in the market?”

The sector is often driven by binary events, when a drug's clinical trials can go better or worse than expected, and either push the share price up or crash it, driving volatility and market dislocations that the trust's managers try to take advantage of. But it can be difficult to know which way things will go.

Earlier this year, the trust's managers trimmed the trust's position in Eli Lilly because it was becoming too expensive – its share price is up 60 per cent in the year to date following the success of its weight-loss drug. Conversely, they added a bit to Novo Nordisk (DK:NOVO B) when its share price pulled back slightly earlier in the summer, as investors awaited the results of a clinical trial on the potential cardiovascular benefits of its weight-loss drug, Wegovy. Novo Nordisk's share price later jumped when preliminary trial results showed that patients who took the drug had a 20 per cent lower chance of suffering a cardiovascular event such as a heart attack or stroke than those who received a placebo.

Where is the biotech rally?

Despite the wealth of scientific expertise in the team, the past couple of years have been difficult for Worldwide Healthcare due to its growth approach. Its bias to biotech, and small and mid-cap names, including in China, didn't do it any favours during the 2022 bear market, and its recovery has been underwhelming so far. This has resulted in a less than stellar medium-term performance, compared with both MSCI World Health Care Index and competitor Polar Capital Global Healthcare Trust (PCGH), which takes a more conservative stance.

Borho says that the current market has been difficult to understand. Higher interest rates are a headwind for growth companies, so it makes sense that investors avoid them. But while this year’s rally went against that principle because it was driven by AI and major tech stocks, biotech companies have been excluded from it. Over the year to 14 September, the Nasdaq Composite index is up 29.7 per cent in sterling terms while the Nasdaq Biotechnology index is down 5.3 per cent.

Borho says that while there are periods of underperformance, he trusts that in the long term their more aggressive strategy will outperform large-cap healthcare names. “The market will at some point start broadening out,” he says. “People will look for areas which are undervalued and dislocated, and biotech is in one of the most dislocated situations I have seen in 30 years investing in the sector.”

Borho also expects a pick-up in merger and acquisition (M&A) activity in the sector, mostly due to the “patent cliff” that big pharma companies will face over the next few years. Between now and 2030, various pharma giants are expected to lose sales exclusivity in the US for some of their blockbuster drugs, because of patent expiries or the end of legal arrangements with competitors. This could pave the way for cheaper alternatives, and data provider Evaluate Pharma estimates that by 2028 the patent cliff will cost the industry roughly $26bn (£20.99bn) a year in sales. The first patent expiry this year was Abbvie’s (US:ABBV) Humira, a drug that acts on the immune system and is used to treat conditions such as rheumatoid arthritis. Johnson & Johnson (US:JNJ) had the same problem with psoriasis treatment Stelara, but earlier this year it reached a legal settlement with competitor Amgen (US:AMGN) to delay its version of the drug until January 2025.

Because of the patent cliff, pharma companies are on the hunt for new drugs and have an appetite for buying smaller firms that could develop them, Borho says. The top contributors to the trust’s performance over the year to March 2023 were Global Blood Therapeutics and Seagen, both of which were acquired by Pfizer (US:PFE). In 2022, the trust started investing in a basket of swaps, which includes about 40 companies that its managers believe could be attractive M&A targets for bigger companies. This basket accounted for 4.5 per cent of the trust's portfolio at the end of August.

The trust's managers have also been increasing its exposure to the medtech sector, which has had a good year so far. US surgical robotics company Intuitive Surgical (US:ISRG) accounted for 4.1 per cent of the trust’s portfolio at the end of August and is up 12.3 per cent so far this year.

“After Covid, there was a huge pent-up demand for routine procedures," explains Borho. "People are going back into hospital to get a hip replacement, for example. This has been incredible for volume growth and for the medtech companies, which have a lot of earnings momentum.”

The same goes for hospital operating companies such as Tenet Healthcare (US:THC), in which the trust had a 2.1 per cent position as of 31 March.

China struggle

Worldwide Healthcare has a 7.1 per cent exposure to China and Hong Kong, which detracted from performance in 2022, chiefly because of Shanghai Bio-heart Biological Technology (HK:2185), which was originally part of its unquoted portfolio. The company listed at the end of 2021, but its share price crashed the following year and is down 94 per cent over one year.

The trust has 6 per cent in unquoted companies, which have also had some challenges, so this portfolio was down 10.3 per cent over the year to 31 March 2023. One of the companies in the portfolio, DingDang Health Technology (HK:9886), listed in Hong Kong in September 2022 but has dropped 79 per cent since.

Despite the generally negative sentiment, Borho is cautiously optimistic about Chinese healthcare companies over the long term. “Valuations are at record lows and healthcare companies typically have revenue growth rates of 20 per cent plus,” he notes. The short-term performance remains uncertain but “a lot of negativity is priced in there".

Over the year to 31 March 2023, the trust's managers did not add any unquoted companies, although they reported in June that they were “optimistic about the potential for more unquoted investments to achieve listings in the current financial year.” Borho is confident in the valuations of unlisted holdings and stresses that venture capital is a core expertise of OrbiMed, the company that runs the trust's investments.

Borho is bullish on the sector’s prospects, but worries about the US political landscape. Last year, the Inflation Reduction Act introduced several measures to lower the cost of prescription drugs for people who get them under Medicare, the US government's health insurance programme for those aged over 65 and younger people with certain disabilities. He is now waiting to see the outcome of the US elections next year. “Typically the best case scenario for the healthcare sector is a split Congress," he says. "That's a 'Goldilocks scenario'."

The trust was trading at a discount to net asset value of 8.3 per cent as of 15 September, and has a share buyback programme which it deploys when this widens to more than 6 per cent. But Borho admits that, while the trust's board remains committed to the programme, closing the gap has become harder in the current environment.

“We do want to defend our discount," he says. "But for as many shares you buy back, it is not clear that you can actually get there.”