PPH - Healthcare In 2024: Navigating The Biopharma Bull Run

2024-01-17 23:22:58 ET

Summary

• The healthcare sector presents a unique investment opportunity in 2024 due to attractive valuation and uncorrelated/robust cashflow of healthcare.
• Biopharma companies have pricing power and ability to adjust drug prices in line with inflation, providing advantage in inflationary environment.
• Healthcare ETFs (XLV, XBI, IBB) offer diverse investment profiles, with some focusing on specific sub-sectors like biotech or pharmaceuticals.
• We plan to increase our healthcare exposure moving into 2024 as we expect a meaningful rerating during 2024 driven by M&A momentum, declining interest rates, and the US election.

Introduction: buy healthcare moving into 2024

The healthcare sector, historically non-correlated to general market trends, presents a unique investment opportunity in 2024.

We believe the recent downturn in biopharmaceutical stocks is largely attributed to regulatory pressures from the Inflation Reduction Act ((IRA)), which is viewed not as a systemic weakness but as a transient obstacle.

Especially considering that 2024 will be an election year and the chance of republican winning has dramatically increased, where Republicans historically tended to be more friendly toward the biopharma sector, which should bode well for the biopharma sector in general. Furthermore, with the Federal Reserve's shift towards rate cuts, there's an anticipatory alignment of biotech and pharma sectors with other high-growth industries like software.

Inflation Resilience and Pricing Power

In contrast to sectors like software, healthcare, particularly biopharma, wields substantial pricing power, historically outpacing inflation. Despite the IRA's pricing constraints, these companies retain the ability to adjust drug prices in line with inflation. We continue to believe the inflation will remain above 2% for the foreseeable future, supported by recently published hotter-than-expected inflation data from December 2023, and we believe the companies or sector's ability to raise the price is extremely important for success. This capability is a significant advantage in an inflationary (or stagflationary) environment, where other sectors may struggle due to the discretionary nature of their products or services (i.e., if someone gets fired, the first thing they will cut down would be Netflix).

Valuation and Risk Assessment

Currently, biopharma valuations are at a nadir, in stark contrast to the tech sector, which is experiencing all-time highs. We believe the market's fascination with AI-driven 'magnificent seven' tech firms carries considerable risk, hinging heavily on the fulfillment of lofty AI expectations. Conversely, healthcare, specifically biopharma, shows limited downside risk given its depressed valuations, exemplified by indices like SPDR S&P Biotech ETF ( XBI ). Furthermore, large pharmaceutical companies are recognized for their robust cash flows and attractive dividend payouts. As such, we find broad healthcare ETFs extremely attractive at this point in time, moving into 2024, and we expect a meaningful re-rating to happen.

Investment Avenues in Healthcare

For investors seeking exposure to the healthcare sector, various avenues exist, including healthcare ETFs. A comparison of these ETFs reveals diverse investment profiles, each with its own set of advantages and drawbacks, as summarized below. Some ETFs may offer broader exposure to the healthcare sector, while others focus on specific sub-sectors like biotech or pharmaceuticals. For most investors to be conservative, we recommend holding a 50:50 mix of XBI and XLV or IBB moving into 2024. XBI holds mostly mid-cap biotechs only (which we believe is the most undervalued at the moment) vs. XLV/IBB, which includes bigger biotech and medical tech companies such as Johnson & Johnson (JNJ) and Pfizer.

1. iShares Biotechnology ETF (IBB)

   • Focus: Mimics the performance of the ICE Biotechnology Index.
   • Performance: Strong with assets worth $7.6 billion and a lower expense ratio (0.45%).
   • Key Holdings: Prominent biotech firms like Amgen Inc.
   • Pros: Diversified exposure in the biotech sector.
   • Cons: Specific focus on biotech might limit exposure to other healthcare areas.

2. Fidelity Select Medical Technology and Devices Portfolio (FSMEX)

   • Focus: Investment in medical equipment, devices, and associated technologies.
   • Performance: Strong, with net assets of about $6.5 billion.
   • Key Holdings: Includes companies like Danaher Corporation.
   • Pros: Exposure to medical technology and device sector.
   • Cons: Higher expense ratio (0.70%) and specific focus on medical devices.

3. Health Care Select Sector SPDR Fund (XLV)

   • Focus: Tracks the Health Care Select Sector Index.
   • Performance: Most popular with an AUM of $37.6 billion.
   • Key Holdings: Diverse, with a large share in Pharma.
   • Pros: High liquidity and diverse healthcare exposure.
   • Cons: Broad focus might dilute exposure to high-growth areas.

4. Vanguard Health Care ETF (VHT)

   • Focus: Tracks the MSCI US Investable Market Health Care 25/50 Index.
   • Performance: High AUM ($16.6 billion) and low annual fee (0.10%).
   • Key Holdings: Wide-ranging, with a significant Pharma component.
   • Pros: Low fees and broad healthcare exposure.
   • Cons: Less focus on specific high-growth areas.

5. iShares U.S. Healthcare ETF (IYH):

   • Focus: Tracks the Russell 1000 Health Care RIC 22.5/45 Capped Gross Index.
   • Performance: Good AUM ($3.1 billion) but higher fees (0.40%).
   • Key Holdings: Pharma, healthcare equipment, biotech.
   • Pros: Good mix of healthcare sectors.
   • Cons: Higher fees compared to some peers.

6. Fidelity MSCI Health Care Index ETF (FHLC):

   • Focus: Tracks the MSCI USA IMI Health Care Index.
   • Performance: AUM of $3 billion and low expense ratio (0.08%).
   • Key Holdings: Diverse, with Pharma being a significant part.
   • Pros: Low fees and diversified healthcare exposure.
   • Cons: Broad focus might not suit investors seeking specific sector exposure.

7. VanEck Vectors Pharmaceutical ETF (PPH):

   • Focus: Tracks the MVIS US Listed Pharmaceutical 25 Index.
   • Performance: AUM of $426.2 million with moderate trading volume.
   • Key Holdings: Focused on pharmaceutical research, development, and sales.
   • Pros: Specific focus on the pharmaceutical industry.
   • Cons: Higher fees (0.35%) and limited to pharma sector.

Risks

1. Regulatory and Policy Changes : The healthcare sector is heavily regulated, and changes in government policy can have significant impacts. New regulations or changes in healthcare laws (such as those pertaining to drug pricing, insurance coverage, or medical device approval) can affect company profits, operational costs, and the market landscape.

2. Product Approval and Patent Risks : A substantial part of the healthcare industry, especially the pharmaceutical and biotechnology sectors, relies on the development of new products and drugs, which are subject to rigorous approval processes by regulatory bodies like the FDA. The failure to gain approval, delays in the approval process, or the expiry of critical patents can negatively impact a company's financial performance.

3. Market Competition and Technological Advancements : The healthcare sector is highly competitive, with continuous innovation and technological advancements. Companies that fail to innovate or keep up with technological changes can quickly become obsolete. This risk is particularly pronounced in areas like biotechnology, medical devices, and pharmaceuticals, where research and development are crucial.

4. Economic Sensitivity and Demand Fluctuations : While parts of the healthcare sector are considered defensive, other areas can be sensitive to economic cycles. For instance, elective medical procedures or high-cost treatments might see reduced demand during economic downturns. Additionally, changes in consumer behavior, insurance coverage, and healthcare spending can affect the sector's overall performance.

Conclusion and Recommendation

In summary, the healthcare sector, particularly biopharma, stands as a bastion of resilience and potential growth in 2024. Its inherent market non-correlation, inflation resilience, depressed valuations, and strong cash flows make it a compelling choice for investors. In light of these factors, a strategic allocation towards healthcare, with a particular emphasis on biopharma, is highly recommended for diversified portfolios seeking both stability and growth potential. Healthcare ETFs offer diverse investment opportunities in this sector. There are ETFs with a broad focus, such as the Health Care Select Sector SPDR Fund ( XLV ) and the Vanguard Health Care ETF (VHT), as well as those with more specific focuses, like the iShares Biotechnology ETF (NASDAQ: IBB ) and the Fidelity Select Medical Technology and Devices Portfolio (NASDAQ:FSMEX). For most investors, we believe holding a 50:50 position of XBI and XLV would be the best mix to minimize the volatility but also capture the upside from the SMID-cap biotech stocks that can re-rate meaningfully in 2024 (especially after the JPM healthcare conference and strong dealmaking momentum).

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