What makes health care a good (or bad) investment?
Lots of people are looking at health care stocks. Since the end of 2015, their performance has been fairly modest, rising by less than 6%, while the rest of the market has returned almost 18%. Health care is among the cheaper sectors, with a forward P/E ratio of only 16.4x, vs the market’s 18.4x. Only telecom, which has falling revenues, is cheaper. So they are intriguing to value investors.
But what makes a healthcare company profitable? Any profitable company is going to invite competition. In order to sustain its profits, a company has to have some kind of structural advantage. This advantage can come from several factors.
The most significant, in healthcare stocks, are intangible assets, particularly patents. Patents typically last 20 years; it takes 8 years to develop a drug – although that time is shrinking. Branding is also powerful. Brands convey a certain quality assurance process, which is especially important in the developing world.
A cost advantage is also a strong driver of returns important. Cost advantages can come from several sources: the location, the company’s supply-chain management, or economies of scale. A related factor is also efficient scale. A company might be profitable treating a certain rare disease, and its competitors know that if they enter that market all the profits would disappear. So they hold off – at least for a little while.
Network effects and switching costs are the final economic moats that contribute to health care company profitability. A network effect creates a situation where the more consumers that use a service, the more valuable that service becomes. This especially applies to health insurers. The more people that enter their systems, the better pricing they are able to obtain. And switching costs are the inverse: when it’s difficult to replace a product or service, people keep using it even if a better product becomes available.
Health Care Payment Network. Source: CFA Institute
Innovation in these areas is by far the most important factor to consider. Since patents provide the widest economic moat, everyone wants to develop a new, patented, blockbuster drug. According to Morningstar, the hottest area of new drug development is in immuno-oncology: drugs that help our bodies find a cancerous growth and destroy it. They help our own immune systems to fight off cancer. The market for these drugs is potentially huge. But once a drug is patented, the clock begins ticking. Profits will plunge once the patent expires and generic competitors enter a market. The big pharma companies truly need to innovate or die.
Finally, we have to consider politics. Healthcare is an intensely political area: through its various programs, the government is the largest purchaser of health care products and services. And people see their co-payments go up and they get upset. It’s easy for politicians to promise to bring drug prices down. Of course, they rarely spell out how they will do this. Nevertheless, health care pricing is a political hot potato: no one wants to touch it, and they toss it away at the first opportunity.
By focusing on innovation and looking for firms with a sustainable advantage, investors can find a lot of valuable companies that appear fairly priced. Health care is a key are of the economy. It belongs in any diversified portfolio.
Douglas R. Tengdin, CFA