Finding Value in Pharma, Biotech and Medtech

Part One of the Finding Value in Health Care Stocks Series

Finding Value in Health Care Stocks

The health care sector is diverse. It spans a wide range of businesses—from the traditional plays of hospitals, health care providers, and pharmaceuticals, to high-tech medical equipment and biotechnology firms.

To find opportunities, the Value Equity team at American Century Investments focuses on health care stocks we believe are high quality and are attractively valued due to temporary reasons. Using a bottom-up approach, our analysts carefully assess the fundamen­tals of each company within our universe and calculate the potential risks and rewards for each. Companies we follow range from $2 billion to $356 billion in market capitalization.

We split the health care sector into five distinct segments and use our in-depth, fundamental analysis to identify the most interesting opportunities within each space. We’ll explore each area further in this two-part series.

Pharmaceutical and Biotechnology Industries

Pharmaceutical (pharma) and biotechnology (biotech) industries focus on the discovery, development and commercialization of drugs. The industries include large drug multinationals, mid-sized specialty companies and generic manufacturers.

The primary difference between biotech and pharma is the basis of the medicine—biotech has a biological basis, while pharma has a chemical basis.  Currently, both pharmaceutical and biotech companies are benefiting from an aging-population demographics tailwind, as seniors who are 65 years of age or older consume prescription drugs at four times the rate of the general population.

We tend to find better risk/reward characteristics in larger pharmaceuticals and biotechs with more mature product offerings. We look for high returns on capital, sustainable competitive advantages due to R&D (this includes innovative drugs and drug pipelines), scale, and solid balance sheets.

Biotech companies are the riskier of the two types of drug makers, in our view, because they focus on novel drug development and clinical research characterized by long development lead times. This high-risk/high-reward nature makes many biotechs appear unattractive in the context of our investment process.

What to Watch

POLITICAL HEADLINES

Drug stocks can be vulnerable to political headlines. Hillary Clinton made negative comments about drug prices during her run for the 2016 presidential election, which impacted drug stock prices for several weeks. Drug stocks were again impacted before the 2016 U.S. presidential election as they became targets of politicians calling for lower drug prices.

The pharmaceutical company’s stock immediately declined after Hillary Clinton tweeted about the price of their product.

Immediately after the election, pharma stocks rebounded until President Trump called for lower drug prices the following month, Yet,  in spite of the political rhetoric, certain pharmaceutical drug stocks have had solid returns and outperformed the broad market during the first six months of 2017. While drug stock prices appear to have rebounded, we are still finding attractive valuations in the group.

MEDICARE RE-PRICING

Potential policy changes could impact drug companies’ revenues. In particular, government pricing structures may change. The prices paid for drugs under Medicare Part D and Medicaid differ, with Medicaid-eligible persons getting lower, subsidized prices through rebates paid by drug makers to government program sponsors.

Over the years there has been talk and proposed legislation that would extend to Medicare enrollees the same kinds of rebates that drug makers are required to provide to those covered by Medicaid. The rebates, of course, would mean reduced revenues for pharmaceutical companies, and we are monitoring the situation. Part of the monitoring incudes stress tests of potential impacts to pharma stocks in our portfolios, and thus far we believe the risk is manageable.

GENERIC DRUG PRICING

Generic companies produce drugs after patent expirations without incurring the upfront cost of research and development. The generic drug industry had been experiencing above-average financial returns over the last several years. Since the beginning of the decade, as many drugs have come off patent, generic companies benefited due to shifting from full priced branded drugs to lower priced generics. Additionally, delayed approvals for generic drugs by the FDA allowed for limited competition and inflated drug prices.

More recently, competitive pressures have emerged. The number of drugs coming off patent has declined in recent years, providing fewer opportunities for generic companies to capitalize on.

                    
In addition, speedier generic drug approvals have facilitated more generic drug launches, which has impacted pricing more negatively compared to historic norms. This has led to accelerated pricing declines among generic drugs.

Speedier Generic Drug Approvals Have Contributed to Pricing Pressure 

Number of Generic Drug Approvals by FDA

Speedier Generic Drug Approvals Have Contributed to Pricing Pressures
Source: U.S. Food and Drug Administration. Fiscal year ends September 30, 2017 annualized. Note: 633 generic drugs have been approved through the first ten months of the FDA’s fiscal year.

The adverse pricing environment for generics has been longer and more damaging than we anticipated. However, we have seen these pricing cycles in generics occur previously and anticipate normal pricing to return.

In the interim, as pricing normalizes, many of the companies are experiencing pressure. We believe generic drug makers are under­earning and attractively valued. Nonetheless, we are conservative in our weights in these companies due to the potential for continued competitive pressures and high leverage in the generic space.

Medtech

Medical equipment and supplies (also known as medtech) consists of devices, supplies, diagnostic equipment, and imaging solutions for hospitals. Medtech offers an excellent example of stocks that often meet our criteria. We look for the potential for high and stable returns, high barriers to entry, high market shares, and product innovations that maintain margins and grow the addressable market.

The industry has consolidated over the last few years, leading to stronger companies and more diverse and stable product lines. Innovation has allowed select companies to maintain attractive profit margins, while strategic acquisitions have created synergies and allowed for improved margins.

Medtech companies have been resilient in challenging times. They maintained steady returns on capital through the Great Recession (2007-2009) and during the push to enact the Affordable Care Act (2009-2010). Additionally, while the Affordable Care Act did not particularly benefit medtech companies, the prospect of “repeal and replace” does not appear to threaten them.

 What to Watch

“VALUE-BASED CARE”

Value-based care is a form of reimbursement that ties payments for care delivery to the quality of care provided, rewarding providers for both efficiency and effectiveness. Payment for services is bundled to a single provider, such as a hospital, which then pays other service providers. If this compels medtech companies to significantly reduce prices, their earnings could suffer.

The current administration seems less likely to promote value-based care as strongly as the previous administration, although we believe that value-based care will become more prevalent in the coming years.High-quality businesses may have greater durability through changing pricing environments. Stocks we like are partnering with providers to better participate in and manage the overall care process. We believe their proactivity better positions them for continued success.

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The opinions expressed are those of Peter Hardy and are no guarantee of the future performance of any American Century Investments portfolio.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

For educational use only. This information is not intended to serve as investment advice. The information is not intended as a personalized recommendation or fiduciary advice and should not be relied upon for investment, accounting, legal or tax advice.