Healthcare: Stock selection increasingly important

Despite healthcare valuations increasing, we still see some stocks as undervalued, with opportunities in the drug and device areas.

Damien Conover, CFA 7 July, 2016 | 5:00PM
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In looking at the core pillar of economic moats of innovation in healthcare, drug companies are rapidly increasing the speed of generating excellent clinical data in areas of unmet medical need, particularly oncology and immunology. Advances in immuno-oncology drugs are reaching the market at half the time of drugs developed a decade ago, partly due to major advancements in science, but also due to more accommodative healthcare regulatory groups.

We expect the shift to continue and to increase drug-development productivity and strengthen the moats for drug companies, especially as the productivity gains are in areas of development that carry strong drug pricing power and steep launch trajectories. Although the patient populations tend to be smaller in these specialty areas, the strong pricing power can easily turn the drugs into blockbusters. In immunology and oncology, drugs tend to carry annual prices of US$25,000 and more than US$100,000, respectively, supporting major markets despite smaller patient incidence rates as compared with historical areas of focus such as high blood pressure.

On the political side, although we expect the rhetoric on lowering drug prices will probably continue as presidential candidates vie for voters, we don't see any major shifts in U.S. drug prices over the next several years. Nevertheless, we expect drug pricing concerns to cause increased volatility in pharmaceutical and biotechnology stocks. However, without a major structural reform and a willingness by patients and doctors to limit treatment options, we don't see any major changes in U.S. drug prices.

Turning to mergers and acquisitions, while the pace of deals is slowing, companies continue to acquire and merge to increase their growth potential through creating scale, cutting costs and focusing on key strategic areas. The persistent low interest rates are also fueling merger-and-acquisition trends because cheap capital is available to fund acquisitions. Beyond the heavy prevalence of M&A in the drug space, we are seeing further consolidation in healthcare devices.  Abbott's (ABT) acquisition of St. Jude helps improve growth prospects while helping Abbott to compete more effectively in the medical device area. We expect the acquisitions will continue but at a slower rate than 2015, partly due to smaller firms holding out for higher takeover valuations.

Top picks

 Allergan (AGN)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: US$370
Fair Value Uncertainty: Low
Consider Buying: US$296

Unlike most of its peers in specialty pharma, Allergan retains one of the most attractive product portfolios and innovative pipelines, particularly in its core markets of aesthetics, ophthalmology, gastro and central nervous system. Allergan's diverse portfolio, key durable products including Botox, and healthy pipeline support a wide economic moat and high-single-digit organic growth over the next five years, in our view. The firm has used a nice mix of focusing on core internal research and development strengths while supplementing its pipeline with mergers and acquisitions, which creates numerous capital deployment opportunities following the expected US$40-billion sale of its industry-leading generics unit to  Teva (TEVA) in mid-2016.

 Biogen (BIIB)
Star Rating: 4 Stars
` Economic Moat: Wide
Fair Value Estimate: US$356
Fair Value Uncertainty: Medium
Consider Buying: US$249

Biogen is the leader in the multiple sclerosis market, with a range of options for patients seeking injectables (Avonex and Plegridy), orals (Tecfidera) or high-efficacy treatments (Tysabri). Competition in MS is heating up, but we still think Biogen has a dominant portfolio that can withstand this pressure, and we assign the firm a stable wide moat rating. We remain bullish on upcoming clinical data over a longer time horizon (2016-18) and think the firm has a promising collection of neurology-focused pipeline candidates. Recent prices appear to be giving the firm little credit for pipeline programs, including Alzheimer's drug aducanumab. The spinal muscular atrophy program (partnered with Isis) should generate Phase III data in late 2016 or early 2017, and we're bullish on its potential in this rare pediatric indication.

 Elekta (EKTA B)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: SEK 90
Fair Value Uncertainty: Medium
Consider Buying: SEK 63

We believe Elekta is well positioned in the radiotherapy market, which has tremendous growth potential as improvements in technology, increasing awareness of the clinical benefits and a favourable cost/benefit proposition should dramatically increase global adoption over the next decade. Further, we think Elekta carries a wide moat, based on a solid position in a market that is characterized by high barriers to entry, high switching costs and strong intellectual property. This field has evolved into a duopoly over the past decade with virtually no new entrants, and the main two players (Elekta and  Varian (VAR)) have built durable franchises and are well positioned for growth.

More quarter-end insights

Stock market outlook: A year of contradictions

Basic materials: Recent commodity rallies leave few opportunities

Consumer cyclical: Market underestimating apparel and e-commerce

Consumer defensive: Not a lot to feast on

Energy: Supply glut continues, but some respite on pricing

Financial services: Accounting for Brexit and the fiduciary rule

Industrials: Valuations stretched, but opportunities still exist

Real estate: 'Safety' becomes more expensive (Friday)

Tech & telecom: We see opportunities in Apple and Microsoft (Friday)

Utilities: Is a sector-shaking pile-up coming? (Friday)

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About Author

Damien Conover, CFA

Damien Conover, CFA  Damien Conover, CFA, is director of healthcare equity research and equity strategy for Morningstar.

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