Sell-Off in Health Care Sector Overlooks Strong Fundamentals
· The broad sell-off in the health care sector in recent weeks was driven more by momentum investors than underlying changes in the sector.
· The broad nature of the sell-off has overlooked positive fundamentals and long-term growth drivers that remain intact for a number of companies.
· We believe the sell-off has created a number of compelling investment opportunities. We are focused on companies creating innovative therapies for high, unmet medical needs and specialty pharmaceutical companies making value-creative acquisitions.
After a strong run over the last two years, stocks for biotechnology, pharmaceutical and specialty pharmaceutical companies have fallen significantly in recent weeks. As of mid-April, the Nasdaq Biotechnology Index is down nearly 20% from its all-time high, established in late February 2014.
While a couple of near-term headwinds surfaced recently, which we detail below, in our opinion much of the sell-off was driven by momentum investors who had indiscriminately bid up stocks for biotechnology and pharmaceutical companies. We are staying the course and believe the broad sell-off in the sector has created a buying opportunity for long-term investors who are distinguishing between the earnings potential of individual companies within the sector.
Psychology Has Changed, Fundamentals Have Not
While there are a couple of headwinds that have negatively impacted the sector, including questions over drug pricing and an Obama administration proposal targeting tax inversions, we believe much of the sell-off in the health care sector is due to momentum-driven investors who have headed for the exits after chasing a rapid rise in biotechnology and pharmaceutical stocks.
The rise among biotech stocks in particular has been a sharp one. The Nasdaq Biotechnology Index jumped 65% from mid-April of 2013 to its high in late February. We believe investors have taken note of the sharp climb and chased many biotech stocks indiscriminately. Similarly, investors have also bid up pharmaceutical companies with potentially promising drug pipelines. At the first sign the rapid ascension might be over, momentum investors have been abandoning the stocks, creating a more dramatic sell-off.
Some of the price corrections may have been warranted, particularly for early stage companies with riskier pipelines that had been bid up in the excitement for the sector. Indeed, we have been avoiding many stocks that we viewed as expensive relative to their risks and growth prospects. Nevertheless, we continue to find a number of opportunities that we view as attractively valued, and this number has been growing with the recent pullback. In fact, after the 20% correction many of the largest biotech stocks are trading at a lower multiple on 2015 earnings than the S&P 500 Index, despite having what we view as faster growth rates than most companies outside the sector.
We believe the fundamentals and long-term growth drivers for many health care companies remain intact. More efficient and effective technology platforms that aid biomedical research have helped to identify a growing number of promising projects. For many biotech and pharmaceutical companies, the novel drugs in their pipelines represent meaningful improvements over existing options, and we believe these new therapies should justify premium pricing and could drive considerable future earnings growth.
Near-Term Headwinds are Overblown
While the recent sell-off was arguably exacerbated by momentum investors, there were some short-term headwinds that emerged recently, most notably questions over the pricing of new innovative drugs. A letter from three Democratic members on the House Energy and Commerce Committee to Gilead about Sovaldi represented a near-term overhang and “headline risk” for the stock and the sector.
Drug pricing has been an issue on and off in the United States for more than 20 years, but the U.S. has historically come out on the side of free markets. We think it is likely that this trend will continue in the future. Overall, we believe price pressure will be focused on products that are undifferentiated from currently available treatments, while companies addressing high, unmet medical needs with novel products will continue to command attractive prices.
In our view, Gilead’s Sovaldi serves as a strong example of innovation. This hepatitis C treatment is undoubtedly expensive on a per-pill basis. However, it represents an enormous advance for patients suffering from the disease, allowing for a higher cure rate with fewer side effects than currently available options, all coming at a lower total cost. It also helps to avoid the significant downstream consequences of untreated chronic hepatitis C infection, which can include cirrhosis, liver cancer, liver failure and death.
Another recent theme in the health care sector has been consolidation in the specialty pharmaceutical industry. Investor interest in recent tax-advantaged deals has been undeniable. As we saw in Actavis’ acquisition of Forest Laboratories, both the acquirer’s and the acquisition target’s stocks rose after the deal announcement as investors began to appreciate the significant potential. We believe cost-cutting opportunities, revenue synergies from cross-selling products, improved diversification of business models and favored tax structures are all levers for value creation in these types of transactions.
Given this view, a recent Obama administration proposal targeting tax inversions has created some concerns for the specialty pharmaceutical sector. A tax inversion is a maneuver that allows U.S. companies to legally reincorporate in a new country when they buy a smaller foreign corporation. The Obama proposal would raise the foreign ownership threshold to complete such deals. Our view is that significant changes to the tax code are unlikely in the near term, and companies that have already completed these transactions would likely be grandfathered in, lessening the impact of any future legislation. We will continue to monitor the developments out of Washington closely, but believe the fragmented nature of the industry and continued low interest rates could lead to further industry consolidation.
Implications for Investors
We maintain our conviction in the growth potential of the health care companies we hold. We believe the recent sell-off in the health care sector represents an attractive buying opportunity for long-term investors. The undiscerning sell-off has ignored the strong fundamentals and growth prospects for a number of health care companies. We continue to focus on companies addressing high unmet medical needs with truly innovative therapies, and select specialty pharmaceutical companies making value accretive acquisitions. Over the long term, we believe the market will more fully value companies with strong fundamentals, and patient and opportunistic investors will be rewarded.
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Investment return and value will fluctuate, and it is possible to lose money by investing.
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The health care industries are subject to government regulation and reimbursement rates, as well as government approval of products and services, which could have a significant effect on price and availability, and can be significantly affected by rapid obsolescence and patent expirations.
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