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Key points

  • Healthcare stocks followed the market lower earlier this year but returns are recovering and investors are taking notice.
  • Inexpensive valuations may provide an attractive entry point to healthcare stocks. The sector’s defensive properties can provide a potential buffer against market volatility.
  • Investors may seek to get tactical within the sector, to capture the return dispersion between industries. For example, devices and providers outperformed biotech and pharmaceuticals in the first half of 2018.
  • Other trends could support the sector: Political risks appear to have reduced; M&A activity is providing a near-term boost to some segments such as biotech; while new markets and product innovation present attractive opportunities for device manufacturers.
  • The secular drivers of aging populations and innovation could power the sector’s growth over the long run.

Symptoms: What’s up doc?

U.S. healthcare rallied in the second quarter of 2018 by more than 5% from its April lows to finish the first half up 3.3%.1 Although the sector followed the broad market lower at times between March and May, it closed the first half of the year as the best performing defensive sector in 2018. Still, investors may consider this an interesting entry point: the sector is trading near its lowest level relative to the S&P 500 in four years (see Chart 1).

Chart 1: Relative performance of US healthcare to
S&P 500

Chart 1: Relative performance of US healthcare to S&P 500

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock, Bloomberg, July 23, 2018. Performance depicted is that of the S&P 500 Index and the Dow Jones U.S. Health Care Index.

Looking deeper at subsector returns reveals considerable dispersion: Medical device companies gained 20%, health care providers 18.1%,and biotech 10.8%, while pharmaceuticals finished the half 1.2% in the red (See Chart 2).2 The 12-month story reveals a similar picture: devices, providers and biotech outperformed, pharma underperformed.3

Exchange traded fund flows appear to be following the performance: U.S.-listed ETPs tracking medical equipment and services indexes saw $930 million of inflows in the first half of the year, while those tracking pharmaceuticals and biotechnology saw $1.05 billion of outflows.4 More broadly, inflows into cyclical sectors have outpaced those into defensive sectors such as healthcare – with $4 billion of the year’s net $4.6 billion of sector-specific inflows going to cyclicals.5

Chart 2: Performance relative to broad US healthcare sector, H1 2018

Chart 2: Performance relative to broad US healthcare sector, H1 2018

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock, Bloomberg, June 29, 2018. Performance depicted is that of the Dow Jones U.S. Select Medical Equipment Total Return Index, the Dow Jones U.S. Select Health Care Providers Total Return Index, the Dow Jones U.S. Select Pharmaceuticals Total Return Index and the NASDAQ Biotechnology Total Return Index minus the return of the Dow Jones U.S. Health Care Total Return Index.

Diagnosis: A closer examination

The performance differentials among health care subsectors do not entirely correspond to underlying earnings trends. For instance, biotechnology has had the best earnings growth over the past three years, but this was not borne out in its performance earlier this year, before the sector surged 10% in July. At the same time, medical devices manufacturers have had stellar security performance in spite of their earnings growth being outpaced by both biotech and healthcare providers (see Chart 3). However, pharmaceutical stock performance has correlated with weak earnings trends in the sector.

Chart 3: Three-year average annual earnings per share growth

Chart 3: Three-year average annual earnings per share growth

Source: BlackRock, Dow Jones Indices, as of July 13, 2018. Based on weighted average annualized earnings of securities in the S&P 500 Index, Dow Jones U.S. Select Medical Equipment Index, Dow Jones U.S. Select Health Care Providers Index, Dow Jones U.S. Select Pharmaceuticals Index and NASDAQ Biotechnology Total Return Index.

Although healthcare companies carry significant idiosyncratic risks, certain themes have an industry-wide significance. Some of the key drivers that have affected health care sub-sector performance in 2018 include:

  • Headline risk from politics and prices: Healthcare is the top issue on voters’ minds ahead of the November midterm elections6 and the cost of healthcare and prescription medicine is in focus. President Donald Trump adopted a combative stance to drug pricing on the campaign trail, rattling pharmaceuticals and biotech stocks. Already facing challenging longer term trends in the form of expiring patents and rising FDA approvals of generics, these stocks face considerable risk if sweeping legislation were to be passed. However, the release of the Trump administration’s blueprint in May gave the industry some relief as it did not contain the most feared proposals: directly allowing government negotiation of drug prices and permitting the importation of foreign prescription drugs.
  • Industry consolidation and challengers: Across the industry globally, $316 billion of deals have been announced this year, up from $155 billion a year ago.7 This mergers and acquisition activity (and speculation around it) has been a significant driver of healthcare stock performance this year, particularly in the context of vertical integration between insurers and pharmaceutical benefits managers. Participants in the value chain have sought to consolidate power and manage costs, while in the biotech space large drug makers have turned to buying smaller players to support flagging pipelines. Indeed, small-cap biotech firms have particularly benefited from M&A activity, outperforming their large cap peers by over 13% YTD.8 At the same time, the spectre of cash-rich new entrants attempting to disrupt the value chain could pose a threat to incumbents, although the industry generally has dominant incumbents and significant regulatory barriers to entry.
  • New technologies and new markets: Investors have rewarded medical device companies leading innovation through R&D and successful new technology developments such as heart valves, spinal cord stimulators, knee-implants and surgical robots. Savings arising out of the U.S. tax overhaul were also a tailwind for the segment. Device manufacturers with greater exposure to emerging markets also appear to have benefited from access to strong demand in fast-growing overseas markets.

Prescription: Short-term defense, long-term drivers

It is important to take note of sector valuations when considering opportunities within healthcare industries. The implication of the above disconnect between earnings trends and price performance is a divergence between investor multiples. Apart from the medical devices industry – which is trading at 24.6 times forward earnings – healthcare providers, biotechnology and pharmaceuticals are all trading at discounts to the S&P 500 forward P/E ratio of 17.3 times earnings. Pharmaceuticals have the deepest discount with 12.6 times earnings.9 Investors may consider this an attractive entry point in a sector known for its defensive qualities.

Demographics and innovation are key secular drivers of future growth for the healthcare sector

    • As noted in Potential growth opportunities in healthcare, we consider that investors potentially stand to benefit from long-term growth opportunities in healthcare. This perspective is based on two key secular drivers: demographics and innovation. Like other developed economies, an increasing proportion of the U.S. population is over the age of 65 years (see Chart 4), and the amount spent on healthcare by Americans continues to rise. The U.S. spends approximately 17% of its GDP on healthcare, the most of any OECD nation and up from 12.5% in 2000.10 Furthermore, spending growth is predicted to outpace average annual overall economic growth by 1.2% per year through to 2025.11

Chart 4: Percent of population +65 years

Chart 4: Percent of population +65 years

Source: United Nations, Department of Economic and Social Affairs, Population Division (2017). World Population Prospects: The 2017 Revision. Forecasts may not come to pass.

  • Meanwhile, advances in computational biology, bioinformatics, robotics and artificial intelligence (AI) are reducing the time and cost of development, as well as developing transformative technologies in the medical devices space. Though healthcare is traditionally seen as a defensive play, the potential to benefit from significant technological advances gives some segments distinctive growth potential. The merit of maintaining exposure to this potential was demonstrated recently within the biotechnology subsector: at mid-year the Nasdaq Biotechnology Index was up 3.1%. A week later, the index’s YTD gain was 9.2% thanks to its largest holding rising over 20% on the back of positive results for a drug trial.12 Drug pipelines are hard to predict but when realized, their impact can be significant.

The bottom line

The first half 2018 was marked by a broad recovery of healthcare stocks, and considerable dispersion within the sector. Political noise, industry consolidation and change are key drivers that have contributed to the divergence of outcomes. We believe that the sector’s defensive qualities may benefit investors concerned about recent market volatility, while secular drivers such as demographics and innovation have the potential to power its long-term growth potential.

Christopher Dhanraj
Head of iShares Investment Strategy
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