Healthcare: Funding pressures take toll on pharma

The essential problem is a combination of government funding pressures and generic competition. US healthcare is the largest pharma industry in the world, but while the US Affordable Care Act was designed by the Obama administration to augment existing policy to universal health coverage, it has had mixed results. Attempts by the Trump administration to repeal the so-called ‘Obamacare’ have also encountered limited success.

The underlying problem for the US government remains exposure to long-term healthcare liabilities that it can no longer afford. Essentially a function of high US debt, the growing cost of drugs provided by pharma groups has been brought into sharp focus. Most noticeably, a high-profile Senate investigation aimed at Gilead Sciences over the spiralling cost of its Hepatitis C drug, Sovaldi, was a crushing blow for the industry and a reminder of the growing pressure to reduce costs.

A large element of this pricing pressure has manifested itself in the actions of the main US drug regulator, the Food and Drug Administration (FDA), to introduce greater competition. Many of the global majors have been confronted by a so-called ‘earnings cliff’ – caused by expiring patents of key drugs and the FDA’s increasingly free market approach to generic competition. This has been particularly damaging for UK groups AstraZeneca and GlaxoSmithKline, with patents expiring on key products inflicting a lasting impact on earnings.

Healthcare firms have responded in a variety of ways, with consolidation the dominant trend, while several ‘tax inversion’ deals – designed to transfer fiscal liability offshore –have been blocked by the US government.

Another significant area of industry response has been to reappraise research and development, with falling returns from drug discovery leading to several changes. Many groups have looked to circumvent the risks of flagging R&D departments by buying biotech groups, such as the Johnson & Johnson deal to purchase Swiss-based Actelion at the start of this year.

In addition, drug discovery has looked to embrace new healthcare technology, and nowhere is this more evident than in the field of oncology. Groups such as Roche and Merck have embarked upon immuno-oncology – the science of building one’s own self-defence mechanism through the immune system, as opposed to traditional treatments that target diseases with single drugs.

The underlying sector remains difficult for investors. Drug discovery has been disappointing, with generic competition reducing the quality of industry earnings. Government budgets are under pressure and drug pricing is only going one way in the medium term.

The response of the industry to consolidate and seek out value in biotech is natural, but fraught with risk and the looming prospect of government intervention.

Dividend yields in the sector remain attractive but may be under pressure as negative industry issues manifest. Indeed, a sector that has been viewed historically as defensive is anything but; the often binary outcome of investment opportunities in this space was clear in the recent collapse of AstraZeneca’s share price.

For investors who are seeking broad healthcare exposure, medical equipment is strongly tied to long-term demographic shifts with more predictable development and earnings potential. 

For pure pharma exposure, investors should adopt a diversified strategy to reduce the stock-specific risk of drug disappointment and achieve some limited exposure to a growth industry full of potential, but increasingly fraught with risk.

Andrew Moffat is an investment manager at Hargreave Hale

Key figures

12.3% - Share of healthcare stocks in the MSCI World index

$3.2trn - Market capitalisation of healthcare stocks in the S&P 500

95ppt - MSCI World/Biotechnology index's outperformance over its parent index over five years

13ppt - Underperformance of the MSCI World/Pharmaceutical index