Healthcare: Sector buoyed by strong 2017

This return partly reflects the fact that some of the negative sentiment from 2016 has begun to dissipate. There has been a focus on the pharmaceutical industry’s overly aggressive pricing, with a growing risk of political intervention – particularly in the US. 

Concerted pressure from major healthcare buyers has seen many firms take it upon themselves to moderate their pricing strategies, both in the US and elsewhere. With these steps towards self-regulation, the tone of political rhetoric has moderated.

The pharma industry drives a significant amount of research and development, and with a number of unmet medical needs, governments seem to acknowledge the threat of intervention is not the most effective way to manage priorities.

The healthcare sector continues to expand. Diabetes, obesity and various forms of cancer are all becoming more prevalent, creating specific health challenges. Sales of cancer treatments are expected to grow around 13 per cent a year over the next seven years, for example. There are also new opportunities to develop treatments for rare health conditions, and both medical device and pharma firms are well-placed to benefit.

Despite the recent gains there is still value to be found. For investors seeking lower volatility, there are a handful of global companies with diverse sources of revenue, generating significant free cashflow and paying attractive dividends. These firms have very different earnings profiles to more volatile early-phase companies that are often cashflow negative, and highly reliant on research outcomes. 

In either case, monetising research involves uncertainty that even the larger players cannot insulate themselves from. Shares in AstraZeneca fell 15 per cent in July after disappointing trial results for a new lung cancer treatment. These kinds of setbacks are almost inevitable.

Research in such areas has become a race for success. Multiple trials exploring various combinations of drugs may take place, with potentially binary outcomes; meaning significant gains for the winners, but setbacks for treatments that fail to deliver. Weighing up the value of drugs in a firm’s development pipeline and adjusting earnings expectations based on the probability of success or failure is critical.

In an increasingly competitive and closely regulated environment, trends to watch include companies scaling up through mergers and acquisitions and working more collaboratively in order to spread risk and development costs.

The importance of collaboration was evident in AstraZeneca’s agreement to partner with Merck on its breast cancer treatment Lynparza, allowing it to pair with Merck’s leading cancer drug Keytruda. AstraZeneca has $8.5bn (£6.6bn) at stake, to be paid if the appropriate hurdles are met. These moves are designed to improve efficiency and mitigate some of the risks of pipeline failure. 

While the strong performance of healthcare stocks year to date has passed without much fanfare, investors should look more proactively at the sector as it offers some attractive characteristics. With the rapid development of new drugs, finding companies with the most attractive pipelines to tap into this growth potential will be the key to investment success.

Richard Saldanha is a global equity manager at Aviva Investors