Opportunities abound in health care stocks

Key takeaways

• Health care can offer an attractive potential combination of growth and defensive features.
• The long-term transition away from a fee-for-service model and toward a value-based model may have created opportunities among managed-care and other companies.
• Our experts have also found opportunities in developers of next-gen biotech treatments that aim to intervene in diseases at the RNA and DNA levels, offering the potential to curb some illnesses at much earlier stages.

Stock investing is never without risk, but the current landscape presents an unusual combination of challenges. The Federal Reserve's aggressive interest-rate hikes raise the specter of a possible recession in 2023, meaning investors may continue to need strong defenses in their portfolios. But with inflation still running near 40-year highs in the US, they also can't afford to give up on the search for growth.

Against this unhealthy backdrop, investors may want to take a closer look at the health care sector, which can offer an attractive combination of defensive and growth characteristics.

Short-term defense, long-term growth potential

Health care accounts for nearly 20% of the US economy¹—a share that has been steadily expanding. Since people by and large take their prescriptions and go to the doctor regardless of the state of the economy, health care tends to be more resilient and less vulnerable to economic downturns than most industries.

This element of steady, consistent demand also makes many health care businesses relatively immune to economic cycles. Further, Eddie Yoon, manager of Fidelity^® Select Health Care Portfolio (), highlights life-science tools and managed-care providers as examples of businesses that have the ability to offset inflationary pressures.

Life-science tools, which include companies that make specific tools or ingredients used in manufacturing biotech and other drugs, enjoy high profit margins and compete in a field with relatively few vendors, which affords them strong pricing power. And managed-care businesses (i.e., health insurance networks), have the "scale and ability to push through premium increases to customers every year," letting them pass through inflationary pressures, says Justin Segalini, manager of Fidelity^® Select Health Care Services Portfolio ().

Finally, the health care industry enjoys the long-term tailwind of demography—the graying of America and the populations of other developed countries in Europe and Asia. For example, due to the aging of the baby-boom generation, more than 10,000 Americans turn 65 every day, making them eligible for Medicare.² Older folks generate a far higher volume of demand for health care products and services—filling more prescriptions and needing more care for chronic conditions than younger cohorts.

A sea change for managed care

One of the most powerful changes in the industry emanates not from R&D laboratories but from a radical shift in the managed-care industry from a traditional fee-for-service model to "value-based care."

In a fee-for-service model, providers are compensated on a per-visit or per-procedure basis, which can incentivize a higher volume of services and procedures. In value-based health care, physicians and hospitals are compensated (and incentivized) based on patient outcomes rather than on service volumes. This can shift the focus to quality of care through proactive and preventive treatments—realigning incentives among payer, provider, and patient.

"The transition to value-based care is a generational change in the health care industry," says Yoon.

Segalini says that this transition is accelerating thanks to strong government backing (the Federal government is the largest payer for medical care¹). For example, the percent of patients served by value-based care models is still in the single digits across the Medicare-eligible population, Segalini says. Yet the US Centers for Medicare & Medicaid Services has stated that it wants 100% of all eligible Medicare participants on some form of value-based care by 2030.³ Because it generally saves money and is popular with seniors, the adoption of value-based care by government programs enjoys bipartisan political support, says Yoon.

Investable opportunities

Of course, it is private-sector managed-care companies that will be running these new value-based care delivery systems for government clients such as Medicare and Medicaid, as well as for corporate customers in the private sector.

"These new value-based care business models are in the early stages of revolutionizing how we pay for care and have the potential to drive revenues, earnings, and business innovation for the next 2 decades," says Segalini.

Competition is heating up among managed-care providers. "There is effectively an arms race among them to grab share," he says. UnitedHealth Group (), Humana (), and Centene () were holdings in Segalini's fund that have illustrated the trend of rapid migration to value-based care networks.

In addition to well-established large health insurance firms moving into the space, several younger, specialized outfits are cropping up to serve a role in the expanding value-based care ecosystem. Holdings in the fund that have represented this trend include Surgery Partners (), an operator of independent surgical facilities that partners with value-based care organizations, and Oak Street Health (), a network of value-based primary care centers that mainly serve Medicare patients. And Agilon Health () provides software and tech to physicians' practices that help them manage the transition to value-based care.

A new golden age for biotech?

While COVID was a global human catastrophe, it created a silver lining in the field of medical research. The remarkably rapid development—and FDA approval—of effective and commercially successful COVID vaccines contributed to a surge in resources pouring into biotechnology research in 2020–2021. George Armstrong, a biotechnology analyst for Fidelity^® Disruptive Medicine Fund (), among other Fidelity funds, traces the origins of the biotech industry back about 20 years to the sequencing of the human genome, but notes that growth in the industry really exploded in the past 5 years, with hundreds of biotech outfits debuting on public markets.

Armstrong credits dramatic recent advances in technology for the swelling number of promising treatments emanating from biotech labs. In earlier times, medicines tended to revolve around treating symptoms of disease. Today's treatments can be far more precise and effective by intervening at the DNA and RNA levels, providing treatment at a much earlier stage in a disease. He compares this to shutting off a pipe before water leaks out, instead of waiting until there's a pool of water on the floor.

Several holdings in the Disruptive Medicine Fund have illustrated this thesis. Alnylam Pharmaceuticals () and Regeneron Pharmaceuticals () both aim to develop therapies that effectively switch off genes that cause certain diseases (via an intervention called "RNA interference"). The R&D pipeline of Vertex Pharmaceuticals () includes a number of projects investigating the efficacy of gene editing.

Of course, developing a new drug is a costly, time-consuming, and high-risk venture. It typically takes 7–10 years to move from Phase 1 through FDA approval for a new treatment, says Armstrong. Largely for this reason, a sort of symbiotic relationship between small biotech firms and giant pharmaceutical corporations has developed, according to Armstrong. The specialized biotech outfits are entrepreneurial risk-takers, but they may not have the financial resources or expertise needed to shepherd a promising treatment through the various levels of approval. Therefore, many of these smaller firms are acquired by big pharma companies when a commercially promising drug reaches a key inflection point, such as proven efficacy in humans.

This year is particularly challenging for small biotech firms without strong cash flows, since access to funding in capital markets has abruptly dried up. For those who want to stay independent, alternative sources of financing are becoming available. For example, Royalty Pharmaceutical () provides financing to early-stage biotech companies in exchange for a percentage of the companies' future drug royalties.

To learn more, check out the Fidelity^® Select Health Care Portfolio, Fidelity^® Select Health Care Services Portfolio, and Fidelity^® Disruptive Medicine Fund, or consider evaluating potential investments with our Stock Screener or Exchange-Traded Fund (ETF) Screener. You can also learn more about sector investing and read more recent market insights and commentary from Fidelity's portfolio managers.