In the first quarter (Q1) of 2013, equity markets—including the health care sector—largely shrugged off the lingering effects of the European sovereign debt crisis and U.S. fiscal woes, and rallied on the rebound in U.S. housing, improved consumer confidence, and the Federal Reserve’s ongoing accommodative monetary policy.
Despite the uncertainty over the global growth outlook, the health care sector continued to perform well on an absolute return basis. This further emphasizes that the demand for health care continues to be stable through multiple economic cycles, as an aging population consumes more health care, both in the U.S. and around the world, and people survive longer with chronic diseases.
Emerging markets have also contributed to the sector’s growth, responding to the growing demand for better health care from a burgeoning middle class. These secular trends could provide a similar investment backdrop going forward.
The combined earnings growth reported by health care companies fell slightly short of analysts’ expectations during the first quarter of 2013 (see the chart below right). This was largely due to the negative earnings growth in the pharmaceuticals industry.
Pharma is by far the largest segment of the health care sector, representing more than 40% of the MSCI U.S. IMI Health Care 25/50 Index (the health care sector component of the broader MSCI U.S. Investable Market 2500 Index) as of May 31, 2013. The next largest industry component is health care equipment, at roughly 19%. Despite the sector’s lackluster earnings growth in aggregate, health care was the market’s best-performing sector on an absolute basis in Q1 2013, returning 15.7% and outperforming the 10.6% return of the broader market, as measured by the S&P 500.
A pattern of negative earnings results for pharmaceutical companies persisted in Q1 2013. The primary culprit was the ongoing expiration of valuable patents.
Looking forward, much of this headwind is now behind the industry and, as product pipelines mature and expand globally, it should return the industry to growth. Pharmaceutical stocks outperformed the broader health care sector in Q1 2013, benefitting from large-cap companies with shareholder-friendly capital allocation policies. Certain pharmaceutical firms with high free-cash flow (FCF) and attractive dividend yields also delivered respectable returns.
Biotechnology continued to perform well, thanks largely to a strong and diverse pipeline of new treatments and the launch of multiple novel products across many disease categories. You can read more about this potential high-growth theme here.
Health care technology stocks have also done well. As health care payers begin to shift toward value-based purchasing and abandon fee-for-service payments, hospitals are leaning heavily on their IT systems to understand their cost structures and revamp their care-delivery models. Moving health care into the digital economy should drive productivity throughout the system and ultimately lower costs.
Health care equipment and supply companies face a difficult market in the U.S. due to an increased focus on cost containment. Nevertheless, these multinational companies have enormous growth potential in emerging markets, as new hospitals are built and the health care infrastructure expands to accommodate millions of people who can now afford medical care. Providing health insurance to this emerging middle class is a national priority for many governments.
Meanwhile, the health care providers and services industry posted a 10% revenue gain for the first quarter of 2013. However, mandatory spending cuts due to the federal government’s budget sequestration could potentially reduce Medicare reimbursements by 2%, which would likely compress profit margins in the industry.
The Affordable Care Act, which begins its final phase of implementation in 2014, could have a positive impact on health care utilization, as approximately 30 million uninsured Americans will gain coverage. While insurance companies will likely benefit from an increase in enrollment, profitability may continue to come under pressure. However, other parts of the health care supply chain could see increased use of health care products and services.
The expansion of Medicaid should also be a positive for managed-care companies focused on the Medicaid population, which is expected to grow to an estimated 84 million people by 2022.1 The rapid growth of Medicaid won’t necessarily translate into free-cash flow for managed-care companies, so I view this group with a certain amount of skepticism given how difficult it will be to underwrite the Medicaid population and the industry’s already slim profit margins.
Despite the strong performance in the first quarter of 2013, valuations within the health care sector remained low by historical measures on a free cash-flow yield basis.
This method of stock evaluation measures a company’s free cash flow compared to its market price. A high FCF yield may represent a good investment opportunity, since investors would be paying a small price and getting high earnings in return. A company with a strong free cash flow has the ability to build its business by launching new products, paying off debt, or other investor-friendly measures.
Currently, the FCF yield of the overall health care sector is above its historical average, which is indicative of strong investment value, but it has declined from recent highs as the stocks have appreciated (see the chart above).