Earnings growth in the health care sector turned positive and exceeded Wall Street analysts’ expectations during the second quarter (Q2) of 2013, moving to a 2.3% rate of growth following a –26% growth rate in the first quarter of the year.
This profit growth was largely due to the exceptional rate of earnings growth in the biotechnology industry, the second largest component of the sector, at roughly 18% of the MSCI U.S. IMI Health Care 25–50 Index at quarter end. The MSCI World Health Care Index, a subindice of the MSCI U.S. Investable Market 2500 Index, is designed to capture the large-and-mid cap segments across 23 Developed Markets (DM) countries.
Looking ahead to the third quarter, Wall Street analysts are currently anticipating a –1.3% rate of quarterly earnings growth, which is down from expectations of 1.1% entering the quarter on July 1, 2013.
The biotechnology industry’s year-over-year profit growth in the second quarter was driven in large part by strong sales. Revenue growth more than doubled for biotechnology companies during the second quarter (see Earnings Scorecard, right).
After decades of investment, the growth of research and development (R&D) within the biotech industry is beginning to produce novel therapeutics for many unmet medical conditions, keeping its pipeline of innovation flowing. In 2012, the largest number of new drugs was approved by the U.S. Food and Drug Administration in a decade.1
Earnings growth for health care providers and services also surpassed analysts’ expectations in the second quarter, due in large part to the improving business dynamics for managed care organizations. The negative implications of the Patient Protection and Affordable Care Act (the official name for what is often referred to as “Obamacare”) appear less onerous than had been originally anticipated by many investors, and the underlying rate of cost inflation remains below long-term trend lines.
That said, what is good for managed care organizations is often bad for hospitals. On a relative basis, hospitals performed poorly in Q2 2013 (–19.6%) compared with managed health care stocks, which returned 0.66%.2 Hospitals remain under pressure due in large part to weak utilization, lower Medicare reimbursement rates, and ongoing commercial headwinds.
Health care equipment and supplies showed disappointing sales and earnings results during the second quarter, largely due to muted organic growth trends and a lack of major new product introductions. Device manufacturers, for example, face increasing price pressure from their hospital investors, which is placing some downward pressure on revenue growth. That said, the strengthening economy and emerging middle class in developed countries should help fuel growing sales for medical products over the coming years. Moreover, small-cap medical equipment investors could continue to benefit from acquisitions by bigger firms.
Health care: A plethora of opportunities
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Valuations within the health care sector, as measured by free cash flow (FCF) yields, were above the sector’s historical average at the end of August 2013, but since 2011 have been moving downward toward their historical norms (see chart below). This method of stock evaluation measures a company’s cash flow compared with its market price. A high FCF yield usually represents a good investment opportunity, because investors would be paying a small price and getting high earnings in return.
Meanwhile, because biotech stocks have performed strongly throughout 2013, valuations have become stretched for some companies, particularly those in the small- and mid-cap segments. Some of these stocks could see more challenging days ahead because they have become expensive relative to current fundamentals. Large-cap, stable-growth companies across the health care sector appear more attractive given the stable underlying business fundamentals, dependable FCF growth, and attractive valuation.
Outlook for health care stocks
Health care is a unique sector in the market. Demand trends are insensitive to economic activity and the sector has global tailwinds stemming from aging populations around the world and an emerging middle class that is demanding better health care. With an inflecting innovation cycle, new therapeutics that address unmet medical conditions are being commercialized with considerable success. This leads to a secular outlook for the health care sector that is mostly positive, and which should continue to be uncorrelated to the broader market.
The health care sector has historically been characterized by steady returns over the long term, and I expect this trend to continue. As people continue to live longer, the sector should benefit from these demographic trends, and the sector could be further boosted by the improving innovations within the industry.
In the short-to-intermediate term, certain stocks could benefit from industry consolidation, driven by the need to reduce costs and respond to changing industry dynamics. Additionally, there is anticipated growth from investments in software and technology platforms that will drive deflationary forces through the health care economy. These new businesses will be the growth companies of tomorrow. Ultimately, we are focused on those companies that can generate the highest risk-adjusted returns for our shareholders.