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Innovation to drive health care stocks

Look for advances in biotechnology and health care information technology.

  • By Eddie Yoon, sector portfolio manager
  • – 07/02/2013
  • Health Care Sector
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Within the health care sector, the biotechnology and health care information technology industries are playing a leading role in advancing not only medicine, but also in reforming the U.S. health care system as providers seek to improve value, quality, and efficiency of care.

Biotechnology delivers inventive approaches to treating disease

Unlike pharmaceuticals’ iterative approach to innovation (e.g., combining doses into a single pill or tweaking the formulation of an existing drug) biotech firms target diseases in fundamentally different ways, creating novel categories of drugs with entirely new mechanisms of actions—all at a rapid-fire pace. The innovation cycle in biotech is potentially hitting its sweet spot and has driven strong results.

The FDA approved 18 new biopharmaceuticals in 2012, and recent clinical trials in multiple disease categories have been promising. More than 40% of new drugs in development are biopharmaceuticals instead of conventional drugs.1 Biologics already on the market have done well, underpinning biotech companies’ sales, earnings, and free-cash flow. These drugs include Avastin, Herceptin, and Rituxan, which are among the world’s top-selling cancer drugs. Biologics now comprise nearly one quarter of the $320 billion spending on pharmaceuticals in the U.S. each year.2

Products from biotech companies have become major game changers in medicine. Pending approval from the FDA, a new drug will be launched this year that boosts cure rates for chronic hepatitis C. Other breakthrough therapies include those that treat several types of cancer, multiple sclerosis, and cardiovascular disease. These innovations fundamentally change the life expectancy and quality of life for patients with these diseases.

Biologics cannot be copied identically in a generic form, so these complex drugs currently don’t face the same competition from generics that conventional drugs do. While this may change in the future, regulation continues to muddle its way through the political process. In addition, a considerable portion of research at biotech companies is funded with private market capital, making discoveries less vulnerable to federal cutbacks from the National Institutes of Health.

Biotech innovation involves more than creating new modalities to treat disease, however. The industry is also taking advantage of our newfound understanding of the human genome. Ten years ago, the first human genome was sequenced at the cost of $3 billion. Today, sequencing a subset of an individual’s genes costs as little as $5,000.3 This is providing biotech companies with a better understanding of the underlying causes of disease, which will eventually lead to smarter, more efficacious medicines.

DNA-based diagnostic tests are on the horizon that will determine which patients will respond to a particular therapy, thus eliminating costly and ineffective drug regimens. Molecular diagnostics may soon be able to screen for specific genetic mutations that cause one drug to be harmful and another safer for an individual. Such patient-centric medicine will save the health care industry billions of dollars a year and provide better and safer care.

A note of caution: Investors should thoroughly consider all of the risks associated with biotech investments as certain stocks in this industry may have the potential to move sharply in either direction.

Technology helps drive innovation

As patients look forward to customized treatments based on their genetic makeup, they are also being given greater responsibility for individualizing their care. With employers moving employees into high-deductible health care plans, consumers will have to make more decisions about how to use their health care dollars effectively, since they will pay for a greater share of medical care out of pocket.

Companies that can help consumers get the most value for their health care dollars will be at the forefront of a powerful new trend toward consumerization of health care. Employers are looking to tech companies to give their employees the right tools to manage their health benefits (see the chart below). Imagine going to an Amazon.com-like portal and being able to compare costs for knee-replacement surgery among different doctors.

Employers and other payers are also demanding more data on safety and outcomes from hospitals, and will require hospitals to share risk with providers through accountable care organizations. Hospitals look to health care tech companies to move them from the analog to the digital world to meet these data demands and to benefit from, rather than suffer the financial consequences of, a rapidly shifting payment model. Today, few software vendors can offer hospitals the solutions they need to adapt to the new world of payment reform, making these companies a potential sweet spot for investment.

Outlook for health care stocks

The health care sector has the potential to continue to deliver strong performance in the months and years to come (See the state of the health care sector for the first quarter of 2013 here). Key investment opportunities may focus on companies that can provide innovative solutions to reduce the nation’s rising health care costs, which, at 18% of current GDP, are on an unsustainable path. These companies typically have disruptive business models that can exert deflationary forces on spiraling health care costs.

As the U.S. health care system evolves into one where value— rather than overuse of medical care—is rewarded, the quality and efficiency of care may follow suit. New businesses could form that help hospitals and physicians fundamentally rethink the way they approach medical care. Reimbursement will focus on performance and quality outcomes. Consumers will be asked to make more-informed decisions regarding their own health care, and technology companies will provide these enabling tools. For example, we may see pediatric clinics staffed around the clock, commanding higher reimbursement rates from payers who would rather have patients treated in clinics than in hospital emergency rooms. Families could find these clinics, read reviews, and see prices on their smart phones. This is the type of evolution I expect to see in the modern health care delivery model.

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1. BioProcess International, “FDA Biopharmaceutical Product Approvals and Trends in 2012,” March 2013.
2. IMS Institute for Healthcare Informatics, “The Use of Medicines in the United States: Review of 2011,” April 2012.
3. Nature News, “Gene Sequencing Leaves the Laboratory,” Feb. 19, 2013.
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