Nourish your Portfolio with Healthcare

True to its defensive form, healthcare has outperformed the S&P 500 by 6% and ASX by 18% since the market peak.1 The sector has been one of the few which has demonstrated real resilience since the outbreak of COVID-19 this year. Not surprisingly, the pandemic has driven unprecedented demand for vaccines, treatments and medical equipment. In addition, ageing demographics and medical innovation continue to underpin long-term healthcare trends. In our view, a diversified investment approach across healthcare sectors may allow investors to capture the upside of healthcare while being protected from unexpected market volatility in this challenging environment.

COVID-19 impact

While hospital workers are on the front lines fighting COVID-19, behind the scenes are numerous companies working on treatment research to combat the pandemic. The urgency to develop antigen testing and vaccine candidates has driven rigorous research activity within pharmaceutical and biotech companies globally. This area has also been a particular focus for governments as billions of dollars have been invested into COVID-19 test kits and potential treatments. Up to August 2020, the US government’s investments into coronavirus vaccine and treatment projects have reached over US$8 billion. Companies partnering with government-driven COVID-19 projects include Johnson & Johnson, Pfizer, and Abbott Laboratories. In Australia, CSL is a frontrunner in the race to developing a potential COVID-19 vaccine in partnership with the University of Queensland2.

Long-term drivers

Ageing demographics and medical innovation continue to underpin long-term healthcare trends. The Australian population is ageing, with 15% of Australians aged 65 and over and the proportion is expected to grow steadily. This trend is not unique to Australia – by 2025, we expect 1 in 5 adults in the US will be over the age of 65, compared to 1 in 12 adults in 1985. Based on our estimates, healthcare costs roughly triple after age 65. These structural changes would mean increased expenditure on healthcare products and services including drugs and treatments for the years to come – a fact that is not affected by geopolitical tensions, where we are in the market cycle, or who wins the U.S. election in November. We recognize that policy should play a role in sector performance, such as Medicare for All in the U.S., which could impact managed care services and hospitals. However, we see any action in the regulatory front to have a temporary effect, as long-term trends suggest increased spending will translate into higher income for companies including pharmaceutical firms and healthcare equipment and services providers.

On the drug development side, advances in computational biology, machine learning, and big data could lead to a substantial paradigm shift in drug development and treatment while dramatically lowering the time and cost of research and development. A partial list of long-term developments to watch include gene therapy, HIV, cancer vaccines, and regenerative medicine.  Both pharmaceutical and biotechnology companies are likely to benefit from advances in computational biology, which is happening at an astonishingly fast pace. Meanwhile, companies may face potential price competition in the future as more companies join to develop better (and cheaper) drugs and treatments.

Valuations and earnings

The COVID-19 impact is particularly murky for healthcare. Some aspects depend on future patient behavior. Do they forgo elective procedures or not? Do hospitals pull back or double down on CAPEX? Still, demographic trends haven’t changed nor has the importance of bending the cost curve lessened. There remains a strong incentive structure for managed care companies, which we expect to continue outperforming. Biopharma remains one of the top spenders on research and development — a precursor to strong cash flow—and there are a series of developments on the cusp of truly reshaping the global healthcare landscape.

Biopharma companies appear uniquely situated to monetize key medical breakthroughs, and demographic trends augur for an even greater demand for such treatments. Such breakthroughs could greatly replenish drug companies patent-protected revenue streams for years to come. Valuations suggest these prospects aren’t priced. Relative healthcare valuations look comparatively cheap, suggesting a greater balance of policy risk is being priced in over the long-term structural growth themes.

Healthcare valuations look cheap as more policy risk than growth is priced in

Healthcare valuations look cheap as more policy risk than growth is priced in

Source: Bloomberg, BlackRock, as of July 31, 2020. Notes: The chart compares the ratio of price-to-earnings ratios on the S&P 1200 Healthcare Sector Index vs the S&P 500.

Defensive characteristics

Although the sector has tended to be a top performer in both late-cycle and recessionary periods, we believe healthcare is an all-weather opportunity. The past two years offer a microcosm: In 2019, the sector lagged the broad market but was still up an impressive 23%. In 2018, healthcare’s resilience was on display: global equity markets were down 9%, but the sector was up 2%. The COVID-19 pandemic has also accelerated demand and technological advancements in the sector. We believe that we are still in the early days of many more breakthroughs and innovations within healthcare.