Politics Can Impact Drug Stocks
There is bipartisan consensus in Washington, D.C., that drug prices are too high. Prescription drug prices in the U.S. are more than 2.5 times more expensive overall than those in 32 other countries, according to a RAND Corp report. 2
As shown in Figure 2, bipartisan rhetoric critical of drugmakers tends to heat up during presidential election years, often causing stock prices to fluctuate wildly. Nevertheless, certain pharmaceutical drug stocks have enjoyed solid returns and outperformed the broad market. Despite the relative strength in stock prices, we believe we are still finding attractive valuations.
Medicare Repricing Creates Headline Risk
Potential policy changes with Medicare pricing structures could affect drug company revenues.
For example, one potential reform would implement the International Pricing Index (IPI) model to regulate the prices of currently expensive medications. Medicare would not pay more for the drugs than the reference prices, the average paid in six developed countries.
A second approach would allow the federal government to directly negotiate prescription drug prices for Medicare beneficiaries and people enrolled in private plans. Proponents of this plan believe it would lower costs on some of the most expensive brand-name drugs and base those prices on the drugs’ clinical benefits.
Other policy proposals would cap prices so they could not rise faster than inflation and limit how much Medicare beneficiaries pay out of pocket each year.
Some politicians and pharma executives argue these changes could harm industry revenues and drain funding for R&D.
We continually monitor drug pricing and other industry issues, conducting stress tests to assess potential impacts to the pharma holdings in our portfolios. We don’t expect drastic Medicare reform and believe these risks are manageable, including direct negotiations between Medicare and drug manufacturers.
Three Drugmakers Stand Out
Among companies we currently find attractive, Merck has a strong balance sheet and has generated significant cash flow. Its stock became attractively valued over worries that its top-selling Keytruda® lung cancer treatment is going off patent in 2029. Legislative concerns have also weighed on Merck, creating further valuation opportunities. We believe these issues are generally reflected in Merck’s stock price, and the company’s pipeline is underappreciated.
Johnson & Johnson and Roche are other high-quality companies whose diversified product portfolios have historically generated stable returns through various economic cycles. We believe they will be able to sustain returns through continued investment in research and development.
Biosimilars May Pose Challenge
In our view, biosimilars could soon become a significant challenge for drug manufacturers as top-selling biologics lose patent protection. Biosimilars are nearly identical copies of biologic drugs.
Biosimilars are complex large molecules that require initial investments of $150 to $200 million in manufacturing and $60 to $100 million in clinical trials per product.3 These steep investments provide relatively high barriers to entry and limit the number of companies investing in this space. Nevertheless, the market is poised for growth thanks to the potential for significant profits that should attract generic manufacturers and original branded-product producers.
We continually monitor the biosimilars market due to its disruptive nature. We expect drug manufacturers to combat any challenges by matching competitors’ prices. Additionally, the erosion curve of a biologic is typically more gradual after a patent loss than a solid oral pill, which can experience more than 90% erosion in the first year of patent loss. We expect manufacturers to offset some of the headwinds with new product launches.
Drug Distributors
Drug distributors provide support software and deliver drugs to pharmacies, physicians and hospitals. They purchase discounted drugs in bulk from manufacturers and then sell them to pharmacies, profiting from the spread. Playing an essential role in the pharmaceutical supply chain, they deliver drugs to the right places at the right times.
Drug Distributors Have Rebounded from Uncharacteristic Price Deflation
Atypical generic price deflation from 2016 to 2018 pressured drug distributors, but pricing has since normalized. Current tailwinds include:
- Specialty drugs made for oncology, rare diseases and other complex illnesses could potentially improve margins.
- Distributors have dropped many non-core businesses to focus on drug distribution.
- Companies have generally reduced their levels of debt, allowing for improved returns to shareholders.
- Opioid lawsuits have mostly run their course, giving us more confidence in distributors’ ability to grow earnings.
McKesson Corp. is a distributor that appears attractive under our valuation framework. The firm has benefited from stabilizing generic drug pricing and strong growth in specialty drug distribution, including biosimilars. We think McKesson should be able to manage any impacts of opioid litigation, given its historically solid balance sheet and free cash flow generation.
Medical Equipment and Supplies
Medical equipment and supplies (aka medtech) include devices, supplies (e.g., bandages), diagnostic and imaging equipment. The Biden administration ran on a platform promising to expand Medicare coverage, shore up the Affordable Care Act and expand Medicaid to additional states. These steps could generally benefit companies in the medical equipment and supplies industries.
Medtech Shows Resilience Through Challenging Times
Medtech companies have been resilient in challenging times. They maintained steady returns on capital through the Great Recession (2007-2009) and during the push to enact the Affordable Care Act (2009-2010). These firms also tend to avoid the political pressures that affect other areas of health care like insurance and pharmaceuticals.
More recently, they have endured pandemic-related swings in volumes. Strains on the health care system during the pandemic discouraged and/or prevented people from getting medical procedures, which pressured medtech stocks and provided value investors opportunities to buy higher-quality companies at attractive valuations.
Quality in Medtech
As value investors, we look for quality first and valuation second. Even though most medical device companies meet our high-quality thresholds, valuations for the group have expanded in recent years, so we primarily focus on those that are inexpensive relative to their peers. We define quality as companies with high or stable returns on capital and those in consolidated markets with high barriers.
We generally like companies with the first- or second-largest share of their markets, good management teams and strong balance sheets. Over the last few years, the industry has consolidated, leading to dynamic companies and more diverse and stable product lines. We tend to avoid companies with balance sheet and financial leverage issues and those with high-growth, high-expectation businesses, which usually trade at a premium.
We like Medtronic and Zimmer Biomet, two current market share leaders with attractive business models and valuations. We think both companies are underearning a normal return on capital, which could lead to an earnings upside in the medium term.
While COVID’s impact on U.S. health systems created volatility for these companies’ stocks, especially Zimmer’s, we expect the return to a more normal environment to support their earnings as people reschedule the elective procedures they postponed during the pandemic.
Innovation Is Another Source of Resilience
Innovation allows select companies to grow revenue in existing markets and create new market opportunities while maintaining attractive margins. Examples include:
- Zimmer Biomet’s smart knee implant can measure and determine the range of motion, step count, walking speed and other gait metrics that could improve post-op rehabilitation.
- Zimmer Biomet’s ROSA Robotics is a multi-application platform that utilizes Zimmer Biomet implants and data technologies to redefine robotics by providing real-time insights during surgery to optimize patient outcomes.
- Medtronic says its upcoming Hugo RAS System “offers a minimally invasive alternative that provides surgeons improved visualization, greater dexterity and ergonomic advantages, often leading to improved surgical outcomes.”
These and other innovations could help drive returns on capital, maintain market share and create new markets that benefit both society and the innovating companies.
Health Care Facilities and Providers
Hospitals and specialized care facilities provide patient treatment with specialized medical and nursing staff and medical equipment.
Many facilities have attractive returns on capital that are generally stable over time and fit our process. But compared to other industries, the capital intensity of these businesses tends to lead to higher levels of capital expenditures (CapEx), which impacts free cash flow conversion. In addition, many facility operators have historically carried high debt levels, which does not fit our process.
Several trends may pressure or bolster health care facilities and providers:
Headwinds
- Increased number of lower-paying Medicare patients.
- Increased number of outpatient surgeries provided outside traditional hospital settings.
- Fewer elective procedures due to COVID-19.
- Margin pressures due to higher labor costs and staffing shortages.
- Competition from telehealth and other alternative care methods.
- Cost-conscious spending due to high-deductible health plans.
Tailwinds
- Improved financial metrics due to lower operating costs spurred by pandemic-related, belt-tightening measures.
- Potentially higher numbers of insured persons due to Medicaid expansion or higher subsidies for the Affordable Care Act’s exchanges.
- New opportunities from hospital-owned ambulatory care centers.
We follow industry leaders whose better relative balance sheets have been attractive when valuation opportunities appear. Companies in this segment can potentially improve performance by adding profitable services, such as outpatient facilities and high-acuity services. Tech upgrades and strategic cost reductions can also lead to operational efficiencies.
Many believed health care facilities/providers would lose revenues when the high number of COVID patients caused people to postpone elective procedures. Despite this environment, Hospital Corporation of America (HCA) was able to benefit from a better payer mix (commercial payers vs. Medicare/Medicaid) because many COVID patients were commercial payers. Acute elective procedures, such as cardio and orthopedics, have also been beneficial.
The largest hospital operator in the U.S., HCA is arguably the best run among its peers, but we believe it trades at generally high valuations. We like HCA when its valuation is attractive because it typically fits our quality framework. Universal Health Services (UHS) has benefited from similar dynamics as HCA in its acute care, but COVID has negatively affected its behavioral health services. Both UHS and HCA face labor shortages and rising wages, especially wages for temporary staffing. High volumes of COVID patients have shut down behavioral services in some instances.
Managed Care Organizations
Managed care organizations (MCOs), aka health insurers, are the gatekeepers to American health care. They combine the functions of health insurance, delivery of care and administration.
MCOs appear attractive under our valuation framework despite the higher pandemic-related expenses. Those costs have moderated but could become a concern if the pandemic worsens. See Figure 3.
MCOs generally have had solid balance sheets, stable earnings and generate strong free cash flow. The volume of elective procedures has stabilized, and the industry currently operates in a relatively friendly regulatory environment.
Health care and health care costs are ongoing political issues, so we maintain vigilance on how the wind is blowing in Washington D.C. Although we think it unlikely, the possibility of implementing a single-payer system could disrupt the current business models of health insurers.
In fact, the potential for COVID-19 to be a significant cost factor and possibility of a single-payer system have led to attractive risk/reward profiles for otherwise strong companies, such as Cigna and Centene.
We Believe Positive Trends Should Bolster Health Care Sector Regardless of Outside Noise
Our focus on companies that have generated high and stable returns on capital leads us to evaluate many firms in the health care sector. We believe investors’ perceptions often fail to match reality, allowing us to own high-quality companies when they become attractively valued. While there is much noise for health care companies to filter, they have successfully adapted to a COVID-19 world and adjusted their business models to meet legislative requirements.
