Drugmakers, Managed-Care Firms Undervalued

Morningstar's US Healthcare Index has increased 16% over the trailing 12 months as global concerns about the coronavirus continue to ease. Additionally, the returns have exceeded the broader equity market gain of about 10%. The generally solid underlying fundamentals of the healthcare sector are likely helping support the returns. Also, with the U.S. elections approaching, we expect heightened investor attention on potential U.S. healthcare policies. However, we don’t expect any major changes regarding reform, partly because both presidential candidates have moderate stances toward healthcare.

Healthcare sector index versus market index. - source: Morningstar

Overall, we view the healthcare sector as slightly undervalued despite the recent market rebound. Our coverage trades at a discount to our overall estimate of intrinsic value, with the median price/fair value at 0.97. With the recent market gains, we see fewer buys in the sector, with only about a third of our coverage rated 4 or 5 stars.

Star rating distribution and average P/FV for sector and industry groups. - source: Morningstar

We continue to see the most undervalued firms in the drug manufacturer and managed-care industries. The valuations of these industries seem to imply significant expected changes in the U.S. healthcare policies potentially driven by newly elected politicians. However, we view the most likely path for U.S. healthcare policy is incremental changes to existing laws that shouldn’t have a major impact on drug or insurance companies.

Potential U.S. election scenarios impact on healthcare industries. - source: Morningstar

From a fundamental standpoint, healthcare firms are adapting to the coronavirus impact and related economic pressures well. The coronavirus impact has caused fewer negative headwinds to the drug and managed-care industries as patients continue to prioritize drug therapy and avoid costly elective surgeries that can weigh on managed-care margins. Also, while the initial hit to demand for the device, dental, life sciences, and hospital industries was severe in April and May, trends are reversing as pent-up demand resurfaces and providers adapt to the pandemic. Additionally, we expect the healthcare sector to emerge largely unscathed from the economic pressures related to the coronavirus as healthcare demand is less sensitive to the economy.

Looking toward a potential cure for the pandemic, we believe the drug group will develop an effective vaccine over the next six months. While we don’t expect strong financial returns from vaccines (largely priced at nonprofit levels), we expect the industry to gain a windfall of goodwill to potentially use in U.S. healthcare policy negotiations.

Leading coronavirus vaccine candidates and expected timelines and supply. - source: Morningstar

Top Picks

Anthem ANTM Star Rating: ★★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $370 Fair Value Uncertainty: Medium

Uncertainty surrounds how the COVID-19 crisis will affect Anthem's near-term results, but we believe the narrow-moat company will be able to manage those risks and thrive in the long run, given its attractive local scale advantages as the Blue Cross Blue Shield licensee in 14 states. The stock price currently represents a very attractive entry point, in our opinion, that also fully accounts for U.S. healthcare policy risk. Therefore, we see limited downside risk at recent share prices, and assuming a relatively status quo policy scenario, we think Anthem's shares could rise substantially once pandemic concerns dissipate.

Biomarin Pharmaceutical BMRN Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $105 Fair Value Uncertainty: Medium

We view BioMarin as undervalued as the market overreacted to the delayed launch of hemophilia A gene therapy Roctavian. BioMarin's orphan-drug portfolio and strong late-stage pipeline continue to support a narrow moat rating, and despite Roctavian's delay (launch likely in 2022 instead of 2020), we're still bullish on the upcoming launch of achondroplasia drug vosoritide in 2021. In addition, we still think Roctavian data support the drug's safety and long-term efficacy, and competitors are just entering phase 3 trials. Similarly, BioMarin is far ahead of competitors in achondroplasia, which has no approved treatments.

CVS Health CVS Star Rating: ★★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $92 Fair Value Uncertainty: Medium

The firm's combination with Aetna should put the company in a much more attractive competitive position as the industry moves toward preferring a more integrated service offering. Investors should benefit from meaningful cost and selling synergies associated with the combination of a leading medical benefits business with the largest PBM and retail pharmacy network in the country. However, the social distancing period caused by the coronavirus is a concern for the retail business, but we don't forecast this as a long-term headwind.