Drugmakers and Managed-Care Firms Still Look Undervalued

Morningstar's US Healthcare Index has increased 40% over the trailing 12 months, which we partly attribute to easing concerns around the coronavirus while risks of new U.S. healthcare policies remain.

Healthcare sector index versus market index - source: Morningstar

Nevertheless, returns have slightly lagged the 58% gain in the broader equity market. Overall, the fundamentals of the healthcare sector are solid, and we expect earnings growth to accelerate for several healthcare industries affected by pandemic restrictions, especially in elective procedures. On U.S. healthcare policy, we don’t expect any major changes, even with Democrats in control of Congress and the White House. We think more moderate changes that target insuring more people and easing some of the patient costs around specialty drugs are more likely.

Overall, we think the healthcare sector is slightly overvalued following continued market gains. Our coverage trades at a premium to our overall estimate of intrinsic value, with the median price/fair value at 1.09. With the recent market returns, we see fewer buys in the sector, with less than a fourth of our coverage trading at 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 U.S. healthcare policies, potentially driven by Democratic control in government. However, given the only slight majority in the Senate along with the complexities of implementing new healthcare policies, we continue to expect only minor incremental changes that shouldn’t have a major impact.

As coronavirus restrictions ease, we expect strong demand to return for the device, dental, life sciences, and hospital industries following the severe pullback in spring 2020, as trends continue to reverse from the initial lockdown and providers adapt to the pandemic. Also, managed-care companies may face some margin pressure as costly elective surgeries increase. However, we don’t expect much change for the biopharma group, where the demand for drugs has been more insulated from the pandemic pressures.

We believe the coronavirus vaccines hold the potential to drive the U.S. toward herd immunity by early summer.

Herd Immunity in the U.S.: Likely By Mid-2021 - source: Morningstar

We expect the industry to gain a windfall of goodwill to potentially use in U.S. healthcare policy negotiations to support overall drug pricing.

Top Picks

Biogen BIIB Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $350 Fair Value Uncertainty: High

While uncertainty still surrounds Biogen's Alzheimer's platform, we are optimistic about the firm's multiple sclerosis drugs and strong neurology entrenchment. Biogen leads the $20 billion global MS market with Avonex, Plegridy, Tysabri, Ocrevus (royalties), and Tecfidera, and the launch of Vumerity partly protects the Tecfidera franchise from generic headwinds in the U.S. Biogen's neurology portfolio outside of MS, including Spinraza and pipeline therapies for several neurological diseases, including Parkinson's, ALS, and Alzheimer's, should help diversify revenue and boost sales growth.

Biomarin Pharmaceutical BMRN Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $101 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

CVS' 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.