Healthcare Sector Outlook: Defensive Attributes Should Shore Up Stocks Amid Economic Headwinds​

Over the past 12 months, overall equity performance has been slightly below the Morningstar’s US. Healthcare Index. While the overall market is still working through many potential challenges, including a slowing economy, rising inflation, and rising interest rates along with banking system pressures, the healthcare sector is fairly immune to these headwinds. The healthcare sector should hold up better than the overall market if these headwinds increase.

The defensive nature of healthcare stocks should support stable demand through economic cycles. We expect our healthcare coverage (especially firms with moats) will be able to largely pass along inflation related price increases due to the strong pricing power enjoyed by the sector due to patents and high switching costs. While rising interest rates may hurt some smaller healthcare companies more reliant on external financing, the majority of our coverage in the mid- to large-cap space generate robust cash flows and could actually benefit from rising interest rates by acquiring cash-needy smaller firms at lower valuations.

On valuation, we view the healthcare sector as undervalued. Our coverage trades below our overall estimate of intrinsic value. We see plenty of opportunities in healthcare, especially in the biopharma industry, healthcare providers, and healthcare plans. The biopharma group holds the most five-star stocks. Conversely, we see fewer undervalued stocks in the device and diagnostic industries.

We see attractive valuations within multiple healthcare industries, including the largest healthcare industry by market capitalization, the biopharma group. The drug group holds several undervalued companies and looks well positioned for long-term growth.

Healthcare Offers Several Industries with Attractive Valuations and Steady Fundamentals

We model out 2.4% annual growth for the large-cap biopharma group over the next five years. This growth rate increases to 3.5% excluding Pfizer’s COVID-19 vaccine and treatment sales, since those sales are likely falling significantly as the pandemic recedes. While patent losses will slow growth, innovation is strong enough to more than offset generic competition. Beyond the biopharma group, we expect the other leading industries of devices, diagnostics, medical supplies, and services to post steady long-term gains. However, firms with high exposure to COVID-19 products like Pfizer and some tool companies will likely face slower growth or a decline in 2023 as COVID-19 -related products fall.

As interest rates increase, we could see a rise in acquisitions as cash-needy smaller companies become more receptive to lower valuation offers. With the larger firms typically generating excess cash, we could see an increase in the deployment of cash toward smaller and more midsize targets.

Top Healthcare Stock Picks

Illumina ILMN

• Fair Value Estimate (USD): 269.00
• Star Rating: 4 Stars
• Uncertainty Rating: High
• Economic Moat Rating: Narrow

Illumina represents a growth-at-a-reasonable-price opportunity for investors with a long-term horizon. As the leading provider of genomic sequencing tools, the company should be able to capitalize on the continued expansion of these applications in research and clinical settings through its legacy business. While Illumina may face more competition in its legacy genomic sequencing technology, the factors that determine its economic moat in genomic sequencing (intangible assets and switching costs) should help Illumina generate economic profits, especially considering its coming-to-market sequencing instruments. Also, Illumina owns the Grail liquid biopsy assets. Recent Illumina share prices appear to only value the legacy business, meaning investors are getting a free option on the Grail assets, which could pay off in the long run even if Illumina unwinds Grail.

Moderna MRNA

• Fair Value Estimate (USD): 266.00
• Star Rating: 4 Stars
• Uncertainty Rating: Very High
• Economic Moat Rating: None

Moderna shares were on a roller coaster in 2021. We think investors were first overly enthusiastic about the potential of the company’s technology but subsequently too bearish on its post-coronavirus growth. We have modest expectations for sales of the firm’s COVID-19 vaccine following massive pandemic demand in 2021 and 2022, but Moderna’s pipeline of mRNA-based vaccines and treatments is advancing rapidly. Even if sales dip in 2023-24, we’re increasingly confident in the long-term sales trajectory of the firm’s diversified pipelines, particularly in the field of respiratory virus vaccines. The firm’s phase 3 RSV and flu vaccine candidates and approved COVID-19 vaccine could eventually form the basis for a single vaccine.

Zimmer ZBH

• Fair Value Estimate (USD): 175.00
• Star Rating: 5 Stars
• Uncertainty Rating: Medium
• Economic Moat Rating: Wide

With the addition of smaller competitor Biomet, Zimmer is the undisputed king of large joint reconstruction. We expect favorable demographics, which include aging baby boomers and rising obesity, to fuel solid demand for large-joint replacement that should offset price declines. However, Zimmer stumbled into a series of pitfalls in 2016-17, including integration issues, supply challenges, and quality concerns, but new management has tackled these issues, and the firm is poised to ramp up its growth.