Healthcare: Stock Selection Increasingly Important

• Strong drug launches and excellent rapidly progressing clinical data in specialty-care areas, such as oncology and immunology, are supporting increased productivity at drug and biotech companies.
• Within the United States, we expect pricing power for drug and biotech companies to remain strong even as presidential candidates make claims to lower drug costs.
• While tapering off a bit, mergers and acquisitions continue at a solid pace, as large conglomerates look for external innovation and opportunities to redeploy capital to increase growth.

In looking at the core pillar of economic moats of innovation in healthcare, drug companies are rapidly increasing the speed of generating excellent clinical data in areas of unmet medical need, particularly oncology and immunology. Advances in immuno-oncology drugs are reaching the market at half the time of drugs developed a decade ago, partly due to major advancements in science, but also due to more accommodative healthcare regulatory groups.

We expect the shift to continue and to increase drug-development productivity and strengthen the moats for drug companies, especially as the productivity gains are in areas of development that carry strong drug pricing power and steep launch trajectories. Although the patient populations tend to be smaller in these specialty areas, the strong pricing power can easily turn the drugs into blockbusters. In immunology and oncology, drugs tend to carry annual prices of $25,000 and more than $100,000, respectively, supporting major markets despite smaller patient incidence rates as compared with historical areas of focus such as high blood pressure.

On the political side, although we expect the rhetoric on lowering drug prices will probably continue as presidential candidates vie for voters, we don't see any major shifts in U.S. drug prices over the next several years. Nevertheless, we expect drug pricing concerns to cause increased volatility in pharmaceutical and biotechnology stocks. However, without a major structural reform and a willingness by patients and doctors to limit treatment options, we don't see any major changes in U.S. drug prices.

Turning to mergers and acquisitions, while the pace of deals is slowing, companies continue to acquire and merge to increase their growth potential through creating scale, cutting costs, and focusing on key strategic areas. The persistent low interest rates are also fueling merger-and-acquisition trends because cheap capital is available to fund acquisitions. Beyond the heavy prevalence of M&A in the drug space, we are seeing further consolidation in healthcare devices.

Top Picks

Allergan

AGN

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $370

Fair Value Uncertainty: Low

Consider Buying: $296

Unlike most of its peers in specialty pharma, Allergan retains one of the most attractive product portfolios and innovative pipelines, particularly in its core markets of aesthetics, ophthalmology, gastro, and central nervous system. Allergan's diverse portfolio, key durable products including Botox, and healthy pipeline support a wide economic moat and high-single-digit organic growth over the next five years, in our view. The firm has used a nice mix of focusing on core internal research and development strengths while supplementing its pipeline with mergers and acquisitions, which creates numerous capital deployment opportunities following the expected $40 billion sale of its industry-leading generics unit to

Biogen

BIIB

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $356

Fair Value Uncertainty: Medium

Consider Buying: $249

Biogen is the leader in the multiple sclerosis market, with a range of options for patients seeking injectables (Avonex and Plegridy), orals (Tecfidera), or high-efficacy treatments (Tysabri). Competition in MS is heating up, but we still think Biogen has a dominant portfolio that can withstand this pressure, and we assign the firm a stable wide moat rating. We remain bullish on upcoming clinical data over a longer time horizon (2016-18) and think the firm has a promising collection of neurology-focused pipeline candidates. Recent prices appear to be giving the firm little credit for pipeline programs, including Alzheimer's drug aducanumab. The spinal muscular atrophy program (partnered with Isis) should generate Phase III data in late 2016 or early 2017, and we're bullish on its potential in this rare pediatric indication.

Elekta

(EKTA B)

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: SEK 90

Fair Value Uncertainty: Medium

Consider Buying: SEK 63

We believe Elekta is well positioned in the radiotherapy market, which has tremendous growth potential as improvements in technology, increasing awareness of the clinical benefits, and a favorable cost/benefit proposition should dramatically increase global adoption over the next decade. Further, we think Elekta carries a wide moat, based on a solid position in a market that is characterized by high barriers to entry, high switching costs, and strong intellectual property. This field has evolved into a duopoly over the past decade with virtually no new entrants, and the main two players (Elekta and

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