Healthcare: Stock-Picking Increasingly Important as Valuations Rise

• The core of research-and-development productivity at drug firms continues at a steady pace, creating innovative drugs that help to offset some pricing pressures from pharmacy benefit managers.
• With Donald Trump as president and the Republicans in control of Congress, we expect a high degree of political effort calling for the repeal of the Affordable Care Act (ACA), but major healthcare changes seem unlikely as the ACA has provided millions with healthcare insurance that will be difficult to strip away.
• Redeployment of capital by the large healthcare companies continues to drive valuations with a focus on mergers and acquisitions, stock buybacks, and steady dividends.

Concerns over pricing power for drugs appears to have partially abated with the drug stocks posting strong gains in the first quarter. We continue to expect near-monopolistic drug pricing as a result of patent protection that supports the core of our moat ratings for the large drug and biotech companies. While drug prices will likely continue to soften in therapeutic areas with less innovation such as respiratory and diabetes, the innovative therapeutic areas of cancer, immunology, multiple sclerosis, and vaccines are poised for strong pricing power as the innovation is powerful enough to provide the drug companies better leverage in negotiations with the payer groups.

Overall, we continue to see steady gains from research and development. Drugs in certain areas of cancer (especially immuno-oncology) are reaching the market at half the time of drugs developed a decade ago, partly due to major advancements in science and clinical designs but also due to more accommodative healthcare regulatory groups. Recent approvals in lung cancer by immuno-oncology drugs look particularly well positioned to drive a major source of drug spending. We expect immuno-oncology drugs to eventually cover most of the major cancer indications.

On the political landscape side, seeking to fulfill the long-standing Republican promise to repeal the Affordable Care Act, Congress faces a tough road to success for several reasons. First, the reality of insurance markets and economics associated with adverse selection are in contradiction to Republican assurances that a replacement plan would cover everyone with quality insurance and cost less money. Second, Republican reform ideas could lead to elimination of coverage of more than 20 million Americans newly insured under the ACA, which would likely result in major political backlash. Third, Republicans only wield a narrow majority in the Senate, which means less than a handful of Republican senators are able to scrap a reform bill. Fourth, and perhaps most importantly, there is significant--potentially irreconcilable--disagreement among Republican camps about what policy should replace the ACA.

Turning to the redeployment of capital allocation, large healthcare companies continue to support dividends, share buy backs, and acquisitions.

Top Picks

Express Scripts

ESRX

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $100.00

Fair Value Uncertainty: Medium

5-Star Price: $70

We believe market participants are underestimating the long-term growth potential for Express Scripts and overestimating the effects of a maturing industry. Additionally, near-term uncertainty regarding the effect of private exchanges on Express Scripts has pressured its stock. We believe private exchange health insurance providers will still need the negotiating leverage and expertise of pharmacy benefit managers. Additionally, the brisk pace of movement toward, and the total number of businesses moving to, private exchanges will be materially less than what some market participants currently expect, in our view. Overall, we view Express Scripts in a solid position with its wide economic moat, solid growth potential, dominant market position, and attractive valuation.

Roche

RHHBY

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $42.50

Fair Value Uncertainty: Low

5-Star Price: $34.00

We think the market underappreciates Roche's drug portfolio and industry-leading diagnostics that conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global healthcare into a safer, more personalized, and more cost-effective endeavor. Roche's collaboration between its diagnostics and drug-development groups gives the firm a unique in-house angle on personalized medicine. Also, Roche's biologics constitute three fourths of its pharmaceutical sales, and biosimilar competitors have seen development setbacks while Roche's innovative pipeline could make these products less relevant by their launch.

Allergan

AGN

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $300

Fair Value Uncertainty: Medium

5-Star Price: $210

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 M&A, which creates numerous capital deployment opportunities following the $40 billion sale of its industry-leading generics unit to Teva in 2016.

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