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We Think Pharma and Biotech Are Undervalued

These industries are the most undervalued in the healthcare sector, owing to potential U.S. drug pricing reforms coming out of Washington.

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Karen Andersen: Morningstar's analysis points to pharma and biotech as the most undervalued industries in the healthcare sector, in large part because of continued overhang from U.S. drug pricing reforms coming out of Washington. In July, the Trump administration decided not to go forward with a plan to eliminate rebates in Medicare. This news boosted share prices for distributors and insurers, but drug stocks sank as investors wondered what reforms would be implemented instead.

One idea is using a price benchmark based on prices in other developed markets to determine U.S. prices for some Medicare drugs. We think this system of price controls would be highly contested by Republicans in Congress and perhaps by the drug industry in the courts.

Congress is also working on bills to control drug costs, and we see pressure from the Trump administration to pass significant legislation prior to the 2020 election. A pending Senate bill could restrict price increases in Medicare and also cap out-of-pocket costs for pharmacy benefits in Medicare, partly by putting drugmakers on the hook for covering the costs of more-expensive drugs. This plan, in contrast to rebate reform, is expected to save the government and patients money.

Overall, we think there could be wide support for some of the reforms in the current Senate package, as it looks like a more moderate reform than international price benchmarks. The proposal could disproportionately affect firms like Gilead with its expensive hepatitis C and HIV treatments, as well as Bristol/Celgene, with cancer therapy Revlimid. Firms with high exposure to physician-administered drugs, like Roche and Amgen, are less likely to be impacted by the Senate bill, as these drugs would not be subject to out-of-pocket caps and don't rely on high annual price increases for profits.

It is very possible a bipartisan bill could pass in the Senate but fail in the House, if progressive Democrats aren't willing to let go of the idea of direct Medicare Part D negotiation. While we expect a continued overhang on drug stocks as drug price overhaul remains a key topic in Washington, we continue to see the industry as undervalued despite strong productivity and promising pipelines.

Karen Andersen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.