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Healthcare Still Looks Pricey

Drug and biotech industries pricing in the risk of policy changes in the U.S., but we don't think there will be a big regulatory impact.

Despite continuing coronavirus concerns, the Morningstar US Healthcare Index has increased 27% over the trailing 12 months. However, returns have underperformed the broader equity market, which posted a 36% gain during the same period. Concerns around new U.S. healthcare policies are likely continuing to weigh on some stocks, as the U.S. market represents a disproportionate share of profits for many of the global healthcare companies due to the high prices in the U.S. and large population base. However, we expect only modest policy changes because Democrats have only a slim majority in Congress and healthcare markets are extremely complex. Overall, underlying healthcare fundamentals look solid based largely on continued innovation. While we expect some increased volatility in healthcare sales due to the emergence of coronavirus variants, we expect an overall acceleration in growth for several more elective healthcare areas through the remainder of 2021.

Exhibit 1: Healthcare Sector Index Versus Market Index

- source: Morningstar

We view the healthcare sector as 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 1.05. We see fewer buys in the sector, with about 25% of our coverage rated 4 or 5 stars. However, valuation in the sector has barbelled, with undervaluation in the larger biopharma group and overvaluation in the device and diagnostics industry. The biopharma valuations imply a high degree of risk involving potential changes in U.S. healthcare policies targeting drug prices. While changes in U.S. drug pricing policies to help reduce out-of-pocket costs are likely, we don’t envision major changes like international reference pricing due to the strong biopharma lobbying group, concerns about disrupting innovation, and a razor-thin Democratic majority with different views than Republicans on addressing drug prices.

Exhibit 2: Star Rating Distribution and Average P/FV for Sector

- source: Morningstar

Conversely, the device and diagnostic space looks more insulated from government policy reform, which is likely drawing more investors to the space along with strong recent results partially driven by pent-up demand from the pandemic. However, we believe the market is extrapolating solid results too far into the future, setting up some excessive valuations.

While the delta coronavirus variant raises the bar to achieve herd immunity, we still expect a return to near normal in 2022 in the U.S. as vaccinations climb and vaccines are approved for younger kids. The biopharma industry should leverage the goodwill of creating the vaccine to support steady drug pricing, especially in the U.S.

Top Picks

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 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.

Merck MRK Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $94 Fair Value Uncertainty: Medium

Merck's combination of a wide lineup of high-margin drugs and vaccines along with a pipeline of new drugs should ensure strong returns on invested capital over the long term. Merck is well positioned to gain further entrenchment in immuno-oncology with Keytruda, which holds a strong first-mover advantage in the large first-line non-small-cell lung cancer market with excellent data. Also, we expect Keytruda to gain approvals in early-treatment settings, which should open up underappreciated sales potential. Merck’s vaccines look ready to drive further gains, led by human papillomavirus vaccine Gardasil.

Vertex Pharmaceuticals VRTX Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $266 Fair Value Uncertainty: Medium

Vertex's cystic fibrosis therapies are poised to dominate the lucrative market for the foreseeable future, based on the disease-modifying potential of the drugs, chronic use by patients, and limited competition. Vertex's leading drug candidates were mostly discovered in-house, lending credibility to its drug discovery technology and potential to generate additional pipeline candidates. Also, the therapies have lengthy patents, protecting the profitable cystic fibrosis portfolio from generics.

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