Healthcare: Valuations Look Attractive Across Most Industries

Over the past 12 months, the overall equity market has outperformed the Morningstar U.S. Healthcare Index. With the market appearing less concerned about recessionary pressures, healthcare seems to have slightly fallen out of favor. If these concerns return, we believe innovation within healthcare and the sector’s defensive nature should support more stable demand relative to the rest of the market.

Healthcare Underperformed the Market In Q2

We view the healthcare sector as undervalued. Our coverage trades below our overall estimate of intrinsic value, with an aggregate price/fair value metric of 0.84. With the exception of medical distribution, healthcare industries look undervalued. We see the most 5-star stocks in biopharma. We believe the market is not fully appreciating the industry’s innovations in several therapeutic areas, including oncology, immunology, and rare diseases.

We See the Most 5-Star Stocks In the Biopharma Industry

In the healthcare plan industry, we believe the short-term headwinds of potential pharmacy benefit reforms and falling support in Medicaid and Medicare Advantage are creating undervalued opportunities, as the industry can offset these challenges over the long run. In the large device industry, we see a mixed valuation picture, with some stocks offering compelling valuations after falling from a bullish run during the COVID-19 pandemic.

We believe the market is underappreciating pipeline innovation, which should support 4.5% compound annual earnings growth over the next five years (excluding COVID-19 products) for the large-cap biopharma industry. The market appears overly concerned by U.S. drug policy changes in the Inflation Reduction Act, a drag on acquisitions from Federal Trade Commission scrutiny, and patent losses. COVID vaccines and treatments also create tough comparables that mask strong underlying industry growth. However, we expect the industry will continue its steady growth despite the headwinds. The obesity drug market has shown excellent innovations and is poised to grow to $65 billion by 2031, led by Novo Nordisk NVO and Eli Lilly LLY. While we see biopharma as undervalued, we view these leading weight loss drug makers as slightly overvalued, with the market getting overly excited about them.

Lilly and Novo Poised to Dominate the Global Obesity Market

Top Healthcare Sector Picks

Illumina

• Fair Value Estimate: $269.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High

Illumina ILMN represents an opportunity for growth at a reasonable price for investors with long-term horizons. 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 it generate economic profits, especially considering its coming-to-market sequencing instruments. Illumina also owns the Grail liquid biopsy assets. Recent Illumina share prices appear to only value the legacy business, meaning investors get a free option on the Grail assets, which could pay off in the long run even if Illumina unwinds Grail.

Moderna

• Fair Value Estimate: $266.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: Very High

Moderna MRNA shares were on a roller coaster in 2021. We think investors were first overly enthusiastic about the potential of the company’s technology, then too bearish on its post-COVID 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 as sales dip in 2023-24, we’re increasingly confident in the long-term sales trajectory of the firm’s diversified pipeline. The firm’s phase 3 RSV and flu vaccine candidates and approved COVID-19 vaccine could eventually form the basis for a single vaccine, and personalized cancer therapy has generated impressive data in melanoma.

Zimmer Biomet Holdings

• Fair Value Estimate: $175.00
• Morningstar Rating: 5 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

With the addition of smaller competitor Biomet, Zimmer ZBH 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 replacements, which should offset price declines. However, Zimmer stumbled into a series of pitfalls in 2016-17, including integration issues, supply challenges, and quality concerns. Still, new management has tackled these issues, and the firm is poised to ramp up its growth.