As the markets continue to pull back on macro headwinds (concerns around inflation and a recession), year to date through Dec. 27, 2022, the broad equity market fell 19.70%, but Morningstar’s US Healthcare Index only fell 5.43% (Exhibit 1). As economic concerns have weighed on the market, we believe the defensive nature of healthcare stocks supports the outperformance. Regarding inflation, we expect our healthcare coverage (especially firms with moats) will be able to largely pass along price increases due to most inflationary pressures given the strong pricing power enjoyed by the sector due to patents and switching costs. However, lags between price increases and inflationary pressures may cause short-term margin pressure for firms that can’t move pricing quickly, typically due to regulations slowing price changes. Also, labor shortages are affecting some healthcare services companies, which may limit capacity and pressure margins in the near term for the industry. Despite some macro pressures affecting healthcare, the sector looks more resilient than the overall market, and the inelastic demand for healthcare should keep sales steady if global economic activity falters.
On a market capitalization weighted-basis, the sector is fully valued, but with the median price/fair value of stocks within the sector at 0.89, we see just over 40 “buys” in the sector, with close to half of our coverage rated 4 or 5 stars (Exhibit 2). We see relatively broad representation of undervalued stocks across the industries within healthcare, except for managed-care companies, which look more fairly valued.
Healthcare looks undervalued across several industries, and we believe the sector should hold up well in the backdrop of several macro pressures (Exhibit 3). The low valuations and the defensive nature of healthcare should enable steady returns for the sector. We view biopharma, the largest industry by market capitalization, as undervalued.
The recently passed Inflation Reduction Act in the U.S. will likely create manageable industry headwinds. With the passage of this legislation, we believe the political rhetoric around high drug prices will fade as the U.S. government will have less responsibility for drug costs, and elderly patients will have much lower out-of-pocket costs. With the U.S. elections yielding a split in power, we do not expect major healthcare policy reforms, leaving healthcare market with a more stable outlook. On the innovation side, we see strong trends across industries. Targeted drugs, new therapeutic mechanisms of action, and advancements in diagnostics and devices will enable strong pricing power and volume expansion.
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