War, Inflation Have Lighter Impact on Healthcare Stocks

With the recent market pullback, the trailing 12-month performance has decelerated with the Morningstar's US Healthcare Sector Index up 15%, a tad ahead of the broader equity market's 14% gain. We believe the outperformance is partly due to the relative safety healthcare stocks provide against the backdrop of the war in Ukraine and inflationary trends. Most healthcare companies generate less than 2% of sales in Ukraine and Russia, so the war isn't having a big impact on the group.

Further, we expect most of our healthcare coverage (especially firms with moats) will be able to pass along price increases due to any inflationary pressures given the strong pricing power, thanks to patents and high switching costs. As the war in Ukraine and inflation have shifted the focus of the Biden administration and Congress, we don’t expect near-term movement on major U.S. healthcare policy, which should ease some pricing pressure risk on the Big Biopharma group.

Exhibit 1: Healthcare sector index versus market index.

- source: Morningstar

Within the healthcare sector, we see just over 30 buys in the sector, with one third of our coverage rated 4 or 5 stars. However, on a capitalization-weighted basis, overvalued large-cap healthcare stocks skew our price/fair value for the sector higher than its median.

Exhibit 2: Star rating distribution and average P/FV for sector and key industry groups.

- source: Morningstar

However, we continue to view the valuation in the sector as split between a general undervaluation in the larger biopharma group and an overvaluation in the device and diagnostics industries. While the biopharma valuations imply a high degree of risk involving potential changes in U.S. healthcare policies targeting drug prices, we see this threat as fading, especially as other priorities increase in the U.S. Further, the fundamental outlook for biopharma firms remains strong, with low patent exposure and several new innovative drugs launching and gaining market share (Exhibit 9d).

Exhibit 3: Potential U.S. policy changes to the drug industry.

- source: Morningstar

Exhibit 4: Large-cap biopharma five-year outlook: Innovation offsetting patent losses.

- source: Morningstar

On the opposite side of the healthcare valuation spectrum, many diagnostic and tool companies look overvalued. We believe this is partly because of strong recent results from pandemic-related activities being extrapolated too far into the future. While we think achieving global herd immunity to the coronavirus seems increasingly unlikely, we expect a return to near normal over the next two years in most developed markets as vaccinations climb and new effective oral treatments reach the market. We expect the demand for COVID-related products to fall substantially by 2024, and the redeployment of capital by firms gaining a windfall from COVID will be an important growth driver for several firms.

Top Picks

Biogen BIIB Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $343 Fair Value Uncertainty: High

The market is overly concerned with the increasingly challenging outlook for Alzheimer's drug Aduhelm, but Biogen is well positioned elsewhere. The firm leads the $20 billion global multiple sclerosis market with Avonex, Plegridy, Tysabri, and Tecfidera, and the launch of Vumerity partly protects the Tecfidera franchise from generic headwinds. Biogen also receives royalties and profit share from Roche on MS drug Ocrevus and cancer therapies Rituxan and Gazyva, boosting Biogen's profitability. Further, Biogen's neurology portfolio outside of MS, including Spinraza in spinal muscular atrophy, should help diversify revenue and boost sales growth.

Ionis Pharmaceuticals IONS Star Rating: ★★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $62 Fair Value Uncertainty: High

The market underappreciates Ionis' growing pipeline of assets. Ionis' antisense technology and intellectual property estate have allowed the firm to create an entirely new class of therapeutics for difficult-to-treat diseases. Antisense therapeutics have the potential to gain access to well-studied targets in the cell that are currently deemed "undruggable," and Ionis could capture this low-hanging fruit in a wide range of diseases. Further, Ionis has attracted big-name partners like Biogen and Roche, and it has one of the broadest pipelines in the biotech sector.

Zimmer Biomet Holdings ZBH Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $175 Fair Value Uncertainty: Medium

With the addition of smaller competitor Biomet, Zimmer is the undisputed king of large-joint reconstruction, by far. We expect favorable demographics, which include aging baby boomers and rising obesity, to fuel solid demand for large-joint replacement that should offset price declines. However, Zimmer stumbled into a series of pitfalls in 2016–17, including integration issues, supply and inventory challenges, and quality concerns that have caught the attention of the U.S. Food and Drug Administration. However, new management has tackled these issues, and the firm is poised to ramp up its growth.