Bigger is better

As well as disruption and innovation coming from smaller, more nimble companies we are now seeing the proactive, larger businesses driving structural change across the healthcare sector.

Since early 2017, small and mid-cap healthcare companies have significantly outperformed the large caps. This started to reverse in 2H18 and while we are not disputing the level of innovation we are seeing in small companies we think some of their valuations are looking stretched.

By comparison, valuations of large healthcare companies continue to look attractive on a relative and absolute basis – the sector’s P/E ratio is in line with the market on a relative basis and is at its long-term absolute average.

For investors, these large companies offer the potential of steady earnings growth, strong cash generation and, ultimately, compounding returns for investors.

Given the potential uncertainties going into 2019 – Brexit, trade wars, rising interest rates, geopolitical uncertainty etc – we think there is a strong case to be made for investing in large healthcare stocks that offer defensive growth. Our focus is on large companies adopting proactive business strategies to embrace and drive change in the way healthcare is being managed, delivered and paid for.

Structural change in any industry has the potential to create winners and losers and healthcare will be no different. In 2017, we articulated a two-pronged investment strategy: (a) focus on large-cap consolidators adjusting to change, and (b) identify small/mid-cap innovators disrupting the industry.

Over the past year, we have seen a significant change at some of the larger companies that has begun to blur these two trends. We are now seeing healthcare management teams becoming more proactive, developing innovative business strategies, disrupting healthcare value chains and building competitive barriers to entry.

We are entering a new phase of structural disruption that is not just about a new therapy or developing a new technology to address a problem (such as GP visits). While all of these are still important, and can be good investments at the right price, the next phase of disruption requires a realignment of interests across the value chain and relies on collaboration.

Dealing with this type of complexity is more the preserve of large companies. All the stakeholders need to be engaged which means nudging patients, persuading doctors, corralling politicians and influencing payers. Certain management teams in the sector are adopting a deliberate strategy, trying to be the agents of change. Driven partly by their own vested interest, it also reflects a recognition that healthcare disruption is inevitable.

Not all large companies are capable or willing to drive such change and some will get left behind. There are many companies that are more reactive, often reeling from the new regulations or procedures being forced upon them by a regulator or by a payer.

Not all proactive strategies will succeed and creating alignment among a diverse set of stakeholders is never easy, even for an industry leader. Nevertheless, we do see a few themes emerging that are a useful guide to which companies may be successful.

For instance, management teams of large-cap companies are getting ahead of healthcare affordability challenges, the most obvious of which is US drug pricing. We are seeing some pragmatic approaches to pricing that are a significant diversion from standard industry practice. The migraine market in the US is a great example of how quickly the pricing landscape is changing.

The challenge and opportunity for us is to find companies and management teams that have differentiated assets and are adapting to a rapidly changing healthcare landscape. Not all large companies will drive such change but we are already seeing large companies adopt a proactive strategy to be the agents of change. These are the ones making investment decisions today that will help shape the future of healthcare tomorrow.

Daniel Mahony, Gareth Powell and James Douglas
Fund Managers, Polar Capital Healthcare Trust
6 December 2018

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