It has been a frustrating year for healthcare fund managers. Despite excellent industry fundamentals that suggested the sector would outperform the broader market, it has continued to lag more economically sensitive sectors as the US economy remained more robust than expected. In addition, despite what we see as limited risks, the sector has been negatively impacted by the outcome of the US elections.
While powerless against such market forces, we are nonetheless convinced that healthcare is primed to deliver strong, long-term outperformance which should come through in 2025 and beyond. This is not about mean reversion or value winning out over growth. It is about healthcare sector fundamentals – innovation and new products, untreated or underserved therapeutic categories, elevated utilisation levels, M&A activity and other longer-term market dynamics including demographics and emerging markets. The opportunity is underpinned by what we believe are very attractive valuations.
Key short, medium and long-term drivers
Over the very long term, healthcare has outperformed significantly: over the 35 years to October 2024, the S&P 500 Healthcare Index has delivered c12% annualised returns, similar to the technology sector. Performance has, however, been cyclical with distinct periods of under- and outperformance, arising from both broad market dynamics – such as when all defensives outperform – and specific industry drivers.
These drivers are particularly favourable at present. Innovation has been notably strong over recent years. Indeed, with 2023 delivering the second highest number of FDA approvals for 30 years, there have been a number of new product launches across different therapeutic categories. Crucially, these include categories which have previously been either underserved, such as obesity and certain cancers, or essentially untreated, as with Alzheimer’s; these also include markets for medical devices, such as irregular heartbeat. We also expect a second wave of robotic surgery given technological advances. In our experience, the operational leverage impact of new products is often underestimated.
Utilisation levels remain elevated for the healthcare industry with significant waiting lists. This is true for most countries and largely stems from the impact of Covid. For example, the number of patients waiting for consultant-led elective care in the UK National Health Service was between two and four million for 2010-20. This has now risen to eight million, although other estimates are up to 11 million. Whatever the precise level, this will be a tailwind for the industry for some time to come. An additional factor behind the increases is the aging population who retired at 65 around 10 years ago – research shows that the prime need for elective procedures is around 75 so demographics are also driving higher utilisation rates.
We also expect ongoing consolidation in the healthcare industry. This will be accretive to growth and returns as companies develop their research pipelines and develop positions in complementary technologies. M&A is a defensive requirement for the large pharmaceutical and large biotechnology subsectors with $150bn of product revenues facing patent expiry between 2025 and 2030 – 20% of total industry revenues. This is an unhelpful headwind, but the sector has demonstrated that it can deliver consistent mid-value M&A. While the terms vary, takeover premiums of greater than 50% are not unusual.
Other longer-term industry dynamics include demand in emerging markets and preventative healthcare, i.e. treating diseases before they lead to debilitating, and expensive to treat, long-term conditions. Emerging markets have long been seen as a potential driver of global healthcare returns as populations, incomes and wealth grow, but the point of realisation has arrived. Between 2014 and 2040, global healthcare expenditure is forecast to increase from $9.2trn to $24trn. The upside in emerging markets is with China and India set to deliver 7.7% and 5.5% annualised per capita spending growth respectively over this period.
The critical ingredients appear to be in place for a new bull market in healthcare.
Crucially, there are also good opportunities to invest in emerging markets with the market generally underappreciating the number, size and scale of companies. There are around 1,600 listed companies in more than 40 countries across all healthcare subsectors. Capitalised at $1.8trn overall, the average market cap is $1.1bn.
Compelling valuations
With strong fundamentals, the healthcare sector is set for take-off, yet valuations are undemanding and allow for significant upside. On 2024 forward P/Es, the sector is at a discount of c15% to the S&P 500, compared to a long-term average premium of 5-10%. Based on strong year-on-year earnings growth from 2024 to 2025, there is significant upside potential here. However, the bigger opportunity is for earnings upgrades from new product cycles and overall industry utilisation.
Valuations are even more compelling still for small and mid-cap healthcare stocks. These stocks suffered due to the tightening interest rate cycle and this is still waiting to be reversed, despite interest rates now being reduced by central banks. There are some extremely good companies here that we believe are far too cheap given the quality of their businesses and earnings growth profiles.
We are also encouraged by two technical indicators we have followed over many years that are both showing ‘buy’ signals for the sector. The first is the rolling five-year percentage change in relative performance – when this has been bottom decile in the past, it has been a reliable signal of subsequent outperformance. In addition, ETF flows were a strong contrary indicator of subsequent outperformance in 2011-14 and 2021-22. It is offering the same powerful indication now.
Is RFK Jr a risk?
It was a genuine surprise to investors and the healthcare industry that President-elect Trump has nominated Robert F Kennedy Jr to serve as Secretary of Health and Human Services (HSS). However, while it will no doubt lead to unhelpful random headlines and weakness in share prices, the fundamental impact is arguably low – and less than the market’s reaction suggests, in our view.
We can create alarming worst-case scenarios – as the market seems to have done – but in practice we think the likely risk across vaccines, drug pricing and the management of the FDA is more moderate. Indeed, negative price action in the next few weeks, or throughout his period as head of the HHS, may present buying opportunities for informed investors. Again, as active investors who can invest across all healthcare subsectors, market caps and geographies, we can minimise the impact of such risks, even in the case of US healthcare.
Summary
The critical ingredients appear to be in place for a new bull market in healthcare. We remain extremely constructive on the sector, buoyed by these near-term factors. For us, they present a compelling case for investing in healthcare now in readiness for the slowdown in US GDP growth. While the market’s euphoric response to the US election result might take time to play out, thoughtful investors will be ready for the healthcare sector to come back into favour in 2025.
