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The global healthcare sector provides goods and services that many of us, quite literally, cannot live without. As discussed in Chapter 2, countries tend to increase healthcare spending as their economies grow. This supports the industry's sales growth and provides a long-term secular tailwind for your portfolio should you invest a portion of your assets in healthcare companies that operate in countries whose economies are growing strongly and that are likely to increase healthcare spending.

Businesses in this sector are regarded as defensive in nature, because many of them generate fairly stable revenue and profitability even in weak economic environments. This is not true of all healthcare companies, though. Some healthcare services are more discretionary in nature than others, and some are dependent on the outcome of a single drug or medical device, which can make the earnings of those businesses much more volatile. Despite having similar sales growth to the market, dividend growth has been above average. Over the past few years, valuations have been somewhat below the market.

The defensive nature of the healthcare sector means that it tends to outperform during bear markets but underperform at the beginning of a new bull market. In this chapter we take a closer look at the six main industry groups in the healthcare sector: (1) biotechnology, (2) healthcare equipment and supplies, (3) healthcare facilities, (4) healthcare services, (5) life science tools and services, and (6) pharmaceuticals.

Biotechnology

Biotechnology companies develop compounds derived from living organisms for the treatment of illnesses and disease. In general, it is best to avoid investing in businesses that do not generate any revenue and many small biotech firms fall into this category. A small position in a company that has a particularly promising drug in development may be okay for investors willing to put in the time to understand clinical trial data. However, it is important to tread carefully since many of these compounds do not get commercialized. Perhaps more than any other industry, buying a basket of biotech companies may be more appropriate from a risk management perspective than investing in only one or two businesses. Larger biotechnology companies, however, often have multiple commercialized compounds that generate predictable earnings, which help insulate the company from periods of economic weakness. Although earnings and share price volatility have been relatively subdued in recent years, both can be high for biotech companies, especially when a new blockbuster drug is in development. The term “blockbuster” refers to a compound with the potential for $1 billion or more in annual sales. There are key differences by region in terms of the size of addressable patient populations across disease and also in terms of pricing dynamics. Other risks faced by the industry include drug pricing pressures in some markets, as well as the potential for less favorable regulatory environments in the future. When industry valuations are depressed there exists a heightened possibility that merger and acquisition (M&A) activity will increase. For companies that are more mature and generate earnings, investors should track revenue by product, gross margins, SG&A expenses, R&D expenses, operating margins, revenues, revenue growth, EPS, and EPS growth. As previously mentioned, keeping up on clinical trial data is important for biotech investors. Good sites to check in the United States include clinicaltrials.gov and PubMed (pubmed.ncbi.nlm.nih.gov). Valuation analysis for biotech companies can be challenging and may be best accomplished through discounted cash flow analysis. For more mature businesses that generate fairly consistent earnings, standard valuation measures such as P/E and EV/EBITDA may be appropriate.

Healthcare Equipment and Supplies

Healthcare equipment and supply companies manufacture a wide variety of devices and supplies used by hospitals and doctors around the world. These companies make everything from surgical equipment, stents, pacemakers, and endoscopes to orthopedic implants and digital imaging systems. Regulatory approval paths and reimbursement grants vary by both region and device. As a result, indications (approvals) and therefore physician adoption may be different across geographies. For example, certain devices may be indicated for a specific use in the United States, but that use may be contraindicated or off-label (not approved) in Europe. Also, pricing strategies can vary by region due to local players’ pricing points and pricing strategies. Healthcare professional shortages (especially nurses) are expected to remain an overhang into the near future. Other economic factors that can impact the industry include supply chain disruptions, raw material costs, labor costs, increasing compensation, healthcare reimbursement changes across hospital inpatients, hospital outpatients, physician payments, and procedure recovery, hospital capital expenditure budgets, R&D reinvestment initiatives (to drive top-line growth), travel (which increases SG&A), tax legislation, and regulatory changes. Important operational metrics that investors should track include sales growth, volume of devices sold, average selling prices, number of sales reps or sales rep adds, sales rep productivity, market share versus other competitors, patient trialing growth versus permanent implant growth, new center adds, per-center cases, and device penetration rates. Important financial metrics include organic revenue growth, gross margin, operating margin, adjusted EBITDA margin, EPS growth, operating leverage, financial leverage, FCF generation, effective tax rates, and net operating losses. Standard valuation measures such as P/E, P/CF, and EV/EBITDA can be used to compare valuations in this industry.

Healthcare Facilities

The healthcare facility industry includes hospital and clinic operators, as well as long-term care facilities. Similar to the healthcare sector as a whole, healthcare facility companies are expected to benefit from growing healthcare spending as economies around the world expand. Economic factors that most impact industry earnings and sales growth include inflation, interest rates, tax benefits, rising case intensity, government budgets for healthcare spending, and changes to reimbursements. Important metrics for investors to follow include inpatient (hospital) admissions, revenue per inpatient admission and revenue per equivalent admission, total inpatient revenue, total hospital revenue, number of hospitals, number of operational and licensed beds, occupancy rate, number of outpatient surgery centers, same-facility admissions growth, square-foot-adjusted admissions growth, revenue per adjusted admission, salaries and benefits as a percentage of revenue, provision for doubtful accounts, operating and EBITDA margins, and leverage (debt/EBITDA). Investors should also note the sources and mix of revenue for healthcare facility operators, favoring companies with a more diverse source of revenue. In the United States, for example, it may be helpful to compare the amount of revenue generated from private insurance to that derived from public insurance (i.e., Medicare and Medicaid). Typically, private insurance revenue is preferred to public insurance revenue since it is less subject to government-controlled pricing. EBITDA (less non–controlling interest) is used for valuation comparisons between firms. Valuation comparisons can be made using the traditional P/E ratio as well as discounted free cash flow.

Healthcare Services

The healthcare services industry includes companies that operate within managed care, retail pharmacy, supply chain and distribution management, and lab services. Telemedicine and internet-based healthcare are emerging opportunities within the industry. Recent entrants into the industry are fueling new innovations aimed at lowering healthcare costs and improving clinical outcomes for patients. There is a trend toward value-based care (VBC), which tries to improve the quality of healthcare and prevent problems before they arise. Most of these improvements are the result of not only better medical tools and devices, but also from enhancements in data management and sharing. Taking a more holistic, data-driven approach and tailoring it to individual patients has allowed companies to make meaningful improvements to patient outcomes. The shift to VBC has been further supported by the adoption of risk-based payment models, where providers are paid a set fee to treat a patient and held accountable for the outcome. This has led to lower hospitalizations, lower medical loss ratios (MLRs), and higher quality scores. Economic factors impacting the industry include GDP growth, inflation, interest rates, government-controlled reimbursement rates (pricing), and healthcare regulation. Potential pricing and regulatory changes are especially important to stay abreast of because the industry is often heavily regulated. For investors focused on the retail pharmacy segment of the industry, store count, generic dispensing rate, revenue per script (generic or branded drug), comparable-store prescription growth, gross profit, and margin (generic or branded drug) and drug price increases are important datapoints to follow. It is important to note that the managed care industry is unique to the United States and not found in other countries. Investors interested in the managed care segment of the industry can monitor the medical care ratio (MCR), Medicare and ex-Medicare membership growth, administrative service fees, and adjusted EPS growth. Standard valuation metrics such as P/E, P/CF, and EV/EBITDA can be used to compare valuations of companies in this industry.

Life Science Tools and Services

Companies in the life sciences and tools industry provide services and tools to support the development of drugs and medical devices. The industry is highly fragmented and experiencing consolidation across all segments. Biopharma, a segment within the industry, continues to lead end market growth driven by novel methods such as cell and gene therapies. Additionally, as drug modalities (methods of application) become more complex, outsourcing will continue to be an attractive option for biopharma companies, and benefit contract research and contract manufacturing organizations (CROs and CMOs) in the process. Within the diagnostics industry segment, new and innovative technologies such as liquid biopsy, early detection, and proteomics continue to remain a focus. Diagnostic companies typically only operate in their respective locale given restrictions related to shipping of biological samples. However, some companies have successfully implemented strategies to sell products outside of their local market that typically involve a kit solution. Economic factors that have a substantial influence on earnings and revenue for life science businesses include interest rates and general inflationary trends (such as commodity and labor costs), regulatory productivity (how quickly new tools and treatments are reviewed and approved), and biopharma and government funding, as well as hospital capital expenditures. Other primary drivers of growth for the industry include aging populations and government support for the academic market, where universities are engaged in developing new therapies. Important metrics for investors to track include sales growth, EBITDA growth, cash burn (how quickly cash is being depleted), revenue per unit, customer adds, volume, installed base, and pull-through. Commonly used measures to assess valuation in this industry include P/E, P/CF, and EV/EBITDA.

Pharmaceuticals

Pharmaceutical (pharma) companies produce chemical compounds to treat disease and improve our health. These companies are considered defensive since many of the drugs produced are essential products for the people who need them. As a result, earnings are relatively predictable for these businesses. However, the earnings power of a pharma company can be materially impacted by the success or failure of a single compound. Drugs under development by the company form its drug pipeline (similar to the biotechnology industry). It is important for investors to monitor each compound as it progresses through clinical trials and is submitted for regulatory approval before it can be administered to patients. New drugs that address a large, unmet need may receive fast-track status and are reviewed more quickly, but most drugs take years to develop and test to ensure their safety and efficacy. Drugs with the potential to generate more than $1 billion in annual sales are often referred to as blockbusters. Existing drugs that are approaching patent expiration are potential risks, as competitors are likely to produce generic drugs at a lower price. Economic factors that have a significant impact on the industry include GDP growth, inflation, interest rates, government healthcare budgets, and changes to pricing and reimbursement rates. Strong and predictable cash flow generation from existing drugs allows most pharma companies to pay attractive dividends, although it is important for businesses in this industry to invest heavily in research and development (R&D) to strengthen their portfolio of patented compounds. Some helpful sites to monitor in the United States include clinicaltrials.gov and PubMed (pubmed.ncbi.nlm.nih.gov). Investors should track revenue by product, gross margins, SG&A margins, R&D, operating margins, EPS, and EPS growth. P/E is a commonly used metric to assess valuation in this industry.