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Sector Scan: Innovation a key driver of health care success

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The other day, a friend of mine had an unfortunate accident, slipping on the ice going to work and we had to take her to the emergency room. As we waited for treatment, I couldn’t help but notice all the various forms of equipment and the many company logos I recognized from positions held in our portfolios. I realized how much things have changed over the years, with the abundance of new and innovative medical technologies, much of which is made by companies held in our funds and pools.

Innovation is one of the most significant trends driving the health care sector today. In the face of rising costs due to an aging population and higher obesity rates, as well as certain political and legislative risks, the ability to innovate may just separate the companies that thrive from those that don’t.

Healthy life expectancy

At a conference I attended in 2016, University of Oxford Professor Sarah Harper coined the term "healthy life expectancy.” She talked about how people are living longer, but in largely poorer health. In our later years, more of us can expect to live with disabilities and medical issues that not only affect our quality of life but are costly to treat. This is leading to increased demand for health care services and significantly higher costs.

At the same time, global obesity rates are increasing across age groups, putting further stress on an already stressed system.

Political and legislative risk

Walter Scott & Partners Limited, sub-advisor on MD Growth Fund, MD Balanced Fund, MD International Growth Fund and the MDPIM International Equity Pool, says health care providers contend with significant pressure from governments to keep health care costs for patients as low as possible, especially as the population continues to age. This has been putting stress on health care stocks since mid-2016.

Then there are the legislative risks affecting the sector. Walter Scott adds that new branded drug production in some regions has been slowed by a tightening of procedures to ensure very high standards of safety, creating additional costs for drug companies.

And even when patents are in place, they’re sometimes infringed upon. Ignoring foreign patents, India has allowed for generics of some drugs to be used domestically and other countries may follow a similar strategy if faced with a health care crisis in coming years.

Against this backdrop, Walter Scott looks for companies that have a leading position in their market or have cutting-edge technology that help mitigate political and legislative risks, including Roche, Novartis and Novo Nordisk. In Walter Scott’s view, Roche is one of the most innovative companies in the sector, and should continue to play an important role in addressing the world’s unmet medical needs.

Disrupting the model

Janus Capital Group, sub-advisor on MD American Growth Fund and MDPIM U.S. Equity Pool, also focuses on innovation when selecting investments. One example involves three companies outside of health care with the potential to disrupt the sector in the U.S.

Recently, Amazon, Berkshire Hathaway and JPMorgan Chase announced that they were forming an independent health care company to lower costs for their employees. Details of the project have been limited, but over the long term, Janus believes the partnership could create a blueprint for using technology to cut costs and achieve better outcomes in the health care sector.

Mitigating the risks

The concerns above have led to some volatility in the health care sector, but thanks to high regulatory entry barriers and the non-discretionary nature of health care spending, the sector typically enjoys high margins that are stable and low leverage, making it generally a defensive sector. However, the key is to find companies that are most likely to benefit from these barriers or that are willing to adapt and innovate.

For this reason, we have much of our health care allocation to companies in the pharmaceuticals and biotechnology industries that provide medication. These positions range from generic drug specialists like Teva Pharmaceuticals to Regeneron Pharmaceutical, known for its advanced ground-breaking medicines.

Janus believes Regeneron’s newly launched Dupixent addresses an unmet medical need, that the company has a strong technology platform and has a growing pipeline of drug candidates, including a number of clinical-stage immuno-oncology antibodies to treat cancer.

We’re also seeing innovation in health care equipment and services.

Fiduciary Management Inc., sub-advisor on MD American Value Fund, MD Equity Fund and MDPIM U.S. Equity Pool, says Cerner has been a key holding in this field, as government mandates push hospitals and physicians to keep electronic medical records. Cerner also offers revenue-cycle management systems, data hosting and IT outsourcing, which are essential for companies seeking to cut costs and become more efficient.

In health care equipment, we hold Intuitive Surgical, which has developed robots to assist with an increasing number of non-invasive surgeries, measurably improving patient outcomes.

Out-of-sector exposure

Our portfolios also have health care exposure from companies in completely different sectors, including industrial conglomerates and information technology firms. For example, 15% of General Electric’s business is health care, as the company is a leader in diagnostic imaging. Air Liquide, a chemicals company, is one of the largest producers of pharmacopoeia-grade gases used in hospitals and medical clinics.

Also, anyone who has spent any time in a hospital knows smart phones are an essential tool for keeping in contact and updating people, as well as simply helping to pass the time. It’s also interesting to note that there are a plethora of health-related smartphone apps as well as other wearable devices that provide opportunities for prevention by providing feedback and monitoring medically important information. Arguably, the best way to reduce costs in the health care system would be to fix health problems before they become serious and require increased care or hospitalization. On the technology side, Google has health initiatives, including working with Ethicon on advancing surgical robots.

A matter of geography

It’s worth noting that most of our health care holdings are in the U.S., Europe and, to a lesser extent, Japan. Health care doesn’t currently play a significant role in our Canadian or emerging markets equity portfolios. In Canada, opportunities simply haven’t presented themselves. In the emerging markets, however, the rising (and aging) middle class is creating stronger demand for health care services, which is a trend we’ll continue to monitor.

My time in the ER gave me a chance to reflect on how the future of the sector lies in those companies that are willing to innovate to meet new demands, which is where we’ll continue to focus. As for those companies that aren’t willing to innovate? If they’re protected by high barriers to entry, the may do just fine. If not, look for them to struggle in the years to come.

As for my friend, she’ll be in a cast for the next couple of weeks, but should make a full recovery.


About the Author

Mark Fairbairn, CFA, B.Eng., is an Assistant Vice President with the Multi-Asset Management team at MD Financial Management. He is responsible for the non-North American equity funds and pools as well as the currency overlay program within the equity funds.

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