July 21, 2021

How can healthcare
regain momentum?

Guest: Michael Rich, CFA, Research Analyst at Eagle Asset Management

In this episode of Markets in Focus

Vaccine earnings may be transitory, but “I’m optimistic that the setup for the back half of this year will be more constructive” for the healthcare sector, said Michael Rich, CFA, Research Analyst at Eagle Asset Management. Rich joins Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers, to explain the innovations in the works that may provide investor opportunity.

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Matt Orton:
The healthcare sector took center stage earlier last year as the COVID pandemic caused a shutdown of the global economy. Despite questions about the viability of hospitals and the cancellation of elective procedures for extended periods of time, innovation within healthcare technology, strong business models of the major providers, and a surge in speculation around biotechnology helped the sector weather the storm.

Healthcare outperformed in 2020 down the market cap spectrum in both small and mid caps, but large-cap healthcare actually underperformed. And so far in 2021, healthcare is underperforming across the board. I find this to be particularly interesting since political headwinds are abating and earnings have held up very well.

This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights.

Here to help provide some context around the healthcare sector and his thoughts on where there might be some opportunities is Mike Rich, research analyst at Eagle Asset Management who focuses on healthcare and income investing. Mike, thanks for being here today.

Mike Rich:
Thanks, Matt. I appreciate you having me. And that was a great setup there. I totally agree, the healthcare sector overall seems like it's been sort of stuck in limbo here for the last six to 12 months.

And you're absolutely right, healthcare earnings were extremely resilient last year, especially early on in the pandemic. And I think earnings actually grew in 2020 primarily by biotech and pharmaceuticals. And as a result of that resilience, in my opinion, the sector hasn't really been able to participate in the quote, unquote recovery trade. Sure there's been pockets of outperformance within hospitals or life science tools, but when more than 40% of the sector's market cap is in biotech and pharmaceuticals and both of those sectors or sub-sectors are lagging, it makes it tough for the overall sector to outperform.

Meanwhile, you touched on it, the debate around drug pricing was a hot topic earlier this year with the change in the administration, and that definitely weighed on the first half performance. But I'm optimistic here that the setup for the back half of this year is a little bit more constructive. The drug pricing debate has sort of moved onto the back burner here, although there were a few headlines late last week, and then the COVID-19 year-over-year comparisons are going to begin to normalize. So hopefully we're entering a period here where we can potentially get better healthcare equity performance.

Matt Orton:
Yeah, I think that's interesting, earnings did actually grow last year, I think one of very few sectors that saw EPS grow year over year. And so when you look to the back half of the year, are there any particular sectors that you think look really interesting? Healthcare equipment and supplies is an area that I would expect should benefit from a reopening, but what are your thoughts on where there could be opportunity?

Mike Rich:
Yeah, I think you're absolutely right. Med tech in particular has been viewed as one of those spaces that should have benefited from the recovery trade, but hasn't really gotten its mojo back yet. So I'm looking for that to happen in the back half of the year. And as I mentioned, with hopefully the drug pricing debate easing here, I think pharmaceuticals can start to get back on track as well.

Matt Orton:
And so let's dive in a little bit deeper, and I think one of the big subjects around healthcare, pharmaceuticals is the topic of vaccines. And vaccines have been critical for the reopening of the U.S. economy and the global economies, but the impact on the companies producing the vaccines has been pretty inconsistent, to say the least. There were some big moves in the smaller companies, but the moves around some of the major pharma companies was a lot more muted. How do you look at the long-term impact of vaccines on these companies and do you think the potential need for boosters changes anything?

Mike Rich:
Yeah, good questions. I am of the opinion that these are likely to be transitory revenue streams that are not going to produce sustainable earnings. So whether COVID-19 vaccines are around for one to two years or even three to four years, I don't think they're going to be treated by the market as quote, unquote core earnings generators.

So for Pfizer, and even more so for Johnson & Johnson or AstraZeneca, I think investors prefer to look through the near-term contribution from vaccines and instead maybe apply a net present value from the earnings stream.

You're totally right. Moderna's stock in particular has gotten a lot more credit, and I think a big part of that has to do with the company's conviction that messenger RNA is going to be a potentially broader vaccine platform beyond just COVID-19. They're exploring opportunities for seasonal flu and RSV and some other indications. That's going to take years to be vetted, but right now, that's generating some excitement from investors, especially in this SMID (small/mid-cap) realm, and I think that's what's set Moderna's stock performance apart from some of the larger cap stocks.

In the case of boosters, I think Pfizer and Moderna, specifically the mRNA vaccines, do have an opportunity to capture a longer earnings tail from boosters, but a lot still needs to play out before we know for sure. So, so far, the CDC and the FDA haven't really fully supported the notion that boosters are going to be needed. They're still focused on the primary vaccine opportunity, but we have seen some preliminary data that suggests vaccine efficacy against COVID variants, including Delta, suggests that boosters will eventually be needed.

So we'll see how the case numbers shake out and how severity trends play out as we get into the back-to-school timeframe, and then I think we'll have a better idea to what extent we'll need boosters.

Matt Orton:
And I think one other follow-up in this realm as you think about the new technology that's embedded with these mRNA vaccines is the intellectual property around them and being able to leverage that going forward. And I think some of these IP rights have started to come into focus, both with respect to deploying these vaccines globally if you relax these to help get the vaccines out internationally, but also when you look at the patent cliffs for some of the larger biotech and pharma companies, perhaps there's opportunity for mergers and acquisitions. How do you look at all of these issues collectively around intellectual property as potential investments or investment themes going forward?

Mike Rich:
Yeah. Sure. I'll start more specifically on COVID-19 IP and then dig a little deeper or go a little broader.

So as it relates to the COVID-19 vaccine patents and the controversy around sharing that IP with developing countries, there's a couple of arguments as to why that could be problematic. The first has to do with the innovator company's legal right to control and profit from their own inventions, which I totally get. And then the second argument has to do with quality. I'm personally more concerned with that latter argument. I'd be nervous about differences in manufacturing expertise and quality, and then changes to the chain of custody with these products and turning them over to new manufacturers. We've already seen enough issues within the U.S. manufacturing these vaccines, so it's hard to see turning them over to developing countries and assuming that it will go perfectly smoothly.

Bigger picture as it relates to IP, I'd say it's critical to the health of the biopharma industry. So in order for a company to invest the more than $1 billion of R&D needed to develop a new drug, they have to have the assurance that they're going to be granted a certain duration of exclusivity, assuming the drug is safe and effective.

So every now and then, you'll see one of these pricing proposals floating around Washington suggesting that maybe we'll shorten the lives of biopharma patents, but ultimately you don't see these proposals usually go very far, and I think that that's because there's an understanding that with the risk associated with investing in R&D, there needs to be a visible reward.

As it relates to patent cliffs, I think it's a necessary evil when it comes to investing in biopharma. There's some really big ones coming up here in the next two years. AbbVie's Humira and Bristol Myers' Revlimid are two of the biggest drugs on the market and both are going to lose exclusivity within the next two years.

But as a biopharma investor, there's two questions you need to answer thinking about patent cliffs. Question number one is: At what valuation is that patent cliff priced in, and [question number two] at what point in time will the market begin to look past the patent cliff and enable the sentiment on a particular stock to improve?

Matt Orton:
So as you do that and assess some of the opportunities down the market cap space in biopharma, how do you assess some of the potential acquisitions that these companies are making or might potentially be looking at in terms of what might add value?

Mike Rich:
Yeah, that's a great question. I'm going to answer this two ways because you touched on the possibility of shorter patent lives or patent rights being adjusted. If that were to happen, again, I mentioned it's critical to the health of the sector, I think you could potentially see a major reduction in biopharma funding and innovation. You'd essentially be disincentivizing companies to invest in R&D and pursue innovation and you'd probably see fewer startups and companies willing to take risks in exchange for less reward.

On the flip side, you might see smaller biotechs looking to sell or monetize their investment faster in order for certainty, and that would prove to be an opportunity for large caps.

The other way to think about it is, as you mentioned, there are large patent cliffs coming up for some of these large pharma and biotech companies and they're constantly on the hunt for new innovative products to fill the gap or fill the hole in their revenue streams.

The trick with that though is a lot of biopharma companies are chasing similar targets or similar indications. Oncology is very popular right now. And I think the trick is trying to identify those assets in SMID-cap biotech that are differentiated, whether it's a differentiated or first in class method of action, or whether it's differentiated efficacy or safety, something that sets an asset or a molecule apart from the competition. Because like I said, there seems to be a lot of companies chasing the same targets.

Matt Orton:
Right, and I think that's an important point, because when you look at where a lot of acquisitions have happened, it has been in oncology and also lumped in the rare diseases where it's much higher point price point drugs, but easier path to FDA review and/or approval. What does that do to some of the more broad diseases that might be afflicting a population? Do you think the focus on biopharma on a lot of these rare diseases is beneficial long-term or do you think there could be opportunities going forward in some broader afflictions to society overall?

Mike Rich:
Yeah, that's a great point. So for the most part, I don't think the pursuit of rare disease treatments is hindering development of drugs in diseases that treat or that affect broader populations. However, an interesting example is we have seen sort of a dearth of development of new antibiotic treatments or antibacterials, and that's sort of become an issue for the population overall. It hasn't really hit the headlines yet, but it is a concern.

So I think there needs to be a balance between the pursuit of rare disease therapies in order for biotech companies to make money, but also the pursuit of treatments for diseases that affect larger populations. A perfect example, and we can touch on this in more detail if you'd like, but Alzheimer's is a disease that affects six million Americans and we've now finally seen approval of a drug that looks like it might, and keyword there is might, be able to affect or slow the decline of patients with the disease.

Matt Orton:
Yeah, I think, Mike, that could be worth diving into, just because the Alzheimer's drug has made such big headlines. And I think there's a bifurcation of opinion whether it was rushed through or whether there is efficacy to it. Do you think there, there is opportunity in this space going forward? Because I think it's definitely been a nemesis to drug companies up until this point of actually finding a solution that can work.

Mike Rich:
Yeah. I mean, Alzheimer's has been a biopharma graveyard for a long time. And one of the most popular strategies or targets here is the amyloid hypothesis or attempting to clear amyloid plaque from the brain and hopefully that leading to slowing decline in cognition and function in patients with Alzheimer's.

I think the jury is still out to some extent because Biogen's drug aducanumab that has now been approved has had some mixed clinical data in the phase three. One trial worked and one trial clearly did not work. But I think we're going to get the answer to the question as to whether this hypothesis is valid within the next year or two.

So Eli Lilly and Roche are both in the middle of phase three trials for their own drugs that pursue the same mechanism of action. So assuming those trials are able to confirm the amyloid hypothesis, these three companies are going to be splitting a potentially very large market opportunity over the next few years and I think it could lead to even more investment in companies pursuing this space, again, assuming they're successful.

Matt Orton:
Great. So let's turn the focus now into areas where you're specifically looking for investment opportunities going forward. I know we've touched on a few of these earlier in our discussion, but as you look out for the rest of 2021 and beyond, are there any specific sectors or industries that you think have a long runway for potential growth. And also, as you think between large caps and then down the market cap spectrum, are there any differences or nuances that our listeners should be aware of in terms of these themes playing out?

Mike Rich:
Sure. I'll try to break this up by sub-industry. I'm always interested in the therapeutic areas, whether that be medical technology or biopharma because they're always coming up with new ways to treat previously untreatable diseases.

So I'll start with medical devices. There's been a few long-term themes here that I think are likely to continue. The first is miniaturization or making devices smaller and easier or less invasive to implant. And a recent example of that is a leadless pacemaker which has just launched. It's smaller than a AAA battery. It's implanted inside the heart, and that eliminates the need for a surgical pocket. It eliminates the need for electrical leads and reduces the risk of infection. So a smaller device, less invasive, better outcomes.

There's been another trend recently towards remote monitoring or remote programming of devices. So think about either an implantable or a wearable device that can collect and transmit real-time healthcare metrics like your heart rhythm or your blood glucose level to your physician or to a caregiver.

And then I think the next step beyond that is using artificial intelligence or machine learning to quote, unquote close the loop and use that real-time data to automatically deliver or adjust a patient's therapy.

So the closest thing to fruition here is probably in the field of diabetes. You've got a handful of companies are all using wearable continuous glucose monitors and proprietary algorithms to automatically instruct an insulin pump how to deliver insulin. And we're not 100% autonomous yet, but we're getting close. So that's an exciting space.

Two other opportunities that are out there in med tech that I'm interested in that are on the near-term horizon, one is renal denervation, and that we're going to get proof of concept or potentially approvable clinical data in the back half of this year. And this is a minimally invasive intervention to treat resistant hypertension. And then another one would be transcatheter mitral valve replacement. These are two potentially huge markets with millions of addressable patients with suboptimal standards of care currently and these two innovations could be game-changers.

If I shift to therapeutics or biopharma, gene editing has been getting a lot of buzz right now. You've probably seen it in the news, but basically this involves a process called CRISPR and it identifies a problematic disease causing section of a person's genome. It basically cleaves it off or snips it out, and then that deleted section is either repaired or it's replaced with a corrected portion of the genetic code.

And up until recently, clinical work here has been focused on ex vivo treatment, so performing the gene editing in the lab and then reinfusing it back into the patient. But a couple of weeks ago, we got proof of concept data in humans that suggest CRISPR can be performed in vivo or just via an infusion, which would be a much more streamlined process.

So a really exciting time for gene editing. It's not a space that as a large-cap investor I can directly invest in, but it's an area where I would expect large-cap companies to pursue via M&A in the next several years, so something I need to be keeping abreast of. So gene editing is being pursued for a host of rare diseases, sickle cell disease, amyloidosis, and some retinal diseases that cause blindness, but I think there could be opportunities in broader, bigger population diseases as well.

Matt Orton:
And Mike, on the flip side, I would be remiss if I didn't bring up some of the areas that you would want to avoid or perceive as having higher risks. Perhaps you can walk us through some of those just so we can balance the risks along with potential returns.

Mike Rich:
Yeah. I'll preface this with saying there's no space in healthcare that is uninvestible, but there's a couple areas I struggle with and one of those is the healthcare supply chain. I find pharmacies and drug distributors' business models to be a little bit challenging, and that's because their prices and their gross margin seemed to be under perpetual pressure. That means that their organic volume and their SGNA leverage needs to work overtime to offset the gross margin pressure that they're seeing, unless they want to deploy the balance sheet via M&A or a lot of buybacks.

So it's not that these can't be good stocks. Actually, over time and recently, some of the distributors and pharmacies have been good stocks, but you need to pick your spots. And I'm of the opinion that some of the valuations of yesteryear, some of these stocks had mid-teens or higher PEs as few as four or five years ago, but I don't think they necessarily returned to those valuations, but from time to time, you'll see a resurgence in these stocks.

Matt Orton:
And Mike, I know there's one area you haven't touched on, which I'd be curious to get your thoughts, is healthcare providers and services. So especially in the large cap space, the bigger HMOs, some of them have performed quite well throughout 2020 and part of '21. Interestingly, with people getting less surgeries and less elective surgeries, their margins have held up better. Any thoughts on how this block of the market could perform going forward, especially if regulatory headwinds might be quiet for a while?

Mike Rich:
Yeah, I think there's two ways to look at the managed care companies. We'll look at the short term and the long term.

So in the short term, you're absolutely right, earnings for these companies and stock performance to boot have been very strong. We've seen fewer doctor’s visits, fewer surgeries, fewer hospital admissions, which is obviously cushioning the earnings for these companies. But to be fair, in 2020, they didn't fully take advantage of that benefit. They did give a lot of money back to clients in an effort to not take advantage of the pandemic.

Over the long term, I think the opportunity in managed care is diversification. So, the biggest company in the space and they've sort of been the first out of the blocks in this effort, but they have done a great job diversifying their company from strictly a managed care company to a diversified healthcare services company.

At this point, 50% of their earnings comes from their internal healthcare services company that consists of a pharmacy benefit manager, a healthcare data and analytics company, and a healthcare provider. So they've done a really nice job diversifying the earning stream. And on top of that business, the healthcare services business is growing much faster than the traditional managed care company. So there's a nice mix shift component going on as well.

Other companies in this space are pursuing a similar strategy, again, moving into new revenue streams, diversifying the company. And I think that's the name of the game for managed care over the long term, is finding new ways to treat patients, reduce costs to the healthcare system, and ultimately make more money for shareholders.

Matt Orton:
And Mike, I also want to bring up the last area that I had asked about, which is across the market cap spectrum: Which areas do you think could be interesting as you move from large down to mid and into small?

Mike Rich:
Yeah, that's a good question, Matt. I think across the board generally, we've always seen smaller cap companies be the ones that are willing to take the most risk and therefore be the most innovative. So while my strategy is focused on larger cap companies within equity income, like I mentioned earlier, it's always important to stay abreast of new technologies or new therapies that are out there or that are in development.

So I think a focus on small cap within both medical devices and biopharma is an exciting place to be looking and something to be paying attention to.

Matt Orton:
Great. Well, Mike, I really appreciate your time today. This was definitely an insightful discussion. It's a very topical discussion given everything that's going on right now. So thank you very much for your time and thanks to our listeners for tuning in. And until next time, take care.

Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.


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