The healthcare sector is one of dynamism, where global demographic trends, breakthrough drug developments, and merger and acquisition (M&A) activity can offer diverse sources of alpha. Historically, the sector has provided access to secular long-term growth and has outperformed broader market indexes, including the S&P 500 and Nasdaq, over full market cycles since the late 1990s (Exhibit 1).
Innovation is modernizing the industry, as technology adoption is improving the patient experience and contributing to lower costs. Patients have become more tech savvy and more aware of their own health. At the same time, advancements in the ability to diagnose, monitor, and treat diseases with personalized therapeutics is creating a broad set of investment opportunities.
We believe the current wave of consumerization and innovation is paving the way for a select group of healthcare companies with access to data to generate durable, outsized growth over the next decade. In our view, moves to replace legacy approaches and provide more impactful and efficient care should parallel the evolution of the information technology sector from 2010 to 2020.
Recent Biotech Drawdowns Mirror Technology’s “Dotcom” Era
Similar to technology’s dotcom crash that preceded the sector’s decade-long run of outsized growth, the healthcare sector has experienced recent volatility. The drawdowns in early stage therapeutics are similar to the drawdowns of less mature technology companies in the early 2000s. Performance of the biotech sector resembles that of the technology sector after the 1999 bull market, when it took nearly two years for the Nasdaq to find its footing following the 2000 crash. Exhibit 2 overlays the past three years of performance for the S&P Biotechnology Select Industry Index (2020-2022) relative to the Nasdaq results (1999-2002). As shown below, the historical return patterns closely match, with an approximate 0.9 correlation coefficient.
A Handful of Winners Could Emerge from Recent Volatility
While the technology sector ultimately recovered from the dotcom crash, the recovery was not uniform. Currently, there are a handful of large technology conglomerates with entrenched competitive advantages. Over the long term, we believe the biotech recovery will follow a similar pattern and expect companies with the best science to lead the way, while others simply disappear.
In the near term, though we continue to be bullish on the outlook for select companies in the biotech and therapeutics sub-sectors, our view in aggregate is nuanced and we expect that alpha generation derived from bottom-up stock selection will be paramount. We believe too much public company creation over the past five years fostered an environment where “less-than-ready" companies were vying for capital, thus overly diluting the pool of investible ideas. Mid-cap biotech has been a more interesting source of long ideas for our team, as many of these companies have pipelines and also offer positive EBITDA. These attributes make them more attractive in a rising rate environment and, more importantly, attractive to larger potential "suitors."
Data should also play a crucial function in defining long-term winners in the healthcare sector. Tech-enabled healthcare is the future of the industry and data enables the development of methods to monitor and optimize the delivery of care and also allows physicians to better understand patients. Over time, we expect the healthcare companies that can effectively collect, process, and interpret data to emerge as the industry’s large conglomerates with established competitive advantages.
The Benefits of Long/Short Active Management
Healthcare’s combination of innovation and performance dispersion among individual companies make it a compelling space for skilled active managers to identify attractive long and short positions.
On the innovation front, advances in DNA sequencing, artificial intelligence, and computational biology in the biotech industry have translated into new treatments for chronic diseases such as diabetes and obesity. There are also early signs that more effective obesity treatments are having a positive impact on cardiovascular disease, which is among the world’s deadliest and most costly conditions to treat. For investors, these advancements are creating new opportunities among select pharmaceutical companies that have the depth of resources—including large balance sheets and workforce—to capitalize on this enormous market for cardiovascular treatments and disease prevention.
At the same time, we also expect the biotech industry to remain volatile. Against this backdrop, we believe that experienced long/short managers will have significant opportunities to generate alpha.
Innovation in the sector expands beyond biotech and biopharma companies. For example, a shift towards a value-based care model where costs are directly associated with the quality of the result is encouraging technology investments to increase efficiencies. Healthcare service providers are guiding this evolution through access to patient data and developing methods to monitor and optimize the delivery of care. Additionally, the forward opportunity for medical equipment appears to be improving as reduced concerns about inflation, nurse shortages, the strong dollar, and hospital spending reduce the backlog for surgical procedures. We believe this should provide above historic trend growth for well positioned companies.
In our view, exposure to the healthcare sector can diversify a strategic asset allocation. As we look ahead, we believe the sector can continue to outperform over the long term, as investors place more emphasis on stable company fundamentals and the significant alpha-generation that broad innovation can provide.
A short sale creates the risk of a theoretically unlimited loss. Investing in the health care sector increases vulnerability to economic, political, or regulatory developments affecting this sector. The share prices of health care companies can drop dramatically. Investing in small-and mid-cap stocks may be subject to more erratic market movements and liquidity constraints than large-cap stocks.
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