A recession playbook to invest in healthcare subsectors

As inflationary pressures mount and interest rates rise, the odds of a sustained economic slowdown have increased.

Equity markets have responded with a sell-off, but some sectors have outperformed others, including healthcare.

For the year ended June 30, the MSCI World Health Care Index returned -10.3 percent, while the broader MSCI World Index fell about twice as much.

It is not surprising that the healthcare sector is proving resilient. In five downturns in global equities since 2000, the sector’s loss rate has averaged about 51 percent. The downside capture ratio is a statistical measure of an asset’s performance in falling markets.

However, healthcare is also made up of several industries that do not move in parallel. Each is affected differently by rising rates, labor costs, and other macroeconomic trends.

Investors who keep these dynamics in mind can potentially maximize the defensive nature of healthcare while positioning itself for growth when the next economic expansion begins.

Best defence

Managed Healthcare: These companies are among the most defensive in the sector.

For one, insurance policies typically have a one-year term, with the proceeds being invested in short-dated securities that roll over. Rising interest rates often have a positive effect on the profits of these companies.

At the same time, premiums (and thus profits) tend to rise in response to inflationary pressures: health plans negotiate rates for commercial plans a year or two in advance, creating regular opportunities to raise prices or adjust benefits.

A deep recession would negatively impact affordability and patient demand for units. But as labor markets remain tight, we have yet to see that happen.

Distributors and pharmacy benefit managers: The business models of these companies are closely correlated with pharmaceutical price and volume trends.

The pharmaceutical industry tends to be a defensive industry during economic downturns and drug price increases, if they occur, are passed on, resulting in higher profits.

Retail pharmacies could see mixed results if affordability declines, but the impact should be mitigated by the fact that most front-end sales are non-discretionary.

Drug: Pharmaceuticals is one of the more defensive subsectors in healthcare as demand for drugs tends to be inflexible.

With strong balance sheets and strong cash flows, large-cap pharma companies are also less sensitive to rising interest rates. With many levers to pull to reduce spending, these companies are less vulnerable to inflationary pressures.

Defense of the second string

Health care provider: Labor is the biggest input cost for providers like hospitals. Profit margins at these companies fell in the first half of 2022 as wages rose before reimbursement rates could be adjusted.

Higher procurement costs also had a negative impact on profitability. Additionally, healthcare utilization has been slow to return to pre-Covid levels due to staff turnover and consumers prioritizing other spending.

In our view, these headwinds are mostly temporary, but will continue to weigh on the sub-sector for as long as they last.

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Medical devices and technology: Volumes for many medical interventions have yet to return to pre-pandemic levels, and with ongoing nurse shortages, prospects for a better-than-trend recovery have diminished.

Additionally, medical device companies typically experience annual price declines. As suppliers face high wage inflation, profit margins could be at risk.

With this in mind, it’s important for investors to focus on finding companies with sustainable competitive advantages – such as a product that dramatically improves the standard of care or addresses an unmet medical need – and the best pricing power among competitors.

Life Sciences Tools and Services: Unlike medical technology companies, life sciences tools and services companies — which provide analytical tools, instruments, supplies, and services for clinical trials — tend to be price makers, and many have recently been able to pass on above-average price increases.

That should help preserve profit margins in the short term. However, given their relatively higher valuations for the sector, these companies are not without risk.

Longtime breeders

Biotechnology: Early-stage biotech companies — those with pipelines in pre-clinical or early clinical trials — are most vulnerable to slowing economic growth and rising rates.

These companies rely on capital markets to sustain future development, and rising interest rates and risk-off sentiment can threaten funding.

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In this environment, investors may want to favor profitable or early-stage commercial biopharmaceutical companies because they have a broader range of funding options and a better chance of being rewarded by investors for positive pipeline developments.

The good news is that valuations are now unusually cheap. Small- and mid-cap biotech companies entered a bear market well before the broader stock market.

Many small-cap biotechs are now trading below the present value on their balance sheets, creating a rare opportunity to invest at a deep discount in these companies’ long-term growth potential.

Contract research institutes: Rising interest rates have negatively impacted biotech funding and valuations for the sector, which is a key end market for CROs.

Emerging biotech companies account for up to 20 percent of the CRO industry’s backlog.

To date, CROs have continued to report solid new business metrics as the record amount of capital raised by the biotech industry in 2020 and 2021 is still being deployed. However, new business metrics could slow if the current risk-off environment continues.

However, in the longer term, the rate of outsourcing to the CRO industry is expected to increase and we believe investors will continue to have an appetite for scientific advances.

Andy Acker and Meshal Al Faras are with Janus Henderson Investors, a member of the Gulf Capital Market Association

Updated September 27, 2022 at 4:00 am