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U.S. Equities

Selectivity Drives Success in Health Care Sector

Regulatory concerns weigh, but innovation is accelerating.

Ziad Bakri, CFA, MD, Portfolio Manager

Executive Summary

  • Regulatory worries weighed on the health care sector early in 2019, but the most innovative companies continue to thrive.
  • Drug development is accelerating thanks to genomics and other breakthroughs, and we are seeking to identify potential winners among small and mid‑size companies.
  • We are overweight in the small life sciences tool segment, which historically has tended to outperform late in the market cycle.

After outperforming the broader market in 2018, health care shares struggled for much of the first half of 2019 due to concerns over a possible U.S. “Medicare for all” system and drug price regulation. Breaking down the sector into its component parts reveals a different story, however. Shares in many of the most innovative companies have performed well in recent months. Moreover, we believe companies producing leading‑edge therapeutics and medical devices offer some of the market’s most attractive growth areas for investors with a multiyear horizon.

Our Focus on Innovation

In the Health Sciences Equity Strategy, we look for companies that discover and develop medicines and therapeutic devices that we believe address patients’ unmet needs and can improve their lives. On the services side, we are interested in providers that can offer better access to health care or lower health care costs. While we are sensitive to valuations, we look for companies with sustainable growth rates. Accordingly, many of our holdings—especially those working on promising new medicines—are likely to be regarded as growth stocks. These innovative companies can be found across all subsectors of the health care sector, allowing us to maintain a well‑diversified portfolio.

We also prefer smaller companies, particularly within the therapeutics space, as they tend to benefit more from successful product launches than larger, mature companies. While this approach can increase volatility at the individual stock level due to the binary nature of clinical drug trials, we seek to manage this risk by limiting position sizes. As potential therapies successfully clear clinical hurdles, we may increase our positions as the risks decline.

We believe our large staff of analysts with extensive medical and scientific backgrounds—I personally can draw on my former experience as a physician—gives us an edge in conducting careful fundamental research on firms of all sizes. Company visits, industry conferences, and other research potentially enable us to develop insights into growth drivers that other investors might miss. Our research relies on much more than just our ability to read to a financial statement or go over a balance sheet.

Opening Quote The good news for health care investors is that drug innovation appears to be accelerating... Closing Quote

Genomics Is Driving a New Wave of Drug Development

The good news for health care investors is that drug innovation appears to be accelerating, as evidenced by 59 new drug approvals by the U.S. Food and Drug Administration’s Center for Drug Evaluation and Research (CDER) last year. Progress in gene therapy is an important driver of new drug development. The cost of sequencing an individual’s genome has declined to roughly USD 100, compared with over USD 1 million a little over a decade ago. Companies are taking information gleaned from genomics to develop targeted therapies that can attack cancer cells or pathogens such as viruses while leaving healthy cells untouched. Genomics also helps companies better understand how an individual will respond to a particular drug.

Sage Therapeutics is developing treatments for central nervous system diseases. As of this writing, it is preparing to launch the first‑ever drug for postpartum depression, which afflicts about 10% of all new mothers. The drug involves a new mechanism that can resolve symptoms rapidly—within a day—and provide lasting relief to patients. It could end up treating a variety of forms of depression and even insomnia—potentially multibillion‑dollar markets. With a market capitalization of almost USD 9 billion, Sage is a mid‑cap company. However, we bought it when it was a small‑cap stock.

The falling costs of gene research allow smaller and newer companies to make important advances. We recently sold our position in Spark Therapeutics, which was acquired by Roche Holding in an all‑cash transaction for over USD 4 billion. Founded in 2013, Spark offers a platform for Roche to develop a range of new therapies for genetic conditions such as hemophilia and retinal disease.

With the advent of electronic medical records and the use of powerful software and computing engines to process “big data,” drug companies can also conduct population studies much more quickly and cheaply. Based on the genome sequencing of a single family with very high cholesterol, for example, Amgen and Regeneron Pharmaceuticals have developed powerful new cholesterol‑regulating drugs.

(Fig. 1) New Drug Approvals Are Accelerating
Annual Novel Drug Approvals by the CDER, 2009 Through 2018

Source: U.S. Food and Drug Administration.

Opening Quote While a transition to a single‑payer health care system would indeed upend the health insurance industry, such a change is likely to take years, if it happens at all. Closing Quote

New Devices and Analytical Tools Offer Opportunities

Innovation is also accelerating in the medical devices industry. One standout firm is Intuitive Surgical, maker of the da Vinci surgical system, a minimally invasive surgical robot operated by a doctor sitting nearby. Intuitive’s robots are rapidly being adopted in surgical centers around the world, and we’re excited about the company’s new product line. Robotic surgery is also poised to get a boost from the arrival of lightning‑fast 5G wireless networks, which promises to make operations conducted remotely safer and more common.

The life science tools industry is the smallest sector in both our portfolio and our benchmark (the Lipper Health/Biotechnology Funds Index), but it is one in which we are overweight and where we see good potential. This diverse subsector includes companies that make analytical tools and other equipment, along with a range of clinical and research services. Illumina is the dominant provider of next‑generation DNA sequencing technologies, which we believe is the best long‑term growth driver in the industry. We also like the subsector because it tends to perform well late in the market cycle. Illumina, Danaher, Thermo Fisher Scientific, and other market‑leading companies generate ample cash, which they can use to buy back stock or make acquisitions.

20%

Health care services stocks’ recent discount to the overall market

Service Providers Struggle Under Regulatory Worries, but Opportunities Remain

We have benefited lately from being underweight in the health care services segment, which has come under a cloud of regulatory uncertainty following calls from Bernie Sanders and other presidential candidates for a single‑payer health care system. While a transition to a single‑payer system would indeed upend the health insurance industry, such a change is likely to take years, if it happens at all. The fundamental earnings backdrop for these companies also remains robust. Nevertheless, we expect services stocks may struggle until the results of the Democratic primaries become clear.

Meanwhile, there seems to be broader momentum for increased government support for managed care, and we’re invested in companies—such as Humana, Anthem, and UnitedHealth Group—that offer Medicare Advantage programs. The U.S. likely will need these private companies to manage health care services and costs, whatever share of the cost the government pays. Health care services stocks have recently traded at a roughly 20% discount to the overall market, creating selective opportunities for those of us with the patience to wait for the regulatory turbulence to subside.

While the health care sector faces heightened political risk as the 2020 election cycle approaches, our longer‑term view on the sector remains positive because of tailwinds related to aging populations, clinical needs, and accelerating innovation. However, we believe investors need to be selective and focus on identifying companies developing innovative, game‑changing therapies and those offering cost‑effective, quality health care services that can create value over the long term.

The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for the portfolio, and no assumptions should be made that the securities identified and discussed were or will be profitable.

Key Risks—The following risks are materially relevant to the strategy highlighted in this material:

General Portfolio Risks
Capital Risk—The value of your investment will vary and is not guaranteed. It will be affected by changes in the exchange rate between the base currency of the portfolio and the currency in which you subscribed, if different.
Equity Risk—In general, equities involve higher risks than bonds or money market instruments.
Geographic Concentration Risk—To the extent that a portfolio invests a large portion of its assets in a particular geographic area, its performance will be more strongly affected by events within that area.
Hedging Risk—A portfolio’s attempts to reduce or eliminate certain risks through hedging may not work as intended.
Investment portfolio risk—Investing in portfolios involves certain risks an investor would not face if investing in markets directly.
Management Risk—The investment manager or its designees may at times find their obligations to a portfolio to be in conflict with their obligations to other investment portfolios they manage (although in such cases, all portfolios will be dealt with equitably).
Operational Risk—Operational failures could lead to disruptions of portfolio operations or financial losses.


Important Information

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

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© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

201907‑907320

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