A recession playbook to invest in healthcare subsectors

The industry has historically performed well during market downturns, but some areas tend to be more defensive than others

Pharma represents one of the more defensive subsectors within healthcare as demand for medicines tends to be inelastic. Photo: Khushnum Bhandari / The National

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

Equity markets have responded with a sell-off, but some sectors have fared better than others, including health care.

For the year to June 30, the MSCI World Health Care Index returned -10.3 per cent, while the broader MSCI World Index declined by roughly twice as much.

That the healthcare sector is proving resilient is not surprising. Across five downturns in global equities since 2000, the sector’s downside capture ratio has averaged about 51 per cent. Downside capture ratio is a statistical measure of an asset’s performance in down markets.

But health care is also made up of multiple industries, which do not move in tandem. Each is affected differently by rising rates, labour costs and other macroeconomic trends.

Investors who keep these dynamics in mind may be able to maximise health care’s defensive nature, while also positioning for growth when the next economic expansion begins.

Best of the defence

Managed health care: these companies are among the most defensive within the sector.

For one, insurance policies typically are one year in length, with proceeds invested in short-duration securities that get rolled over. Rising interest rates are often accretive to these companies’ earnings.

At the same time, premiums (and therefore profits) tend to rise in response to inflationary pressures: health insurance companies negotiate rates for commercial plans one to two years in advance, creating regular opportunities to lift prices or adjust benefits.

A deep recession would have a negative impact on affordability and unit demand by patients. But with labour markets remaining tight, we have yet to see that happen.

Distributors and pharmacy benefit managers: these companies’ business models are tightly correlated with pharmaceutical pricing and volume trends.

Pharma tends to be a defensive industry during economic downturns and drug price increases, should they occur, get passed along, leading to higher profits.

Retail pharmacy could experience mixed results as affordability decreases, but the impact should be mitigated by the fact that most front-end sales are non-discretionary.

Pharmaceuticals: pharma represents one of the more defensive sub-sectors within health care as demand for medicines tends to be inflexible.

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

Second-string defence

Healthcare providers: labour is the largest input cost for providers, such as hospitals. These companies’ profit margins contracted during the first half of 2022 as wages rose before reimbursement rates could be adjusted.

Higher supply costs also had a negative impact on profitability. In addition, healthcare utilisation has been slow to return to pre-Covid levels as a result of workforce turnover and consumers prioritising other spending.

In our view, these headwinds are largely temporary, but will pressure the sub-sector for as long as they persist.

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Medical devices and technology: for many medical procedures, volumes have yet to return to pre-pandemic levels, and with nursing shortages persisting, prospects for an above-trend recovery have diminished.

What’s more, medical device companies typically have year-on-year price depreciation. With providers facing high labour inflation, profit margins could be at risk.

Against that backdrop, it is important for investors to focus on finding companies with sustainable competitive advantages — a product, for example, that drastically improves the standard of care or addresses an unmet medical need — and the best pricing power among peers.

Life sciences tools and services: unlike medical device companies, life sciences tools and services companies — which provide analytical tools, instruments, supplies and clinical trial services — tend to be price makers, and many were recently able to pass on higher-than-normal price increases.

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

Long-term growers

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

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

In this environment, investors may want to favour profitable or early commercial biopharma companies as they have a wider range of financing options and a better chance of being rewarded by investors for positive pipeline developments.

The good news: valuations are now unusually cheap. Small- and mid-cap biotech companies entered into a bear market long before the broader equity market.

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

Contract research organisations: rising interest rates have had a negative impacted on biotech funding and valuations for the sector, which is a key end market for CROs.

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

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 put to work. However, new business metrics could slow if the current risk-off environment persists.

In the long run, though, the rate of outsourcing to the CRO industry is expected to grow, and we believe investors will continue to have an appetite for scientific advancements.

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