Healthcare benefits from defensive qualities

In recent months the healthcare sector has shown its defensive characteristics by outperforming the overall market in a difficult environment.

Fernando Luque 16.04.2003
In the first quarter of this year the healthcare sector, as measured by the MSCI Healthcare index, lost 1.5% in dollar terms against a 5.5% decrease in the MSCI World. March was particularly positive for the sector as it gained 2.7% compared with a loss of 0.5% for the overall market. It seems that, as the manager of the ING Healthcare fund has said, the geopolitical and macroeconomic environment favoured the sector’s defensive characteristics.

One aspect of the sector’s defensive qualities is its above average dividend yield. Nowadays it is not easy to find a sector whose main companies have increased their dividends every year since 1998.

But many analysts do not expect excellent results for this first quarter because of the impact of important patents expirations last year. Some big pharmaceutical companies - such as AstraZeneca, Bristol Myers Squibb, Schering-Plough and Wyeth - are expected to deliver significantly lower profits for this period. But as one market analyst commented: “Given that 2002 was so disappointing, 2003 is going to look good on a relative basis”.

One of the most important development in the sector is Pfizer receiving approval from America’s Federal Trade Commission’s for the nearly $60 billion Pharmacia acquisition. Pfizer was indeed one of the best performing shares over the past month with a gain of 4.5%.

But not all the news was positive. HealthSouth, a healthcare services provider, was involved in a new accounting scandal in America. The company’s shares lost almost 97% of their value on March 25th.

Biotech outperformed

The biotechnology sector clearly outperformed the overall market and the broader healthcare sector during March but also over the first quarter of this year. Indeed the Nasdaq Biotech Index gained 3.1% in the first three months of this year compared with a decline of 55% in the MSCI World. During March the difference was also important in favour of the biotech sector as the Nasdaq Biotech index increased by 6.8% while the MSCI World index dropped 0.6%.

The sector benefited from the solid results and outlook provided by the industry leaders. Biogen, for example, rose by almost 13% at the beginning of April after it announced better than expected results for its first quarter. Genentech also reassured the market by saying that it expects double digit earnings per share for the period 2005-2010.

Even if the first quarter results are a little disappointing for the big pharmaceutical companies it is likely that the sector fundamentals will improve. This year’s figures should look relatively good as the bulk of patent expirations took place in 2001 and 2002. It is also expected that an increase in the number of new drug approvals could boost the sector.

Demography is also an important factor to the industry. In three years 30% of the American population will be over 50. This demographic shift will benefit the sector as the bulk of drug spending is for people above this age.

But investors should not forget that the sector could be strongly affected by political decisions. In particular the overhaul of the Medicare programme in America, which provides government health insurance for the elderly, has not yet received congressional approval but will have a tremendous impact on the main pharmaceutical firms. Whether positive or negative will depend on its final implementation – the project is expected to lower the price of some drugs but there could be a positive effect in terms of volume.

Historical ranges

Prospects for the biotech sector look increasingly positive. As Morningstar’s analysts in America commented in a recent report: “Unlike in the late 1990s, when biotech hype led to inflated stock valuations, current market prices are more closely aligned with the firms’ ability to generate near-term cash flow”. The general sentiment is that valuations are more in line with historical ranges.

So investing in a biotech fund can benefit long term investors who want clear exposure to growth. According to Evan McCulloch, the manager of the Franklin Templeton biotech fund, a biotech stock typically becomes profitable two to three years after it launches its flagship drug”. That is why he expects a lot of companies to become profitable by 2005.

There is also positive sentiment regarding the number of drug approvals for this year. Many analysts think that 2003 will see an increase in drug applications and approvals, partly because several prominent new drugs were delayed in 2002.

Another positive point in favour of the biotech sector is that most of the analysts expect more consolidation not only from the big pharmaceutical firms but also from the big biotech companies. Mr McCulloch says that: “In the biotech sector … there are basically two types of companies: companies with no products but lots of cash, and companies with no cash but with a product. Therefore it makes sense for these two types of companies to merge.”

“Moreover, some of the big biotechs are facing weakening drug pipelines, and they will increasingly need new products”. He gives the example of IDEC Pharmaceutical which has recently signed a collaboration with Biogen to co-develop three cancer drugs.

Large pipelines

On the other hand, the biotech sector is not facing the same problems as the large drugmakers. A recent report by Citigroup, an American bank, points out that: “Biotech has one of the largest pipelines…In addition, most patents for biotechnology products do not expire for several years”.

But investors should remember that not all biotech shares face the same risks. The larger biotech firms have plenty of cash but there are also a lot of small companies that need cash. And according to Michael Sjöström, the manager of the Pictet Biotech fund: “The only area of caution remains cash-strapped early-stage companies, which are facing a difficult time in the current market environment”.

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Fernando Luque

Fernando Luque  es el Senior Financial Editor de