Finding Value in European Healthcare

Despite a dramatic re-rating in valuations over the past several years, we have continued to find value in Europe, especially among pharmaceutical and healthcare firms. Healthcare, which includes pharmaceuticals, medical devices and biotechnology, was recently one of the largest sector overweights among our strategies. As we are bottom-up stock pickers, the overweight position in the healthcare sector has developed over time through a combination of our finding what we view as attractive stocks and the performance of the strategies' portfolios since the end of 2009, rather than by a tactical or thematic decision. Since early 2009, shares of many of our European pharmaceuticals holdings have more than doubled in value, including dividends, due to a significant rerating of their price-to-earnings ratios from depressed levels. In our view, the sector still does not look expensive, and we continue to see value. For example, we have been seeing improving signs of pipeline productivity. Back in 2009, Research and Development (R&D) productivity was on the decline, with many companies investing significant amounts to research new drugs, only to see them fail. We saw a very long period of relatively few drugs coming to market, and those that did struggled to gain market share as they were largely undifferentiated from incumbent products.

Over the past decade, many companies addressed the problem of diminishing R&D productivity, and we are beginning to see their organisational and strategic changes bear fruit. Many firms acknowledged that they were failing in this important function and made dramatic changes to their operations. Firms have been trying to return to a more scientific approach by splitting R&D into areas of specific scientific focus and engaging with the academic, medical and biotech communities rather than taking an "industrialised” view of the development process, which, in our view, had been a significant problem. Most importantly, many R&D groups shifted their focus to biologic and specialty products that targeted diseases with unmet medical need instead of simply developing their own versions of previously successful products. Largely as a result, companies have begun to enjoy higher probabilities of clinical success, less-competitive markets and stronger pricing power, even in Europe where pricing historically has been a headwind.

In our view, the regulatory backdrop is becoming much more favourable, especially in the US market. We are seeing a greater level of beneficial interaction between industry and the US Food and Drug Administration in terms of the design of clinical trials and agreements on relevant data. These factors have, in our view, led to an increase in the probability that any single new product will be successful. We find the potential for volume growth, especially in emerging markets, to be another reason for optimism, even in the face of increasing, pricing pressure. Many major European pharmaceuticals companies were the first to invest, and heavily, in emerging markets.

The volume opportunity in emerging markets from rising Gross Domestic Product (GDP) and ageing populations is so significant that it is, in our view, likely to outweigh the cost consciousness of governments, which are the largest consumers (as payers) of healthcare. We believe volume growth is likely to increase as healthcare spending growth has historically outpaced GDP growth, often by significant margins. Additionally, many governments, especially those of China and until recently, Latin America, have been committed to building out their healthcare infrastructure. Government influence and cost containment in emerging markets is a risk factor to consider, but we still believe that the volume opportunity is likely to outweigh those concerns and be a long-term, secular tailwind for growth for many European pharmaceutical companies.

We are less encouraged by the prospects for growth in European markets. In Europe, governments are the sole payers, and austerity programmes have resulted in an aggressive pursuit of pricing concessions from the pharmaceuticals industry. In the United States, private insurers are still tolerating significant annual price increases, but in Europe, we have been seeing significant price cuts as well as a robust review process to ensure that any new drugs brought to market offer a compelling value proposition relative to current, competing therapies. However, if an innovative new treatment demonstrates such a value proposition, even the austerity-conscious European market is willing to allow pricing that, in our view, yields a favourable return on investment.

The US market is the most profitable market for pharmaceuticals and the healthcare sector in general, due primarily to the pricing power that many firms enjoy in dealing with private insurers and Medicare. Medicare, by law, cannot directly negotiate prices with pharmaceuticals companies, and we do not expect that to change in the near future. Additionally, while private payers are attempting to implement more sophisticated business models to reduce healthcare costs, until the fragmented insurance industry consolidates, which we believe is many years away, we do not anticipate any significant change. Despite the re-ratings for many pharmaceuticals companies, we still think that, on a long-term basis, valuations for European pharmaceuticals firms offer a favourable risk-reward proposition. While these firms are based in Europe and seem to carry a valuation discount because of this fact, their operations are global, with significant business operations in emerging markets and the United States. Due to pricing power, low manufacturing costs and high operating leverage, these companies often generate enormous free cash flow. As we look through the end of this decade, we believe growth, dividends and shareholder returns can lead to healthy returns from these holdings with optionality from the potential contributions of a more robust drug-development pipeline.