2023 was a tough year for healthcare investing, resulting in the sector lagging the broader indices by the widest margin since 1999. We believe the outlook for 2024 is much more favourable as the sector’s valuation is highly compelling, while many of the headwinds are abating.
Companies in the US healthcare sector faced a wide range of challenges in 2023:
- Rising interest rates posed a problem for small/mid cap biotech and medical technology companies for much of the year depressing share prices and hindering access to capital
- Life science tools and contract research organisations were hit by post-Covid inventory reductions and tight research budgets
- In the US, managed care organisations had to deal with declining Medicaid enrolment and rising utilisation rates
- Large-cap biopharmaceutical companies remained under pressure due to patent cliffs and the impending Medicare price negotiations under the Inflation Reduction Act
- The stocks of the broader medical technology industry came under pressure – despite improving operating performance – as investors worried that increasing adoption of highly effective anti-obesity medications would impair long-term commercial markets for device manufacturers.
In fact, had it not been for the significant outperformance of the anti-obesity stocks, the healthcare sector would have been down for the year. Moving into 2024, the outlook is significantly rosier.
Sector valuations at attractive levels
Entering 2024, the healthcare sector is trading more or less in-line with its historical valuation range, but at the low end of its 10-year range relative to the broader market (see Exhibit 1 – S&P healthcare sub-index relative to the S&P 500).
The increasing valuation discount reflects investor uncertainty around the sector’s financial prospects. This was driven by downward revisions predominantly within the life science tools and CRO (Contract Research Organization) industry, fundamental concerns related to the large-cap biopharma industry and, in our view, irrational fears about the long-term viability of medical technology markets.
These factors resulted in significant outflows from the broad sector as investors chased performance in other areas of the market.
The pain was even worse for small/mid (SMID) cap biotechnology and medical technology stocks, where a bear market of more than two years has driven enterprise value to revenue (EV/R) multiples to the bottom end of their 10-year historical ranges (see Exhibits 2 and 3).
We see this as an opportunity for investors as we believe many of the factors that led to healthcare’s underperformance in 2023 are either improving or about to, and because strategic acquirers appear both motivated and financially able to act.
Fundamental backdrop remains positive
Several of the fundamental headwinds to healthcare in 2023 are improving or about to, in our view.
In recent years, medical procedural volumes have been constrained. This was initially due to the pandemic and then by staffing and supply chain issues. In 2023, these constraints began to ease and trends are continuing to improve – a clear positive for medical device manufacturers (and their stocks).
While such constraints worked against managed care stocks in 2023, it could be less of a headwind in 2024 since the insurers can price for trend for the new year.
Meanwhile, the outlook for the much-beleaguered life science tools and CRO industry may be poised for a rebound as post-covid inventory reductions should be nearing their end and biotech capital markets are rebounding.
Lastly, the regulatory backdrop remains very supportive of biotechnology and medical device companies. The evidence for this is the continued high rate of drug approvals (Exhibit 4) and device approvals by the US Food and Drug Administration (FDA) – which is critical for the fundamentals of the most innovative companies in healthcare.
Waning irrationality over anti-obesity medications
Even some of the less fundamental (or at least exaggerated) issues impacting healthcare appear to be waning.
Medical technology stocks came under pressure last August with the release of headline data from the SELECT (placebo control) study. This established that glucagon-like peptide-1 (GLP-1) agonists – a class of medications used to treat type 2 diabetes and, in some cases, obesity – could significantly reduce the risk of cardiovascular events in obese patients without diabetes.
Investors rapidly decided this data indicated that GLP1s represented an existential risk for the med-tech industry. Their concern was based on the assumption that widespread adoption of (and adherence to) GLP1s would significantly reduce risk of stroke, peripheral arterial disease, obstructive sleep apnoea and many other downstream repercussions of obesity.
After the full study details were presented in the autumn and with more time to analyse the situation, investors have grown increasingly comfortable with this risk, such that subsequent studies of these drugs seem less likely to cause a major shift in med-tech share prices.
Other points worth noting here are that:
- These diseases are due to many cumulative factors beyond obesity, for example, age
- The drivers of obesity (unhealthy lifestyles) are showing no signs of going away
- Adherence to medications is nowhere near 100%
- Many other drugs have reduced cardiovascular risks in clinical trials by at least as much as GLP1s without causing a decline in medical technology end markets.
As such, we do not view these drugs as an existential threat to the industry.
M&A activity should remain strong in 2024
2023 was a banner year for mergers & acquisitions (M&A) activity in biotechnology, with around USD 140 billion in announced deals, one of the biggest years on record (Exhibit 5).
We see this trend continuing in 2024 due to rebounding biotech share prices, easing long-term interest rates and the fundamental challenges facing the large cap biopharmaceutical industry.
Approximately one quarter of estimated 2024 large cap biopharma revenue is set to face patent expiry by the end of the decade, while Medicare direct price negotiation (under the Inflation Reduction Act) will likely create another headwind starting in 2026.
Combined with the fact that large cap pipelines are insufficiently deep to replenish this revenue gap these factors create a massive incentive for consolidation. And with the US Federal Trade Commission increasingly scrutinizing larger cap deals the SMID cap biotechnology stocks will be the only way for the industry to fill these revenue gaps.
Importantly, large-cap biopharmaceutical companies have plenty of capacity to execute on M&A.
At present, publicly traded US and European large-cap biopharmaceutical companies are maintaining low leverage debt to earnings before interest depreciation and amortisation (Debt/EBITDA) ratios of below 1.0x, while consensus estimates for EBITDA and free cash flow exceed USD 325 billion and USD 200 billion respectively – even before accounting for the potential firepower of Asian or private companies.
Stabilising interest rate backdrop: a clear positive
Over the last few years, central bank rate rises have pressured valuations for the most innovative pockets of the healthcare sector – SMID cap biotechnology and medical device stocks.
As noted earlier, the EV/revenue multiples for these stocks are near 10-year lows and many biotech stocks are trading below cash.