In Healthcare, Drugmakers and Managed-Care Firms Look Attractive

Morningstar's US Healthcare Index has increased 16% over the trailing 12 months, as concerns about the coronavirus and potential major U.S. healthcare policy continue to ease. However, the returns have slightly lagged the 19% gain in the broader equity market. While the largely solid underlying fundamentals of the healthcare sector are likely helping to support the returns, we believe some concerns remain around changes to U.S. healthcare policy, albeit at a lower level than before the November elections. Overall, we don’t expect any major changes regarding healthcare reform, but rather more moderate changes that target insuring more people and easing some of the patient costs around specialty drugs.

Healthcare sector index versus market index - Morningstar

Overall, we view the healthcare sector as slightly overvalued following the spring 2020 market rebound. Our coverage trades at a premium to our overall estimate of intrinsic value, with the median price/fair value at 1.09. With the recent market gains, we see fewer buys in the sector, with around one fifth of our coverage rated 4 or 5 stars. Within the sector, we continue to see the most undervalued firms in the drug manufacturer and managed-care industries. The valuations of these industries seem to imply significant expected changes in U.S. healthcare policies, potentially driven by newly elected politicians. However, we expect only incremental changes to existing laws that shouldn’t have a major impact on the drug or insurance industries.

Star rating distribution and average P/FV - Morningstar

Potential U.S. policy impacts on healthcare industries under Biden - Morningstar

Overall, healthcare firms have adapted well to the coronavirus impact and related economic pressures. The drug and managed-care industries tend to be more insulated from the pandemic pressures as patients continue to prioritize drug therapy and avoid costly elective surgeries that can weigh on managed-care margins. Also, we are seeing demand return for the device, dental, life sciences, and hospital industries following the severe pullback in April and May, as trends reverse from the initial lockdown and providers adapt to the pandemic.

Looking ahead, we believe the drug firms hold the potential to end the pandemic with vaccines. Two leading vaccines from Pfizer and Moderna have shown efficacy rates close to 95%, and we expect them to launch for broad usage in the middle of the first half of 2021, following emergency use authorization in December 2020. We expect the industry to gain a windfall of goodwill to potentially use in U.S. healthcare policy negotiations to support overall drug pricing.

Leading coronavirus vaccine candidates and expected timelines and supply - Morningstar

Top Picks

Biogen (BIIB)
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $346
Fair Value Uncertainty: High

While uncertainty still surrounds Biogen's Alzheimer's platform, we are bullish on the firm's multiple sclerosis drugs and strong neurology entrenchment. Biogen leads the $20 billion global MS market with Avonex, Plegridy, Tysabri, Ocrevus (royalties) and Tecfidera, and the launch of Vumerity partly protects the Tecfidera franchise from generic headwinds in the U.S. Biogen's neurology portfolio outside of MS, including Spinraza and pipeline therapies for several neurological diseases including Parkinson's, ALS, and Alzheimer's, should help diversify revenue and boost sales growth.

Biomarin Pharmaceutical (BMRN)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $101
Fair Value Uncertainty: Medium

We view BioMarin as undervalued as the market overreacted to the delayed launch of hemophilia A gene therapy Roctavian. BioMarin's orphan-drug portfolio and strong late-stage pipeline continue to support a narrow moat rating, and despite Roctavian's delay (launch likely in 2022 instead of 2020), we're still bullish on the upcoming launch of achondroplasia drug vosoritide in 2021. In addition, we still think Roctavian data support the drug's safety and long-term efficacy, and competitors are just entering phase 3 trials. Similarly, BioMarin is far ahead of competitors in achondroplasia, which has no approved treatments.

CVS Health (CVS)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $92
Fair Value Uncertainty: Medium

The firm's combination with Aetna should put the company in a much more attractive competitive position as the industry moves toward preferring a more integrated service offering. Investors should benefit from meaningful cost and selling synergies associated with the combination of a leading medical benefits business with the largest PBM and retail pharmacy network in the country. However, the social distancing period caused by the coronavirus is a concern for the retail business, but we don't forecast this as a long-term headwind.