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Quarter-End Insights

Drugmakers, Biotech Pressured by Policy Risk, but We Don't Expect Big Regulatory Changes

We also expect a return to more elective procedures.

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Against the backdrop of easing coronavirus concerns, the Morningstar US Healthcare Index has increased 30% over the trailing 12 months.

Healthcare sector index versus market index. - source: Morningstar

However, healthcare returns have underperformed the broader equity market, which posted a 44% gain during the same period. Concerns about U.S. healthcare policies are probably weighing on some stocks, as the U.S. market represents a disproportionate share of profits for many healthcare companies because of the high prices in the U.S. and large population. But we expect only modest changes due to the complexity of healthcare markets and the Democrats' only slim majority in Congress. Overall, underlying healthcare fundamentals look solid, and we expect an acceleration in growth for several more elective healthcare areas where demand fell as a result of COVID restrictions.

We view the healthcare sector as slightly overvalued following continued market gains. Our coverage trades at a premium to our overall estimate of intrinsic value, with the median price/fair value at 1.11. With the recent market returns, we see fewer buys in the sector, with about 19% of our coverage rated 4 or 5 stars.

Star rating distribution and average P/FV for sector and industry groups. - source: Morningstar

We continue to see the most undervalued firms in the drug and biotech industries. With solid underlying fundamentals of growth in these industries, valuations imply a high degree of risk involving potential changes in U.S. healthcare policies targeting drug prices. While we expect moderate changes in U.S. drug pricing policies, we don’t envision significant changes like international reference pricing due to the strong biopharma lobbying group, concerns around disruption in innovation and lifesaving medicines, Republicans' preference for less interference with market forces, and the complexity of changing drug prices.

As trends continue to reverse from the initial lockdown and providers adapt to the pandemic, we expect strong demand to return for the more elective areas of healthcare like device, dental, life sciences, and hospital industries following the severe pullback in spring 2020. We don’t expect as much change for the biopharma group, where the demand tends to be more insulated from pandemic pressures. In time, we expect a return to a more normal prepandemic market, driven by effective coronavirus vaccines. We believe the U.S. will be close to herd immunity by summer.

Herd immunity in the U.S. likely by mid-2021. - source: Morningstar

We expect the biopharma industry to use the goodwill of creating the vaccine as leverage with non-COVID drug pricing, especially in the U.S., where potential new policies are weighing on valuations.

Top Picks

Merck & Co (MRK)
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $94
Fair Value Uncertainty: Medium

Merck's combination of a wide lineup of high-margin drugs and vaccines along with a pipeline of new drugs should ensure strong returns on invested capital over the long term. Merck is well positioned to gain further entrenchment in immuno-oncology with Keytruda, which holds a strong first-mover advantage in the large first-line non-small-cell lung cancer market with excellent data. Also, we expect Keytruda to gain approvals in early-treatment settings, which should open up underappreciated sales potential. Merck’s vaccines look ready to drive further gains, led by human papillomavirus vaccine Gardasil.

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.

Vertex Pharmaceuticals (VRTX)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $259
Fair Value Uncertainty: Medium

Vertex's cystic fibrosis therapies are poised to dominate the lucrative market for the foreseeable future, based on the disease-modifying potential of the drugs, chronic use by patients, and limited competition. Several of Vertex's leading drugs were mostly developed in-house, lending credibility to its drug discovery technology and potential to generate additional pipeline candidates. Also, the therapies have lengthy patents, protecting the profitable cystic fibrosis portfolio from generics.

Damien Conover does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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