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Quarter-End Insights

Biopharma Stocks the Most Undervalued in Healthcare

The defensive nature and the relative safety of healthcare stocks are supporting the sector's outperformance.

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As the markets continue to pull back on several macro headwinds and potentially high valuations, the trailing 12-month performance has decelerated, with the Morningstar US Healthcare Index down 1.5%, ahead of the broader equity market’s 11% decline. We believe the defensive nature and the relative safety of healthcare stocks are supporting the outperformance.

Healthcare Performance

Table comparing healthcare performance and U.S. equity performance.
  - Source: World Bank, Morningstar Equity Research. Data as of June 27, 2022.

The war in Ukraine shouldn’t have much of an impact on healthcare stocks, as the sector generates less than 2% of sales in Ukraine and Russia. Further, we expect most of our healthcare coverage (especially firms with moats) will be able to pass along price increases due to any inflationary pressures, given the strong pricing power enjoyed by the sector as a result of patents and high switching costs. Also, the cost of goods sold is generally a very low percentage of sales, further limiting inflationary costs on the margins for the sector.

Additionally, recessionary concerns are increasing as interest rates climb to combat inflation, but healthcare demand is fairly inelastic and holds up well during most recessions. Finally, as recessionary concerns, the war in Ukraine, and inflation have taken the focus of the Biden administration and the U.S. Congress, we don’t expect near-term movement on major U.S. healthcare policy initiatives, which should ease some pricing pressure risk on the Big Biopharma group.

Healthcare Rating Distribution

Chart with star rating distribution by healthcare subindustry.
  - Source: World Bank, Morningstar Equity Research. Data as of June 27, 2022.

We view the healthcare sector as slightly undervalued. Our coverage trades slightly below our overall estimate of intrinsic value, with the median price/fair value at 0.93. We see just over 41 buys in the sector, with over a third of our coverage rated 4 or 5 stars.

Biopharma Sales Were Largely Unaffected by Last Major Recession in 2008-09

Chart showing how biopharma sales performed during recession.
  - Source: World Bank, Morningstar Equity Research. Data as of June 27, 2022.

Biopharma stocks represent one of the must undervalued industries within the healthcare sector. As the macro headwinds weigh on the overall market, we believe the biopharma fundamentals should remain solid. In the last major recession in 2009, biopharma results held steady and we expect a similar outcome if another recession hits. The steady demand for drugs along with the insurance protection that enables payment shouldn’t be overly impacted by economic pressures. The device industry also looks undervalued with the market potentially underappreciating the innovation and switching costs within the space. While device innovation tends to be more evolutionary rather than revolutionary, we see several areas of exponential growth in the device space.

We are particularly intrigued by advancements in liquid biopsies, transcatheter valves, and renal denervation products, which we spotlight as exponential technologies that could significantly move human health prospects forward and support strong gains for the leading companies providing the innovation. However, we continue to urge caution in some diagnostics companies as the market is still likely extrapolating strong recent results (partly driven by the pandemic) too far into the future.

Summary of Exponential Technology Opportunities in Medical Devices and Diagnostics ($B)

Table listing several emerging technologies in medical devices and diagnostics.
  - Source: World Bank, Morningstar Equity Research. Data as of June 27, 2022.

Top Picks

AptarGroup (ATR)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $132
Fair Value Uncertainty: Medium

While narrow-moat Aptar has been facing some pressure from higher input costs and an uneven consumer recovery, we think these headwinds are temporary, and we consider Aptar to be a high-quality business offering opportunity for long-term investors. In our view, a growing presence in Asia, strong switching costs in the prescription market, and high barriers to entry in large-scale pharma packaging support Aptar’s long-term prospects and economic moat. Investors should be prepared for margin and profit variability in the near term due to the ongoing pandemic and high inflation, but we think these cost pressures will mostly subside by 2023. Most of the margin growth we expect is from Aptar returning to a prepandemic margin level, though we also see margin tailwinds from the mix shift toward pharma and some operating leverage.

Illumina (ILMN)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $377
Fair Value Uncertainty: Very High

Illumina represents a growth-at-a-reasonable-price opportunity for investors with a long-term horizon. As the leading provider of genomic sequencing tools, the company should be able to capitalize on the continued expansion of these applications. Also, Illumina owns the Grail liquid biopsy assets, which target a nascent exponential technology opportunity for the earlier detection of cancer. While regulators may eventually force Illumina to unwind the Grail transaction, we suspect the company will be able to hold on to those assets long enough for the market to recognize the significant growth potential. While Illumina may face more competition in its legacy genomic sequencing technology, the factors that determine its economic moat in genomic sequencing—intangible assets and switching costs—may help Illumina generate economic profits for the long run.

Moderna Therapeutics (MRNA)
Star Rating: ★★★★
Economic Moat Rating: None
Fair Value Estimate: $232
Fair Value Uncertainty: Very High

Moderna shares were on a roller coaster in 2021; we think investors first became overly enthusiastic about the potential of the company's technology but subsequently too bearish on its postcoronavirus growth. While we have modest expectations for sales of the firm’s COVID-19 vaccine following massive pandemic demand in 2021 and 2022, We think Moderna’s technology is particularly well validated in the field of respiratory virus vaccines; the firm’s RSV, seasonal flu, and COVID vaccines could eventually form the basis for a single vaccine, as mRNA technology is well suited for combinations.

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