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Quarter-End Insights

Stock-Picking Increasingly Critical in Health Care

Despite full valuations overall, we do see some opportunities, especially in pharmacy benefit managers.

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  • In aggregate, the health-care sector is fairly valued, but there are a few pockets of opportunities, particularly in pharmacy benefit managers (PBMs).
  • Mergers and acquisitions are intensifying in the pharmaceutical and device industries, as large conglomerates are looking for growth avenues as well as opportunities to cut costs.  
  • Drug development in specialty-care areas, including virology and oncology, is increasing the productivity of drug and biotech companies.  
  • Overall health-care utilization remains tepid, despite passing the worldwide economic downturn by several years, but we continue to expect gradual improvement over the next year.

Strong gains over the past couple of years have led the health-care sector to largely meet our fair value estimates in aggregate. However, in each industry, several stocks offer attractive valuations. In particular, we believe the pharmacy benefit manager industry offers more appealing valuations. In the table below, we highlight a few of our top picks, including two PBMs. Overall, we believe the current environment for health care lends itself to a stock-pickers' market rather than a focus on industries.

In the pharmaceutical and device industries, companies are acquiring and merging to create scale and focus in key strategic areas, in addition to deploying their previously trapped overseas cash, as is the case with the pending acquisition of  Covidien (COV) by  Medtronic (MDT). While the completion of some major acquisitions is still not certain--such as  Valeant's (VRX) bid for  Allergan (AGN) and  Pfizer (PFE) potentially returning to an  AstraZeneca (AZN) bid--we believe the deals show an increased focus by firms to create scale in order to cut costs as well as to concentrate on high-return business lines. The lack of strong pipeline productivity over the past decade is also probably driving some of these firms toward consolidation.

When it comes to innovation in health care, after decades of focus on the primary-care market, the increasing movement of drug companies toward specialty-care areas should increase drug-development productivity. The pipelines of the major biotech and pharmaceutical companies are focused on smaller patient populations in areas such as immunology, virology, and oncology. We believe these areas offer unmet medical need, which should lead to better approval odds and stronger pricing power. Further, despite treating smaller patient populations, these indications can turn into major blockbusters, as shown by  Gilead's (GILD) spectacular launch of virology drug Sovaldi ($2.4 billion in the drug's first quarter on the market).

While the economic downturn passed several years ago, health-care utilization remains tepid. Historically, a lag of a couple of years tends follow a recession before health-care spending returns. However, the magnitude of the recession and increasing cost-sharing with patients has delayed a sharp rebound in health-care use. We expect a gradual increase in demand for health care, but probably not a return to 2007 levels anytime soon.

Top Health-Care Sector Picks
Star Rating Fair Value
Fair Value
Consider Buying
Catamaran $57 Narrow Medium $40
Express Scripts $89 Wide Medium $62
Pharmacyclics $127 None High $76
Data as of 06-23-2014

 Catamaran (CTRX)
Catamaran is the third-largest pharmacy benefit manager, with more than 250 million adjusted claims processed in 2013. The firm was recently formed through the merger of PBM information technology provider SXC Health Solutions and pure-play PBM Catalyst Health Solutions. The company manages the cost of prescription drugs for its clients. Catamaran is poised to produce solid economic profits over an extended period, as its robust claim volume gives it the opportunity to take advantage of two key industry drivers: supplier pricing leverage and centralized cost scale. We believe these factors are underappreciated by the market, making the stock look undervalued.

 Express Scripts (ESRX)
Express Scripts is the largest pharmacy benefit manager in the United States. Through its mail-order pharmacy and network of retail pharmacies, the company manages the cost of prescription drugs for its clients. We expect Express Scripts to administer around 1.5 billion adjusted prescriptions in 2014. In our opinion, market participants are underestimating the long-term growth potential for the firm and overestimating the effects of a maturing industry. Near-term uncertainty regarding the effect of private exchanges in the U.S. upon Express Scripts has also pressured the stock. We believe private exchange health insurance providers will still need the negotiating leverage and pharmacy benefit management expertise of the PBM. Additionally, we believe the pace of movement--and the total number of businesses moving--toward private exchanges will be materially less than what some market participants currently expect.

 Pharmacyclics (PCYC)
Pharmacyclics is a biopharmaceutical company focused on developing and commercializing innovative small-molecule drugs for the treatment of cancer and immune-mediated diseases. Its lead drug, Imbruvica, is partnered with Janssen Biotech ( Johnson & Johnson (JNJ)); it is approved for chronic lymphocytic leukemia and mantle cell lymphoma and in development for several other hematological cancer indications. Pharmacyclics also has two oncology products in Phase II clinical development and several preclinical molecules in lead optimization. We believe the market is undervaluing the potential of Imbruvica. We expect the drug to reach peak sales of more than $6 billion as it expands its label from second-line CLL and MCL to additional types of hematological cancers and to first-line patients.

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