Posted by Nick Frelinghuysen on January 11th, 2016
For much of the past several years, health care has been a leadership sector contributing positively to S&P 500 performance. A big portion of that positive performance has come from biotechnology as well as large pharmaceutical stocks. The year 2015 was the first moment that some of the growth trends underpinning this multi-year rally have encountered speed bumps. Some of these bumps bear monitoring into 2016 in terms of how we view portfolio positioning within the sector.
The first issue to garner attention in 2015 was Gilead’s Solvaldi/ Harvoni treatments for Hepatitis. The drugs’ pricing became ground zero for a Congressional debate and media focus on US pharmaceutical pricing, given the high cost of the therapy. Despite representing a new ‘cure’ for Hepatitis, pharmaceutical benefit managers (PBMs) took a hard line on Gilead’s pricing and the company was forced to offer steeper discounts and rebates to large purchasers. A second issue: total US prescription drug spending rose 12.2% in 2014 and has continued apace in 2015—these ratesof increase are 5x the 2013 growth rate. Why? US consumers and health care payers were spoiled for several years between 2009-2013 during which there was an unprecedented bolus of patent expiries for some of the nation’s largest drugs by revenue (Lipitor, Plavix, Zyprexa, Nexium, etc.). That significant deflationary benefit has passed. Last, in late 2015, the revelations around Valeant Pharmaceuticals (VRT) practices on drug pricing shenanigans—as well as dramatic price hikes on a number of relatively old topical products acquired in recent acquisitions—created a firestorm in which pharmaceutical company ‘greed’ dominated the news cycle for two weeks. Valeant’s stock fell 70% – sending a chill through the sector. The fact that the company was disproportionately owned by many of the top hedge funds only made the spiral in the stock more dramatic.
Since the passage of the Affordable Care Act, the responsibility for health care costs in the US has begun shifting more toward Medicare and Medicaid. Given these programs are under financial stress, this trend toward ‘public vs private payer’ is directly at odds with the fact that US drug companies have long had an unusual ability to boost prices well beyond the inflation rate even when demand for those drugs is stagnant. The top 30 selling drugs’ wholesale prices in the US have increased by over 60% over the past 5 years. These price increases are 3x the rate of prescription growth. To be fair, some of this growth has been driven by an unusually large influx of new and innovative therapies to treat auto-immune diseases and cancer, but it’s important to make distinctions between what is true ‘value-add’ and just pricing for pricing’s sake.
What does this all mean to us as investors? We believe the pressure to continue to reduce costs within the US health care system is a secular trend—the current pace of pharmaceutical price inflation is not sustainable. Thus, we believe it is critical to focus on areas of the health care food chain where we believe differentiated technology and the ability to reduce costs and improve patients’ lives are key competencies—otherwise you face pricing pressure. Valeant held no interest for us as an investment because the company seemed to possess none of these attributes. Moreover, it followed a ‘roll-up’ strategy in which it used cheap debt to buy smaller companies, starved the companies of R&D and produced little in new innovation. Conversely, we are invested in Edwards Lifesciences (EW) precisely because we believe it IS producing unique products (heart valve replacements specifically) that both improve patients’ lives and represent a technological innovation which is likely better insulated from pricing pressure. We are also researching CVS Pharmacies since it is a direct beneficiary of a demographically driven trend towards growing prescriptions and generics (on which CVS makes better margins). CVS also benefits from being at the leading edge of a push to control drug costs by managing drug formularies and insurance network choices through its Caremark pharmacy benefit manager. Moreover, the company’s rollout of a cheaper, but likely equally efficient, alternative to routine $200 visits to the doctor’s office – the in-store ‘Minute Clinic’ – is also on trend with the move toward lowering health care costs and driving more foot traffic to the stores.
In both cases, these companies have the kind of attributes we are looking for in health care names, where we believe an increased focus on true innovation and cost control will become only more pronounced in terms of what represents value – as well as protection from an increasing focus on reducing US health care costs.