Vital signs—long/short opportunities in healthcare stocks

These transformative changes, along with a history of low correlations and idiosyncratic return drivers among healthcare stocks, make the sector particularly attractive for long/short managers with specialized expertise. In our view, investing in this highly complex area demands an understanding of scientific and regulatory factors and a web of relationships that exists among healthcare constituents.

During the first part of the current decade, a rising tide lifted all boats, with a large majority of healthcare stocks delivering positive returns, but that regime is starting to shift. For the past two years, the number of stocks turning in negative performance has increased. We believe that, given the many complexities that characterize this large and growing sector, differentiated returns may be the rule rather than the exception going forward, potentially creating an attractive environment for long/short investors for several more years. 

It’s clear to us that some companies will thrive in this new environment, while others will fail to adapt. Successful companies will likely be those that are on the cutting edge of science and technology, facilitate information sharing, or offer high-quality products or services at a lower cost. Companies that get left behind may include providers of undifferentiated products or services, inefficient resource allocators, technology laggards, and business models that are heavily dependent on areas of healthcare where volumes are too high based on current, yet changing, incentives.

Healthcare services comprise many niche areas whose often-narrow functions can be misunderstood by market participants. In addition, this subsegment has had low correlations with other healthcare subsegments, making it a distinct and potentially diversifying opportunity set. Unlike biopharmaceuticals or medical technology companies, healthcare services tend to be local, not global, necessitating segmented research that accounts for local factors. We believe outperformers will be those that provide value, information, and transparency; align incentives; and successfully manage day-to-day business execution. Certain healthcare IT companies, hospital service outsourcers, and low-cost outpatient care providers are likely in this camp. Among the losers, we expect to see certain service providers whose business models are heavily reliant on the patient volume in high-cost settings to be challenged.

Drug development is incredibly expensive and time-consuming. By some estimates, it takes an average of $1 billion to develop a drug and 10 phase 1 drug candidates to yield one marketable product.¹ Success depends on a company’s scientific acumen, target selection, clinical trial design, regulatory expertise, and a global market rollout strategy—including responsible pricing. Over time, a company must be able to fill its pipeline repeatedly with high-potential drug candidates that can sustain future growth as older drugs become obsolete or lose patent protections.

We think innovative drug companies and makers of complex generics and biosimilars should do well; branded drug companies tend to succeed when they introduce novel drugs that address unmet medical needs, substantially improve standards of care, or bring costs down elsewhere in the system. Companies that don't do as well may include those with drugs set to go off patent or with little in their pipeline to offset competitive threats to older, undifferentiated drugs. Finally, short opportunities will likely arise amid clinical trial failures or during periods marked by emotionally charged rhetoric about drug prices, as is often the case during political election cycles.

In this industry, a constant upgrading of innovation is vital, as is scale in disease procedures, which allows companies to offer hospitals both quality and value. In a fee-for-outcome-based system, scale matters more. As more technologies are reimbursed according to preestablished, episode-of-care budgets, hospitals are increasingly looking to extract higher savings from device makers. Reimbursement incentives for doctors and hospitals also influence the prevalence of certain procedures or products, so understanding the complexity of how incentives work is a crucial skill set.

In our view, companies most likely to thrive include those that can provide value to hospitals, either in the form of shorter procedure times or shorter postsurgical hospital stays, or those that offer discounts on bundled products. We believe larger, diversified medical technology companies may be well positioned for this changing marketplace.

Finally, life science technology offers a variety of tools and products that have helped scientists explore biology and manufacture products in novel ways and that are an essential part of the drug discovery process. Understanding how this fragmented market can grow and consolidate is key. 

In our view, while sector-based long/short strategies offer the potential to generate returns in a multitude of market environments, the key to successfully navigating healthcare requires cross-sectional knowledge of contingencies that can affect sentiment and fundamentals, introduce risks and rewards—both real and imagined—and lead to bouts of volatility. Long/short managers have many ways to navigate short-term shifts by varying net exposure, increasing or decreasing exposure to sector or market hedges, and reducing gross exposure when stock-level conviction is low. Ultimately, investors who have extensive, long-term experience in a sector should be able to mitigate risks through both bottom-up and top-down decisions. With healthcare, which has undergone massive growth and profound transformation over the past 20 years—and appears to be continuing on that trajectory today—contextualized understanding of incremental shifts in science, technology, and policy is, in our view, critical for success in long/short investment approaches.    

1 “Global Pharmaceuticals: R&D productivity continues to see upswing—good news for drug investors,” Bernstein, October 2016.