Beyond the headlines: why healthcare merits an upbeat outlook

With the November 2016 U.S. presidential election drawing closer, public dialogue in the United States about drug pricing has escalated.

Two additional factors have elevated the typical election year din about healthcare to uncomfortably high levels. First, the high-profile cases of unscrupulous behavior by a handful of biopharmaceutical companies came to the public's attention just as the election cycle began. In addition, 2014 was the first year in over a decade in which aggregate spending on pharmaceuticals in the United States grew at a double-digit rate.

Fortunately, these issues are likely behind us, and the spike in spending was most likely a one-time occurrence. Most, if not all, of the companies engaged in outrageous pricing behavior have been punished or fined and their malfeasant practices shut down. Moreover, the vast majority of the 2014 surge in spending can be attributed to just one drug, Gilead's Sovaldi, the first drug to cure-rather than simply treat-hepatitis C.¹ Absent the massive $20 billion launch of Sovaldi and other hepatitis C drugs that followed, the 2014 drug spending increase would have been much closer to average annual growth in total healthcare spending. Over the next decade, the U.S. Centers for Medicare and Medicaid Services expect annual spending on pharmaceuticals to grow in line with total healthcare spending, at about 5% to 7%.

While we expect some of the commotion concerning drug price increases to subside after the U.S. election, we recognize that pharmaceuticals, like all components of healthcare spending, will continue to face reimbursement pressure as the world struggles with escalating healthcare costs. Understanding which companies are better at navigating these pressures has always been a critical component of our investment research, and we do not expect this to change. If anything, as spending on pharmaceuticals skews toward higher-priced specialty drugs that can command more than $10,000 per month for treatment, deliberation of how drugs are priced is likely to intensify. And finally, the value created by breakthrough scientific advances is likely to receive more consideration and scrutiny.

We believe extraordinary breakthroughs in disease treatments will continue to command premium pricing. That said, to afford these novel advances, payers will need to identify ways to save money elsewhere. We see opportunities for savings in multiple areas:

• Escalating pressure on undifferentiated compounds in crowded therapeutic categories will continue to provide a source of savings with the adoption of more stringent managed care techniques, including prior authorization, narrow networks, quantity limits, and restrictions on off-label uses, among others.
• Over the next decade, a large number of biotech drugs will begin to lose patent protection. In the next year alone, innovator compounds generating nearly $60 billion in revenue annually will lose exclusivity.
• New reimbursement models are emerging as the U.S. healthcare system transitions from a fee-for-service model to a fee-for-value model. This transition is meant to better align financial incentives throughout the system by rewarding participants for providing high-quality care as cost effectively as possible, rather than aiming for the greatest economic return. U.S. Medicare and many commercial payers, for example, are already experimenting with ways to make doctors financially indifferent to the type and quantity of drugs they administer to patients.

We remain extremely optimistic about the long-term outlook for the healthcare sector. In the relative calm that should follow the U.S. election, we expect the market to refocus its attention on healthcare's attractive fundamentals in 2017 and beyond. In addition to a biopharmaceutical innovation cycle, powerful demographic tailwinds such as aging populations in developed economies and the growing wealth of emerging-markets populations should escalate demand for healthcare products and services.

Finally, we believe that active management will benefit from a growing divergence in healthcare stock performance, as society seeks ways to more effectively allocate healthcare dollars. The companies that thrive in this new environment will offer groundbreaking innovations or provide high-quality healthcare at a lower cost. However, companies that offer incremental advances or have business models that rely on the exploitation of reimbursement rules and short-term arbitrage opportunities will struggle.

1 This is not a recommendation to buy or sell any security. Solvadi and Gilead are trademarks of Gilead Sciences, Inc. or its related companies.