Healthcare Stocks Under the Microscope

Vinay Thapar: Investors in healthcare stocks were disappointed in 2023, as the sector underperformed global markets. But taking a closer look under the sector’s hood reveals a more complex picture. In key industries, earnings growth forecasts are healthy and valuations look attractive. With mega-cap technology stocks driving global equity markets amid excitement over artificial intelligence (AI), other sectors have been left behind. And while AI fueled the market in 2023, the benefit accrued primarily to the technology sector. I think investors have overlooked the opportunities and applications for AI within the healthcare sector, where you can find near-term profit growth resiliency and longer-term AI optionality. From a fundamental standpoint, profitability in the healthcare sector remains solid, growth opportunities abound and the political environment remains manageable.

Vinay: As active investors, we focus on quality businesses that benefit from durable business growth trends across the sector and trade at attractive valuations. These include diagnostics and life-sciences companies that help improve early detection of diseases, and technology companies, which may benefit from introducing AI-driven solutions to improve outcomes not only in medical provision but across the entire healthcare sector. Innovative equipment companies are also developing new ways to improve outcomes, such as through robotic surgery and other types of minimally invasive procedures. Biotechnology stocks are relatively expensive, so investors must be especially careful to ensure that the business and growth profile of a company in this group justifies the price tag. 

Many growth trends in the healthcare sector are driven by the need for efficiency and cost savings in healthcare systems around the world. As a result, I think these trends will persist over time and are unlikely to be derailed by macroeconomic weakness. The key to success for equity investors, in our view, is to invest in business, not science. That means investors should search for healthcare companies with high-quality businesses and avoid predicting the outcomes of scientific research and development, which is notoriously hard to do. Healthcare companies like these are well-equipped to overcome short-term market weakness and provide equity investors with innovative sources of consistent growth for challenging conditions ahead.

Vinay: AI offers tremendous potential to improve the efficiency of the healthcare system by speeding up clinical trials, reducing the administrative burden and improving outcomes through reductions of medical errors. We believe these potential efficiencies are not reflected in the valuations of many companies in the space. Following are some examples of AI innovation that we’re seeing in the healthcare sector. 

In the not-so-distant future, we will likely have AI-powered nursing assistants capable of assisting with illness diagnosis, appointment scheduling and completing outpatient medical charts, saving medical staff many hours of work. 

Another area of opportunity is the more accurate reading of medical images. In a 2020 study, Google demonstrated that its AI algorithm was more effective than experienced radiologists at reading mammogram images to detect cancer, an exciting development that will likely translate into better patient outcomes. 

AI is being introduced in commercial tools by companies including US-based Veeva Systems and Ireland-based ICON. As AI capabilities improve and become more widely used to diagnose disease, we believe companies that offer software as a service for healthcare will enjoy greater demand. Veeva and Japan-based M3 offer a range of software services, from clinical trials to home health monitoring to marketing software for pharmaceutical sales. 

Vinay: When I took over this fund in 2013, our objective was to create an investment process based on a strong belief that when selecting healthcare companies, it’s more important to focus on business fundamentals than trying to predict scientific outcomes. So rather than trying to bet on whether a drug trial will be successful, and the stock price will rise, we invest in companies that already have a profitable business model and proven product range at attractive valuations. Investing effectively in healthcare stocks requires a unique set of skills. Applying a disciplined investment process that integrates the diverse factors that affect healthcare businesses, investors can access sources of strong earnings growth that can help capture long-term return potential in an equity portfolio.

Vinay: Investors often think healthcare stocks are vulnerable to volatility in election years, but the historical record tells a different story. In fact, we believe political uncertainty doesn’t necessarily pose acute risks to the healthcare sector. And if we consider that 10% of global GDP is now spent on healthcare, the sector enjoys a structural tailwind that should pick up momentum as populations age, regardless of short-term policy changes. Even US firms that are more domestically oriented may have business models that are partially sheltered from US regulatory and reimbursement risks. Examples include pick-and-shovel stalwarts that operate behind the scenes to supply drug developers, medical device manufacturers and hospitals. In addition, diagnostics and software services are unlikely to face political pressure, particularly because they can help reduce costs for healthcare systems. Similarly, the AI innovation that I mentioned earlier is a trend that I doubt will be derailed by politics. Finally, we could end up with a divided government again, and this typically reduces the likelihood of passing major new legislation. It also limits the potential for budget cuts that could imperil funding for big agencies like the US Food and Drug Administration and National Institutes of Health.

Vinay: Valuations remain reasonable in healthcare, especially following underperformance in 2023. We believe that by investing in highly profitable businesses, with strong reinvestment opportunities (including AI), investors can generate attractive long-term, risk-adjusted returns. Though macroeconomic growth may affect select subsectors of healthcare, we continue to believe that the economic sensitivity of the sector remains low relative to other sectors, while the innovation potential remains high. Ultimately, I’m confident in our long-held philosophy and process—with the goal of delivering a consistent exposure to profitability and growth—which have proved successful for investors in the past. While the market will continue to debate the ultimate level of interest rates and its impact on the broader economy, we maintain our belief that much of the normalization of rates has already occurred. Given the continued innovation in the sector, combined with strong levels of profitability and less dependence on economic conditions, we continue to believe that the healthcare sector offers compelling long-term opportunities for equity investors.