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Here are two health-care sectors worth watching

  • Two key themes likely to outlast headlines are demographics and a renewed emphasis on cost control in health care.
  • Biotech investments offer best of both technology and health-care worlds.
  • The $1.3 trillion managed-care space is a bellwether of, and entry point to, the entire health-care sector for investors.

The noise out of Washington regarding changes to the Affordable Care Act and health care seems to never end. Despite the lingering uncertainty, there are several longer-term industry trends worth highlighting.

For advisors, it's important to spot areas most likely affected by those trends and evaluate whether they represent potential growth opportunities for client portfolios.

A lab worker at Spark Therapeutics in Philadelphia, PA.
Brad Quick | CNBC
A lab worker at Spark Therapeutics in Philadelphia, PA.

Two key themes that are likely to outlast the headlines are demographics and a renewed emphasis on cost control in health-care services, in our view. Specifically, let's look at two health-care sectors that could see the greatest impacts: biotechnology and managed care.

Biotech

From an industry perspective, biotech occupies a unique hybrid position. It's both a tech-like sector, offering secular growth potential, and a health-care sector, with corresponding defensive characteristics.

That defensive position came under attack in 2015 as political rhetoric from both sides zeroed in on perceived unfair drug pricing. Nonetheless, there are two factors worth noting regarding biotech that may make this a good entry point for investors:

1. It is under-owned and undervalued: Historically, biotech has traded off fundamental drivers: drug pipelines, product growth, mergers and acquisitions activity, and patent protection. However, as the 2015 political imbroglio increased drug price uncertainty, investors pulled money broadly out of health care.

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That shift in sentiment has made current valuations more attractive. Over that past 20 years, the price-to-earnings ratio of the Nasdaq Biotechnology Index has averaged 2.3 times the S&P 500 P/E ratio; today, the current ratio is mere 1.3x, a 54 percent discount to its 20-year average (according to Thomson Reuters, as of Sept. 26, 2017.)

2. Long-term drivers are intact: Drug pipelines are notoriously challenging to predict over the short term, given the deep level of medical knowledge required, clinical testing and regulatory review. However, two trends appear supportive over the long-term. First, advances in computational biology, bioinformatics and artificial intelligence are permanent features helping reduce the time and cost of drug development. Second, approval rates by the U.S. Food and Drug Administration have steadily risen over the past two decades, climbing from 23 percent in 1994 to 89 percent and 77 percent in 2014 and 2015, respectively. Biotech's historical drivers currently appear intact, making it one of the rare sectors that enjoys long-term growth potential at a reasonable price.

Managed care

Few industries occupy an intersection as large or as important as managed care. The $1.3 trillion managed-care space is essentially a middleman for the entire health-care sector, helping to manage, improve and lower health-care costs, according to the federal Centers for Medicare and Medicaid Services (CMS).

Given its size (62 percent of addressable health-care spending) and centrality, it's worth examining a number of macro trends that point to long-term growth potential. (Note: Total addressable health-care spending is $2.1 trillion. Managed-care companies service $1.3 trillion [62 percent], leaving an $800 billion untapped market opportunity [$430 billion in Medicare, $386 billion in Medicaid].)

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1. Legislative tailwind: In one of the biggest industry surprises this cycle, the ACA has added over 15 million newly insured and, by most estimates, added roughly $40 billion in recurring industry revenue — turning out to be a tailwind, not a headwind, as feared (according to the CMS.) As a result, equity multiples rebounded alongside improving operating fundamentals. A secondary potential tailwind is tax reform. The managed-care industry faces one of the highest effective tax rates, meaning any tax cuts would likely have a larger benefit to managed care than to other, lower-taxed sectors.

2. Demographics are destiny: Few sectors stand to benefit from aging demographics as much as health care, in our view. More than 10,000 baby boomers age into Medicare each day, and while the commercial market is largely saturated, the federal insurance program remains a high-growth opportunity for the managed care industry. Medicare spending is roughly 20 percent (or roughly $650 billion) of total health-care spending, yet Medicare Advantage (offered by private companies) is only 32 percent penetrated by managed care companies, according to the CMS.

"A complementary focus on biotech and managed care sectors can help advisors build an exposure covering both defensive and growth opportunities."

3. Cost trends: Health-care costs are important to monitor, as they are a revenue source for health-care providers but an expense paid by the managed-care space. The good news is the cost-conscious shift from fee-for-service to fee-for-value should put structural downward pressure on the pace of cost growth. The steady push to higher out-of-pocket costs may also help move consumers towards lower-cost alternatives. Managed care could also stand to benefit from any change to drug pricing, making it a potentially attractive hedge against risks to biotech and pharmaceuticals.

Role in a portfolio

Demographics and managing health-care costs are two long-term trends likely to outweigh political uncertainty, in our view. In an uncertain health-care policy environment, a complementary focus on biotech and managed care sectors can help advisors build an exposure covering both defensive and growth opportunities.

— By Tushar Yadava, investment strategist at BlackRock

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