Health care stock picks: Worst performing sector has opportunity

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The tides have turned for the health care sector. In the second half of 2018, health care was the best performing sector in the S&P 500 index, rising 3.7 percent vs a 7.8 percent decline in the S&P 500. So far in 2019, with the market gaining upside momentum, health care has become the worst performing sector, advancing only 4.6 percent through Wednesday, while the S&P 500 is 11.9 percent higher.

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Given the recent trend for M&A in the sector, its valuation discount and ability to provide a hedge in periods of uncertainty or weakness, we were curious if we could find potential opportunities in the health care sector given recent weakness -- to prepare our portfolio for a slower growth environment. Biotech and pharmaceutical companies account for 48 percent of the market capitalization of the overall health care sector and, as such, can be considered key indicators for the direction of the sector.

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Drug approvals continue to rise from the 2016 low, with a record 62 medicines approved by the Food and Drug Administration (FDA) last year. Drug pipeline productivity has benefited from several years of investor support, especially within the biopharma space. Admittedly, the sales potential has declined from 2017’s peak, but with $24 billion in sales expected in 2023 the outcome remains solid.

Additionally, approval times are expected to continue to decline under the Trump administration’s FDA and, as more drugs become approved, sales should receive a boost. Biotech companies and their drugs have grown in popularity as patient demand for their lifesaving therapies continues to rise and pricing power remains intact due to limited competition.

Healthy M&A

These companies have become quite attractive takeover targets as free cash flow has improved over the years and valuations contracted. Health care companies account for a third of the dollar value of all M&A deals announced on a year-to-date basis. These companies are also receiving significant premiums when they are acquired.

On Monday, Thermo Fisher bought Brammer Bio for $1.7 billion. On average, the biotech M&A deals announced this year are receiving a 111 percent premium to the price they traded at one week before the deal announcement. That compares to the 35 percent premium that all M&A deals received year-to-date.

ObamaCare individual mandate

Despite all the buzz around these stocks from an M&A and pipeline perspective, the biotech industry group is about flat at 0.1 percent on a year-to-date basis and the pharmaceuticals industry has increased 4.5 percent, below the health care sector average. The largest valuation discrepancy comes from the biotech industry, which trades at a 23 percent discount to its historic average.

Hospital companies haven’t fared well either given the removal of the individual mandate from ObamaCare and the soaring premiums for health insurance. The Trump administration’s renewed focus on dismantling ObamaCare in its entirety will not bode well for the health care providers and services industry near-term. An economic slowdown could also negatively impact this group more than other areas of health care.

Areas of opportunity

While the health care sector does face some headwinds, at CFRA we think there might be some opportunities within the beaten up sub-industries and view the sector’s defensive nature as a reason to have some exposure to the group.

Stocks to watch: BioMarin Pharmaceuticals and Allergan

CFRA has several Strong Buy (5 STARS) and Buy (4 STARS) rated biotech and pharmaceutical stocks, but two that stand out to me are BioMarin Pharmaceuticals and Allergan.

BioMarin has become increasingly proficient at commercializing and developing rare disease treatments, with six treatments available now and three in late-stages of the pipeline. Financial stability is rare for many biotech companies, but BioMarin posted positive operating cash flow for the first time in 2018 and has over $1 billion in cash and equivalents on hand. CFRA expects 30 percent upside in the stock from here.

Allergan has been a beaten up stock and is now 25 percent off it’s 52-week high. Losing exclusivity on certain drugs, particularly Restasis for dry eyes, has led to a decline in sales. Things could stabilize later this year, however, when promising new drugs move from the development stage to the marketing stage. The company’s flagship aesthetic products, Botox and Juvederm, which account for 30 percent of sales, will also aid in stabilizing the bottom line.

TickerSecurityLastChange%Chg
BMRNBIOMARIN PHARMA75.50+0.50+0.67%
AGNALLERGAN PLC166.00-0.10-0.06%

From a fundamental perspective, the health care sector has a solid track record of beating earnings expectations by a better-than-average margin. Over the next few quarters, it may be more difficult for the sector to provide that type of result as analysts have been less willing to cut expectations for defensive sectors’ earnings in what was a slow-growth first quarter. As the 2020 election heats up and Democrats likely focus on health care as a key policy objective, the sector could see more volatility.

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President Trump will likely continue to beat the drum to remove ObamaCare and oppose any health care solutions from the Democratic presidential hopefuls, increasing political uncertainty for the sector. That being said, we see some bright spots with regard to the sectors' drug pipeline potential, M&A activity and R&D investments. Biotech, pharmaceuticals and life science companies stand to benefit the most.

Lindsey Bell is an investment strategist at CFRA Research. She brings a broad perspective given her background working in investment banking, equity research and on the buy-side for a charitable trust. Lindsey is a frequent commentator on FBN and FNC.