By Lewis Krauskopf
NEW YORK (Reuters) - If 2016 is any guide, pharmaceutical, biotech and other healthcare stocks could be in for a rough summer and fall heading into another round of U.S. elections.
But investors may be able to hedge such risks while remaining in the sector if they are willing to pay a premium for medical product companies outside the pharmaceutical supply chain.
As with the 2016 presidential election, prescription drug costs could become a hot topic as mid-term U.S. Congressional elections near, inflaming investor concerns that prices for medicines may not be sustainable in the face of government and market pressures.
Just on Wednesday, U.S. President Donald Trump said major drug companies would announce price cuts in two weeks, underscoring how the issue remains in the political spotlight.
Shares of pharmaceutical, biotechnology and other companies in the supply chain will be in the cross-hairs of investor unease over a tougher environment for drug pricing. But given their already sluggish performance, many of those stocks trade at relatively discounted levels and are enticing to investors who believe risks from Washington rhetoric or from the election results already are accounted for in share prices.
Shares of other medical product companies, like makers of heart devices, knee replacements or tools for drug research, present healthcare options shielded from pricing attacks. But those stocks generally trade at steeper valuations, based on price-to-earnings ratios.
"There are opportunities within healthcare that really don’t have much concerns they are going to go after pricing," said David Heupel, a healthcare analyst with Thrivent Financial.
But, Heupel added, "there certainly is a price to pay."
ELECTIONS EQUAL VOLATILITY
So far in 2018, the S&P 500 healthcare sector (SPXHC) is down about 0.2 percent against a 1.4 percent increase for the broader S&P 500 (SPX).
The health sector lagged severely in 2016 over concerns of a victory by Democratic presidential candidate Hillary Clinton, who made high drug prices an issue in her campaign against Trump. That year, the healthcare sector dropped nearly 10 percent from Aug. 1 until the Nov. 8 election, versus only a modest overall market drop.
“Elections bring volatility, especially within healthcare," Heupel said. "I don’t think this will be any different."
Healthcare stocks briefly rallied last month after Trump unveiled an administration plan to lower drug costs for consumers that avoided aggressive measures. But some analysts say the plan could cause volatility as details become clear.
Overall this year, shares of pharmaceutical <.SPLRCCARG> and large biotechs <.SPLRBIOT> have slumped 6 percent and 5 percent, respectively. Those companies, along with pharmacy benefit managers, drug wholesalers and others in the supply chain, comprise over half of the sector.
By contrast, healthcare equipment shares overall <.SPLRCMED> are up 10 percent in 2018, with the life science tools and services index <.SPLRCLSCI> up 7 percent, although a couple of company stocks have lagged.
Shares of other companies in the sector, such as health insurer Humana (N:HUM) and lab-testing company Quest Diagnostics (N:DGX), have also climbed this year.
“In the healthcare space, it really depends on where you’re allocated in terms of success," said King Lip, chief investment strategist at Baker Avenue Asset Management. The San Francisco firm's holdings include animal health company Zoetis (N:ZTS) and surgical robot maker Intuitive Surgical (O:ISRG).
Analysts also point to lackluster outlooks for much of large pharma and biotech, with company-specific setbacks afflicting Celgene Corp (O:CELG) and others, versus strong financial results and outlooks by healthcare equipment companies.
GOOD FUNDAMENTALS
"A lot of the medtech stocks, it’s not just that Washington isn’t targeting them," said Teresa McRoberts, healthcare portfolio manager at Fred Alger Management. "Fundamentally, a lot of them do have interesting new products," she said, adding they are beating earnings expectations and raising forecasts.
But buying healthcare stocks away from the prescription pricing glare comes at a cost. The healthcare equipment index, for example, trades at 21.2 times earnings estimate for the next 12 months, according to Thomson Reuters Datastream, 16 percent above its five-year average.
Conversely, pharmaceutical companies trade at 13.7 times forward earnings estimates, 14 percent below their five-year average, with biotech companies at 12.6 times, a nearly 20 percent discount.
Matthew Miskin, market strategist at John Hancock Investments, said he worries about risks facing biotech and pharmaceutical stocks heading into the election, but "you are getting compensated for that risk."
"The market has already priced a lot of that in and these companies are still turning out really good earnings growth and the demographic backdrop isn’t going away," Miskin said, referring to the expanding aging and middle-class population globally.
Some investors shrug off the political risks.
Nathan Thooft, co-head of global asset allocation at Manulife Asset Management, expects healthcare to outperform the broader market over the next year, citing potential deal-making activity and reasonable valuations without much sensitivity to interest rates.
"The headline risks come and go. They are always going to come and go," Thooft said. "But ultimately people will look at this and say these stocks do deserve some attention."