putnam white paper: a checkup on the health-care sector

8/3/2019 Putnam white paper: A checkup on the health-care sector

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PUTNAM INVESTMENTS | putnam.com

For any investor constructing a portolio o health-care stocks, a major benet

is the diversity o the subsectors. Health care spans a wide range o industries

globally, each with a unique set o opportunities. The sector continues to playa deensive role in investment portolios, but many o its industries also oer

compelling long-term growth potential. From biotechnology companies ocused

on personalized medicine to drug giants looking or innovative ways to combat

the patent cli, there are many reasons to be optimistic about investment

opportunities in health-care stocks. At the same time, there are many challenges,

not the least o which is investor uncertainty about cuts in government spending

on health care worldwide.

A notable decline in health-care utilization

For investors, the health-care sector has long been known or its deensive char-acteristics. Its sae-haven status oten buoys its stocks through downturns or

pullbacks in more cyclical or discretionary areas, such as automobile-, equipment-,

or construction-related equities. The premise is simple: health-care products and

services tend to stay in demand regardless o economic conditions. Even through

recessionary periods, most people will not orgo important health procedures or

treatments.

Health-care stocks have maintained their deensive nature in recent years,

outperorming the broader market through the global economic downturn o

20082009. And in 2011, the MSCI World Health Care Index has outperormed

the MSCI World Index by 13.60% (as o September 30).

December 2011 White paper

A checkup on the

health-care sector

While utilization trends are

important, the diversity ohealth-care subsectors

ofers investors a range o

growth opportunities.

Challenges such as patent

expirations are prompting

companies to seek new

ways to grow earnings.

The sectors exposure to

government spending and

legislation is one o the

greatest challenges acing

health-care stocks today.

Over the next 10 years,

some o the most

pronounced growth in

health-care spending is

projected or emerging

markets such as China,

India, and Brazil.

Kelsey Chen, Ph.D.

Portfolio Manager, Equity Analyst

Christopher J. Stevo, CFA

Portfolio Manager, Equity Analyst
http://www.putnam.com/


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DECEMBER 2011 | A checkup on the health-care sector

While stocks in the sector have remained relatively

strong, we have seen a notable diversion rom past

patterns o health-care utilization. Following the down-

turn that began in 2008, doctor visits, elective surgeries,

hospital admissions, and lab tests all declined (Figure 1).

While such declines in utilization are not unusual duringeconomic slowdowns, they have been more pronounced

in recent years. Whats more, we have observed this

trend even among those who remained employed and

had health insurance coverage.

While lower utilization puts pressure on some

health-care industries, it can be benecial or other

subsectors. Managed care, or example, has been the

strongest-perorming area in 2011, as lower utilization

helps HMOs keep expenses under control. Low utiliza-

tion has the opposite eect on device makers, drug

companies, and hospitals, all o which ace challenges

when ewer people are spending money on health care.

We expect utilization to remain at these relatively lowlevels while macroeconomic uncertainty persists. Trends

could improve when we see more positive indications

o an economic recovery and a better employment

picture. Over the longer term, as the Patient Protection

and Aordable Care Act takes eect, we anticipate that

millions more people will have access to health insurance,

which should also boost utilization.

Figure 1. Do I really need that surgery? Fewer people sought health-care services

ater the downturn

Patient visits to physicians oces, change rom prior year

-6%

-3%

0%

3%

6%

2011201020092008

Source: IMS Health.


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Health-care reorm: Jitters, then relie

The enactment o the Patient Protection and Aordable

Care Act in March 2010 and the debate preceding

it took its toll on the health-care sector. Investors do

not like uncertainty or surprises, and until recently it had

been dicult to assess the potential impact o health-

care reorm on businesses. As a result, many rms

lowered their earnings guidance in 2010.

In 2011, investors gained some clarity and businesses

had time to digest the numbers and get a better

understanding o the legislations impact on their unda-

mentals. This clarity combined with the belie that

much o the negative sentiment was already priced into

health-care stocks resulted in a relie rally or the

sector in 2011.

Health-care stocks: A tale o two quarters

-15%

-12%

-9%

-6%

-3%

0%

3%

6%

6/30/105/31/104/30/103/31/10

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

6/30/115/31/114/30/113/31/11

Q210

Reform is enacted

investors are nervous

S&P 500 Index

S&P 500 Health Care

Index

Q211

One year later

more clarity and

a relief rally

S&P 500 Index

S&P 500 Health Care

Index

Source: Putnam. The S&P 500 Index is an unmanaged index o common stock perormance. You cannot invest directly in an index. Past perormance is

not indicative o uture results. Perormance shown is not representative o any particular investment. Investing in the health-care sector involves more

risk than investing more broadly.

3

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The macroeconomic challenge: Budget

deicit pressures, political debates

From a macroeconomic and political perspective, the

sectors exposure to government spending and legisla-

tion is one o the greatest challenges acing health-care

stocks today. In 2009 and 2010, ongoing debate around

U.S. health-care reorm took its toll on the sector. Stocks

struggled in the months preceding the passage o the

Patient Protection and Aordable Care Act in March 2010,

and did not begin to recover until investors gained a better

understanding o the legislations impact on business

undamentals. However, just as reorm worries eased, new

concerns emerged related to the U.S. budget decit. With

the potential or more than $1 trillion in budget cuts over

the next decade, Medicare which accounts or a signi-

cant portion o the U.S. budget is particularly vulnerable.

The same pain is being elt in international markets and

in Europe in particular, where debt crises have escalated

and many governments are cutting health-care spending

in an eort to reduce budget decits.

Examining the subsectors

Despite the macroeconomic challenges, investors can nd

an array o growth opportunities across this diverse sector.

At the same time, health-care stocks in most subsectors

are attractively priced. Recent market downturns have led

to historically low valuations, as measured by the S&P 500

Health Care Index (Figure 2). A closer look at the challenges

and opportunities in each industry rom pharmaceu-

ticals and technology to managed care highlights the

long-term potential or health-care equities.

Pharmaceuticals: Pricing power, patents,

and pipelines

Within the pharmaceutical industry, pricing power the

ability o drug companies to maintain or raise prices on

their products is an important consideration. Recently,

pricing power has been an issue or rms with signi-

cant exposure to Europe. Austerity measures in the

region eorts to reduce budget decits have meant

imposing deeper price cuts on pharmaceuticals, which

has hurt some drug stocks. In the United States, drug

companies continue to have quite a bit o pricing power

or truly innovative products, but it is unclear how long

this will continue, given the United Statess own

decit challenges.

Combating the clif

For many pharmaceutical companies, the most signi-

cant headwind in recent years has been the so-called

patent cli. In 2011 and 2012, the patents on many o

the worlds leading drugs are expiring, paving the way

or lower-cost generic drugs. The loss o exclusivity or

these branded drugs many o which are top sellers

could result in signicant revenue losses or their makers.

It is important to note, however, that the patent cli

threat has been widely analyzed and anticipated by

investors and businesses. It has been priced into the

stocks or some time, and the eects o the patent expi-rations have played out as expected. At this point, the

most important observation to make about the patent

issue is that it has prompted companies to nd new ways

to sustain their long-term growth.

We have been analyzing the strategies that companies

have implemented to combat the eects o patent

expirations. In some cases, cost-cutting measures intro-

duced as a result o the recession have meant leaner,

more ecient rms that continue to generate prots.

Attractive valuations are also helping to mitigate thenegative impact o the patent cli. For many companies

in the pharmaceutical sector, we are seeing historically

low P/E ratios along with strong cash fows and attrac-

tive dividend yields.

Progression in the pipeline o

truly innovative drugs, attractive

valuations, and some good news

with late-stage clinical trials or

high-proile companies have all

brought positive momentum to

pharmaceutical stocks.


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Whats in the pipeline?

A key driver o growth or pharmaceutical rms is the

pipeline new drugs that are in development, testing,

or clinical trials. An important component o our analysis

is the quality o a companys pipeline, and particularly

the late-stage pipeline drugs that have progressedthrough the rigors o clinical trials. Recently, the early

FDA approval o several truly innovative drugs has

brought positive momentum to the industry, and we

are optimistic that pipelines are shaping up to help drug

companies combat the patent cli.

Another way or drug companies to enhance late-stage

pipelines is by collaborating with biotechnology compa-

nies either by partnering to develop new products or

through mergers and acquisitions. Today, many large

pharmaceutical companies have healthy balance sheets

and strong cash fows, and we expect some will put that

cash to work by either acquiring or orming partnerships

with biotechnology companies with promising pipelines.

In recent years, pharmaceutical M&A activity has been

slow, due in part to the uncertainty o the macroeco-

nomic environment. In the long term, however, the drive

to make acquisitions and expand business may helppharmaceutical companies become more diversied

and create more stable sources o income.

Worldwide expansion

Many o the large, global drug companies are increasing

their ocus on emerging markets to improve their top-

and bottom-line growth as U.S. and European sales slow.

Emerging markets oer signicant growth potential, and

even as pharmaceutical companies cut jobs in the United

States, they are adding to their head counts in emerging

markets to capture growth opportunities.

Figure 2. Health-care valuations are near historic lows

Valuations or companies in the health-care sector have become more attractive in recent years

and have approached historic lows.

5

10

15

20

25

30

35

40

S&P 500 Health Care Index P/E ratioS&P 500 Index P/E ratio

201120102009200820072006200520042003200220012000

P/Eratio(forward12mon

ths)

Source: Morningstar Direct.


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Biotechnology: High-growth potential in small

and mid caps

One o the most exciting aspects o the health-care

sector is the remarkable innovation o biotechnology

companies. Rigorous research and development is

leading to more technologically advanced products

that oer vast improvements in the way illnesses

and diseases are treated. As with the pharmaceutical

industry, the power o the pipeline is a key driver o

growth in biotechnology.

While pharmaceutical rms develop more traditional

chemical-based products, biotechnology companies

work with living organisms to develop drugs and thera-

pies. Biotech companies tend to devote more time and

resources to research and development than traditional

drug manuacturers. Many biotechnology companies,

particularly in the small- and mid-cap space, are not

yet protable. As a result, they are more vulnerable

to market volatility and have struggled in the recent

macroeconomic environment. While robust pipelines

o innovative compounds may oer considerable long-

term growth potential or biotech companies, investors

recently have been less willing to take a risk on the

outcome o clinical trials.

For large-cap biotech companies, we expect growth

to remain slow over the near term, as there is a scarcity

o promising late-stage compounds and an overall lack

o M&A activity. For small- and mid-cap companies,

a wider array o high-growth product opportunities

makes these stocks more attractive in our view in

part because many companies have become appealing

targets or acquisition.

Drug development gets personal

The uture o product development in pharmaceuticals

and biotechnology lies in personalized medicine

which, put simply, is to tailor a drug or compound

based on a persons genetic makeup.

A recent example, approved by the FDA, is a compound

that targets lung cancer patients with a rare genetic

abnormality. While these patients represent a small

portion approximately 5% o the lung-cancer

patient population, directly targeting a specic gene

mutation has boosted the products ecacy. The product,

which is in pill orm, has tested extremely well in shrinking

and stabilizing tumors in these patients.

We are seeing more evidence that pinpointing specic

patient populations helps to improve R&D productivity.Although such personalized products oer benets or

ewer patients, their higher success rates can enhance

pricing power or the companies that develop them.

From biotechnology companies

ocused on personalized

medicine to drug giants lookingor innovative ways to combat

the patent cli, there are many

reasons to be optimistic about

investment opportunities in

health-care stocks.


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The opportunity in generic drugs

Outside the United States, many markets still have rela-

tively low penetration rates or generic drugs. These

drugs can provide signicant cost savings or patients

and health-care systems, and the growth potential in

these markets may represent an attractive investment

opportunity. Increased utilization could benet

companies that specialize in generic drugs, as

well as large pharmaceutical rms that partner

with generic companies or create generic divisions

within their own businesses.

Generic drug use is relatively low in many international markets

0% 20% 40% 60% 80% 100%

United States

Canada

Germany

United Kingdom

Brazil

France

Turkey

Australia

Hungary

Spain

Italy

Japan

81%

89%

75%

24%

40%

46%

50%

41%

51%

65%

52%

71%

Source: IMS Health.

The biotech patent cli

Biosimilars generic versions o biotechnology drugs

also represent an attractive opportunity. An estimated

$86 billion in biotech products will lose patent protection

by 2020, oering substantial potential or companies

that can develop biosimilar products. Barriers to entry

are high in this segment o the market, due to the

complexity o the compounds and the typically lengthy

and challenging approval process.

90% o biotechnology drugs will have gone o patent by 2020

Patents expiring

20162020

Patents expiring

20102015

Patents expired in

2009 or earlier

$93 billion

all biologics

$17

billion

$45

billion

$24

billion

Drugs representing $86 billion in sales will have lost patent protection by 2020

Source: TEVA Pharmaceutical Industries.

7


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Medical technology: Managing product

lie cycles

Declines in utilization trends have dampened the

perormance o medical technology stocks those

o companies that develop devices such as coronary

stents, articial heart valves, and replacement hips

and knees. As volumes have slowed, these companies

have struggled with pricing pressure as they compete

or market share. We believe most medical technology

companies will continue to struggle with slower growth

until utilization trends pick up.

For device companies, rather than the threat o generic

competition, the challenge is product lie cycle manage-

ment ensuring that their devices do not become

obsolete. While medical technology rms dont roll

out brand-new products as requently as biotech

companies, they must continually improve the eatures

o their devices to gain market share and pricing power,

and to ensure that their products continue to oer a

competitive edge.

Managed care: A benefciary o

lower utilization

The global economic downturn and the resulting

decline in utilization o health-care products and

services has been most benecial or managed-care

companies. HMO earnings exceeded estimates in 2011,

and all managed-care companies raised their guidance

or the ull year, driven mainly by lower-than-expected

cost trends a measure o how much businesses are

paying to provide medical services or their employees.

When ewer people visit the doctor, elect to have

surgery, or otherwise cut back on health-related

spending, the result is lower expenses or health insurers.

A recent challenge or managed-care companies was

the eect o the health-care laws medical loss ratio

(MLR) provision. The provision requires companies to

spend 80% to 85% o premium dollars on medical-

care and health-care quality improvement. While still a

concern, it appears that the provision may not be as big a

burden or these companies as initially eared.

Another segment o the health-care services industry

hospitals has not ared as well in the lower-utilization

environment, as declines in patient volumes hurt hospital

revenues. Hospital stocks have also been pressured by

investor worries over potential cuts to Medicare

reimbursements.

For device companies, rather than the threat o generic competition,

the challenge is product lie cycle management ensuring that their

devices do not become obsolete.


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Over the next 10 years, some o the greatest growth in

health-care spending is projected or emerging markets

such as China, India, and Brazil. For many reasons,

growth opportunities are abundant in developing

economies, but selecting health-care stocks, particu-

larly among the smaller-cap companies based in these

regions, is not without its challenges.

Growth opportunities abound as

wealth increases

In rapidly growing economies, rising wealth and higher

levels o disposable income are ueling increasing

demand or medical products and services rom the

same consumers who are buying more homes, cars,

and televisions. As they grow wealthier, many o these

countries are adopting a more western liestyle, with less

physical activity and higher caloric intake. At the same

time, many o these countries have much higher levels o

tobacco consumption. As a result, we are seeing a large,

underserved need or treatments o problems such as

heart disease, diabetes, and smoking-related ailments.

In emerging markets, where GDP is projected to grow

rapidly, we expect that health-care spending will keep

pace with and in some cases exceed GDP growth

(Figure 3).

One example o the need: Diabetes and cancer

in China

China provides a great illustration o the growth poten-

tial o emerging markets. According to the International

Diabetes Federation (IDF), China has more people with

diabetes estimated at 92.4 million than any other

Projected GDP growth, 20102020

Source for projections: 2010 PriceWaterhouseCoopers, LLP.

Brazil

38%

45%62%

100%

140% 115%

167%

57%

USA

India

China

Projected health-care spending growth, 20102020

A large, underserved need in emerging markets

Figure 3. In the United States and many emerging markets, health-care spending is expected to

grow aster than GDP


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nation in the world. At the same time, the IDF estimates

that more than 60% o these diabetics are undiagnosed

and untreated. Also worth noting is the prevalence o

cancer in China. The disease is now the leading cause

o death in Chinas urban and rural areas, ollowed by

cardiovascular and cerebral vascular diseases.1

From2003 to 2008, the number o cancer patients increased

by 56.6%. There is a clear need or prevention and treat-

ment strategies or these diseases, and as wealth in

China grows, so do the opportunities or companies that

provide health-care products and services.

1Ministry o Health o PRC, Citi Investment Research and Analysis.

While higher income levels are prompting individuals

in China to spend more on health care, government

spending is providing an additional boost. In recent

years, the government o China has signicantly

increased its spending in the health-care sector (Figure 4)

and has implemented system reorms to greatly expandhealth insurance coverage. These reorms should lead

to higher expenditures, particularly in areas such as

pharmaceuticals and devices, which bodes well or

health-care companies with exposure to China.

Figure 4. Government health-care spending in China

Annual expenditures in renminbi (RMB)

0

100

200

300

400

500

2011 (through 9/30)201020092008200720062005200420032002

RMB

(billio

n)

Sources: Ministry o Finance, China; Morgan Stanley Research.


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Large multinationals have low exposure to

emerging markets

Compared with other industries, health-care compa-

nies have relatively low exposure to emerging markets.

For example, i you look at sales data or leading global

consumer goods companies, you will nd a signicant

portion o sales in some cases more than 50% are

rom emerging markets. Within the health-care sector,

that concentration is much lower. A French phar-

maceutical giant with one o the highest exposures,

or example, derived only 30% o its 2010 sales rom

emerging markets. And most other global health-care

companies have signicantly less exposure.

Challenges or investors

Investors can gain exposure to emerging markets by

targeting developed companies with exposure to these

regions, or by investing in companies that are based in

emerging markets. Investing in large, established health-

care companies oers many advantages. Their larger

market capitalizations mean their shares are easier to

trade. In addition, most o these companies have solid

corporate governance policies and lower regulatory

compliance risks. On the other hand, they may have

lower growth potential than companies based in

emerging markets.

In many cases, valuations and growth potential are

attractive or emerging-market health-care companies.

However, these stocks pose volatility and liquidity risks,

and they can present greater regulatory compliance

risks because the health-care industry is not as strictly

regulated in these markets. The investable universe o

emerging-market health-care companies is relatively

new; many publicly traded companies have only been

listed in the past ve years or so. Ideally, a diversied

health-care portolio should gain exposure to emerging

markets through a range o developed and developing

market stocks.

Kelsey Chen holds an M.B.A. rom

the Wharton School o the University o

Pennsylvania, a Ph.D. rom the University o

Texas Medical School, and a B.S. rom Wuhan

University in Wuhan, China. She joined Putnam

in 2000 and has been in the investment industrysince 1999.

Christopher J. Stevo has an M.B.A. rom

The University o Chicago Booth School o

Business and a B.S. rom the Wharton School o

the University o Pennsylvania. A CFA charter-

holder, he has been in the investment industry

since he joined Putnam in 1999.


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Putnam Investments | One Post Office Square | Boston, MA 02109 | putnam.com EO140 271575 12/11

All unds involve risk, and you can lose money. See the

prospectus or details.

The views and opinions expressed are those o Kelsey

Chen and Christopher Stevo, are subject to change with

market conditions, and are not meant as investment

advice.

Investors should careully consider the investment

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beore investing. For a prospectus, or a summary

prospectus i available, containing this and other

inormation or any Putnam und or product,

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The inormation provided relates to Putnam Investments

and its aliates, which include The Putnam Advisory

Company, LLC and Putnam Investments Limited.

Issued in the United Kingdom by Putnam Investments

Limited. Putnam Investments Limited is authorized and

regulated by the Financial Services Authority (FSA). This

material is directed exclusively at proessional clients and

eligible counterparties (as dened under the FSA Rules)

who are knowledgeable and experienced in investment

matters. Any investments to which this material relates

are available only to or will be engaged in only with such

persons, and any other persons (including retail clients)

should not act or rely on this material.

Prepared or use with wholesale investors in Australia

by Putnam Investments Australia Pty Limited, ABN,50

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putnam white paper: a checkup on the health-care sector

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