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By Mustafa Sagun, Chief Investment Officer, Principal Global Equities It’s easy to get wrapped up in the headlines when it comes to investing. But for long-term investors, it’s important to separate rhetoric from reality. This was demonstrated most recently in the public outrage over Turing Pharmaceutical’s decision to raise the price virtually overnight on Daraprim, a drug that treats the parasite infection tonoplasmosis, from $13.50 a pill to $750 a pill – an increase of 5,000%. According to industry estimates, drugs such as Daraprim usually see a 3% to 20% annual increase. The decision made on September 21 by the firm was pounced on by presidential candidates, such as Hillary Clinton who proclaimed, “Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.” It wasn’t long before the company reversed course on its product price increase, but nevertheless, the damage had been done as the firm’s decision to increase the price of its product had worked its way into financial markets, particularly impacting healthcare stocks. Since then (September 21 to October 6), the S&P 500 healthcare stocks underperformed the S&P 500 index by about 5%, giving back its year-to-date outperformance. This was mainly driven by ETF selling, as evident from high transaction volumes in key healthcare ETFs (see portfolio insight for more on why ETF selling is an opportunity for fundamental stock pickers). Political rhetoric aside, let’s take a closer look at the reality in this situation to determine if there’s any real negative impact to the fundamentals of healthcare company stocks. The Reality: The reality is that there’s no regulation without legislation. More specifically, there’s no legal way for a sitting president, or any political candidate for that matter, to regulate drug pricing in the United States. Only a change in current laws could do that! And bipartisan legislative action is highly unlikely for at least the next two years or for that matter, perhaps even longer. The other reality is that financial fundamentals are better than ever for biopharmaceutical companies. Business models, product offerings, pipelines, and management quality are considerably better now than they were 10 years ago, resulting in sustainable earnings growth for these companies that is superior to most other sectors of the S&P 500. Another key point is that earnings are stable, as are earnings estimates and guidance. While some stock prices are down more than 20% since mid-summer highs, valuations are attractive and, in fact, quite compelling on a PEG (price earnings per unit of earnings growth) basis. So, the relative underperformance experience cannot be explained by earnings and fundamentals. Rather, the fact of the matter is that short-term concerns, without earnings support, create opportunities for long-term investors. Granted, the healthcare sector has been a long-term winner within the S&P providing a 21% annualized return versus 15% for the S&P 500 since 2012; thus, a pullback is normal. However, we should still recognize that the healthcare sector trades at a lower multiple than the market as a whole while providing higher earnings – two sought out characteristics for fundamental investors. Our healthcare analysts acknowledge that the cloud of uncertainty over drug prices may persist for some time. However, we believe this is an opportunity to take advantage of cheap valuations in companies with improving earnings and fundamentals, as fundamentally nothing has really changed for these companies. They just got cheaper! Portfolio Insight: Focusing on Company Fundamentals As long-term, research-driven fundamental investors, we try to cut through all the rhetoric to focus on the company-specific information that affects earnings and valuations. We believe that it’s important for long-term investors not to paint an entire sector, and every company within that sector, with the same brush. After all, ETF selling by thematic investors is an opportunity for fundamental stock pickers. In other words, a healthcare ETF sells all stocks based on their association to the sector, whereas fundamental investors may buy back a select few due to their superior fundamentals. That’s the essential nature of a bottom-up stock picker; remain calm, stay the course, and focus on sustainable earnings growth that has valuation support. At the end of the day, we seek out opportunities to exploit the behavioral biases that hype and rhetoric create. (click to enlarge) While there are near-term headwinds stemming for the drug price control rhetoric from democratic candidates, fundamentals and earnings have not changed and the recent price weakness has provided further valuation opportunities. Scalper1 News
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