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Confidence in stocks has started to drain away in spite of a cracking start to the year. The challenge we all face involves three possible scenarios. The first is that we have miraculously escaped a recession and that profits will start growing again in the second half of the year, buoyed by strong employment growth, resilient consumer spending and a resurgent China.
That is the bull case. The bears have two different arguments. Their first is that we have not avoided recession and corporate earnings will sag — probably in the range of 10 to 20 per cent over the next 12 months. The alternative bear case is to accept much of the bull argument but to point to persistently high inflation, which will in turn provoke those hawkish central bankers to keep raising interest rates.
My gut instinct is bearish: I think we have another 10 to 15 per cent still to come off US markets, for instance. This prompts me to make a suggestion: maybe the best way to play these contrasting narratives is to think of sectors you’d want to be invested in whether markets turn bearish or bullish.
One such sector is healthcare. This global sector incorporates two contrasting types of business — boring, large-cap stocks in the pharmaceuticals and healthcare services subsectors, which traditionally provide some defensive qualities if the economy starts to slow. One doesn’t have to think too long and hard about why that might be. Much healthcare spending is not terrifically cyclical.
The more exciting bit of the healthcare spectrum is more bullish, less defensive and frankly more growth-oriented (sporting higher valuation multiples). Biotech stocks are what everyone gets excited about when talking about genomics, CRSPR gene-editing machines and curing cancer.
But beyond biotech there’s also a long tail of interesting healthcare data businesses and medical equipment suppliers, all of which are riding long-term trends such as ageing, more healthcare spending and big data.
Let’s start with the less exciting bit of the spectrum. This is a sector dominated by big pharma, many, but not all, of which are big US companies. In the past few months investors have started fretting about poor earnings growth from these drug majors. In a sense this is the flip side of being defensive — if things don’t look quite so bad with the broader economy, then investors look askance at the defensive qualities of healthcare stocks.
On the brighter side, analysts at Morgan Stanley recently put out a survey of US hospital executives which showed that hospital capital expenditure in 2022 and 2023 was likely to be up by 4 per cent in each year. The survey also revealed that hospital utilisation was likely to be above pre-Covid levels in 2023, driven in part by a return of pent-up demand.
Healthcare stocks tend to be a safe haven during periods of higher than expected inflation, especially if they get stuck in a range between 3 and 7 per cent. Vincent Deluard is a strategist for trading services company StoneX and has run numbers showing pharmaceuticals have maintained 15-20 per cent margins over the past 40 years.
“They have almost no exposure to energy and basic material costs: their main expenses are research and development, marketing and lobbying . . . the US healthcare sector is [also] monopolistic or oligopolistic with great price-gouging pricing power. Inflation in drugs prices and medical services has been twice that of the broad consumer price index in the past 40 years,” Deluard says.
So for defensive investors who don’t buy into the mantra of “don’t panic, inflation is crashing and markets will boom”, healthcare funds might be a sensible spot for your investments. But which funds?
In the table below I’ve summarised recent performance data for a range of actively managed investment trusts — there are three of note — alongside passively managed exchange traded funds (ETFs), most of which invest in the large US healthcare sector alongside a handful of European and world trackers.
The returns suggest that you would probably have been better off investing in a US healthcare sector ETF. I think the Polar Capital Global Healthcare Trust can nonetheless point to an impressive record, although its yield at under 1 per cent is a trifle underwhelming when compared with the 3.7 per cent on offer from the Bellevue Healthcare fund (which is also more mid-cap focused).
By contrast, biotech has had a very tough time in the past few years. Although the sector looked like it might enjoy a better start to 2023, sentiment has soured again in recent weeks. One salutary indicator of this is the Conviction Life Sciences fund, whose putative IPO slated for in late 2022 was pulled in January. Its central argument was that prices for small cap biotech stocks outside the US were near all-time lows. This is true and they have in fact gone lower in recent weeks, with many businesses trading below their net cash.
Indeed, there is some hope that mergers and acquisition activity might pick up this year as more blockbuster drug patents drop away, forcing the big outfits to buy innovative tiddlers. A case in point — only this week Pfizer is rumoured to be about to pounce on SeaGen in a $30bn deal.
If biotech deal flow does pick up we could see biotech funds shoot up in value. In terms of listed funds, there are a handful of funds focused on large to mid-cap stocks such as Biotech Growth Trust (which I have owned in the past), International Biotech and BB Biotech, alongside a clutch of funds that focus much more on private businesses plus a smattering of small-cap minnows. In this latter category we have RTW Ventures, Syncona and Arix — all three of which I own.
These have all had a terrible time in the past two years but if bullish sentiment does return they are primed to benefit. I’d highlight Arix, which has had its fair share of troubles (Neil Woodford on the share register, shareholder activists, management changes) but is now trading at a little over its net cash. In effect by buying the shares now, you’d get a substantial portfolio of private businesses for free.
One last point — the table suggests that in fact most investors would have been much better off investing in a biotech tracker such as the Invesco Nasdaq Biotech index rather than the small-cap/private funds I’ve mentioned above, although the Biotech Growth Trust and International Biotechnology have also kept up and sometimes lapped the ETF.
My bottom line? A two-step strategy might make sense: stick with defensive healthcare large caps for the next year and then switch into biotech as the outlook for the wider economy becomes clearer. But for the adventurous among you, my money is still on the biotech VCs and funds investing in small caps. Valuations are at rock bottom and I suspect the upside is substantial. Just be prepared for a bumpy ride in the short term.
David Stevenson is an active private investor. Email: adventurous@ft.com. Twitter: @advinvestor
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