Opportunities in Healthcare Stock
A lower probability of major reform, attractive growth dynamics, strong franchises, and low valuations strengthen the thesis for these stocks, say Dodge and Cox's Charles Pohl and Diana Strandberg.
Opportunities in Healthcare Stock
Dan Culloton: Hi, I am Dan Culloton, associate director of fund analysis at
Morningstar, and I'm here with Diana Strandberg and Charles Pohl
from Dodge & Cox Funds. They have worked on both the Dodge
& Cox International, Dodge and Cox Global and Dodge & Cox
Diana and Charles, thank you for being here today.
Diana Strandberg: Thank you.
Charles Pohl: Thank you for having us.
Dan Culloton: As bottom up global investment managers, you guys have a very
broad view of equity markets all over the globe. To focus in on
healthcare, because there has been a lot of news, obviously, we’ve
got healthcare debate in recent elections. How has the election in
Massachusetts and the effect that has had on the healthcare debate
in Washington affected your view of the healthcare statute, are
they still more attractive, less attractive?
Charles Pohl: Oh, I think it has to improve the situation. We spend a lot of time
over the last year with our healthcare team in Washington, meeting
the various folks involved, trying to understand the impact that the
various different bills would have had on our healthcare holdings. I
think it’s fair to characterize the impact for both the senate and the
house bills would have been negative on our holdings. But in spite
of that anticipation of a negative outcome there, we still thought it
was a very attractive area for investment, and would have been
overweight that are.
The election in Massachusetts has greatly reduce the likelihood
that either of those bills will be passed. And so that’s got to make
the whole investment thesis more attractive, and we’re evaluating
how much more right now.
Dan Culloton: What were some of the other fundamental factors that you let you
do this healthcare overweight in the global, international and stok
Charles Pohl: I think the evaluations on many of these companies had to gotten
to very low levels, probably out of concern on the part of many
market participants that the healthcare reform would do a lot of
damage to their profitability. And we think that many of these
businesses are very strong franchises, has historically been able to
earn very good return on capital, in the pharmaceutical and the
medical device sectors in particular. Patent protection is quite
strong, and really creates good franchise value there. And with
both the aging of the US population, and then on top of that, as the
emerging markets gain in terms of wealth and income, there is a
rapidly expanding demand for better quality healthcare there. And
so, these companies have the ability to expand their revenues and
earnings into those markets as well.
So we see some attractive growth dynamics, strong franchises and
we had quite low evaluations here. So that’s a very attractive
combination to us.
Dan Culloton: In regards to the pharmaceutical stocks, there has been lots of
concern over the years, even before healthcare reform was on the
table, about their ability to develop blockbuster products to replace
things that are going off patent or being challenged by generic
drugs. Is that already priced in the stocks or are there are things in
the pipeline for these companies that can really prove to be
revenue earning generators for them?
Diana Strandberg: We think that the evaluation starting point for many of the worlds
pharmaceutical companies reflects a great deal of pessimism about
what you just pointed. There has been a lack of successful
innovation, really, over the pass decade, and then on top of it, some
very profitable drugs have come off patent, creating earnings at
these companies, and the specter of what regulation might mean.
Starting from very low evaluations, these companies in general are
very, very cash generative businesses. When we look at what
technology is allowing pharmaceutical companies to do in terms of
increased compounds going through their R&D efforts, what we
would call a Dodge & Cox shots on goal without a prediction of
the outcome. That has been steadily rising.
We also look at the fact that there has been consolidation in the
industry, and you now have maybe two handfuls of companies that
stand between innovation and the ultimate customer. And so we
think the world’s pharmaceutical companies are essential in
helping any innovation, whether internal or elsewhere, be able to
develop and get approved, marketed and then into patients hands.
And so that’s still a very, very strong franchise.
Charles mentioned the opportunities in the developing world. And
I want to step back for a moment when we think about valuation in
relation to the fundamentals, when our analysts are looking at
individual businesses, they are thinking about over three to five
year period, what might the financial model look like if things
don’t work out, if innovation doesn’t take place, if growth is
disappointing, if regulation is draconian, and what might that mean
from a valuation and therefore, a potential return perspective for us
from today’s starting point.
When we go through a thought exercise of really stress testing
some of the negatives and discussing them very intensively, the
cash generating power of these business is enough to keep you
pretty patient as a shareholder even if some of these negatives
materialize. We also ask our analyst to think about what are the
financial, what is the profit loss, the cash or the balance sheet look
like if things really do work out. And then what do we think might
be a likely outcome as way to frame our discussions around the
Opportunities in Healthcare Stock
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