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 Fund. 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 portfolio? 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 key drivers.