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Health care managed to outperform the S&P 500 last year, especially as the broader market faced waves of volatility. But can the sector keep that momentum going in 2023? Greg Bonnell speaks with Tarik Aeta, Global Health Care Analyst at TD Asset Management, about the outlook going forward.
Greg Bonnell: Health care stocks outperformed the S&P 500 last year, but will that outperformance continue in 2023? Joining us now to discuss his outlook for the sector, Tarik Aeta, Global Health Care Analyst with TD Asset Management. Great to have you back on the program. Let’s start off by talking about that outperformance. Let’s look under the hood. What were some of the winners of last year?
Tarik Aeta: Yeah, so looking under the hood, there’s quite a bit of divergence. So the winners were the pharma and biotech companies. They were up in the low-double digits driven by mid-single digit EPS growth, but also valuation gains. And really the strong pockets there were companies that have some sector tailwinds behind them, so companies like Novo Nordisk and Eli Lilly, operating in diabetes and obesity, names like Merck that are benefiting from the growth of Keytruda, which is going to be the world’s best selling drug this year, driven — it’s a cancer drug.
Also, beyond the pharma and biotech companies, we saw a strong performance out of the health insurers. They grew earnings 13%, driven by continued growth of Medicare Advantage– that’s health insurance for those over 65– as well as growth in the services business. So you have companies like UnitedHealth going outside their traditional competency of just doing insurance and growing their services businesses over time, as well.
In terms of where the underperformers were, those were mainly the medical device companies. So their earnings were down 4% for the year. And there was a mix of factors. On the volume side, we saw hospital staffing shortages that really weighed down on volumes. That hurt them. And the other thing also hurting them were margins. So you had higher costs for shipping, for commodities, for labor. That weighed on margin. At the same time, they’re stuck under multiyear contracts with hospitals, so they were pressured.
And last but not least, the life science tool companies were also pressured. Their earnings are expected to be down 4% once we get the Q4 results. And their core base businesses are performing well, but on the other side, they saw headwinds from COVID testing volumes declining and demand for COVID vaccine manufacturing equipment declining as well.
Greg Bonnell: All right, so that was the story of 2022. You put a nice little nutshell for us. What about this year? We’re firmly now into 2023. What’s your outlook for the health care sector? What are you taking a look at?
Tarik Aeta: Yeah, so in terms of 2023, I don’t think the health care sector will repeat the same level of outperformance we saw in 2022. And it’s a couple of reasons for this. So first of all, earnings are expected to decline 3% this year, driven by continued headwinds from vaccine demand continuing to decline, antiviral demand continuing to decline, and testing declining.
And also, as well, last year we saw quite a bit of rerating for health care. So health care went from trading at a 20% discount to the S&P 500, and we closed the year with health care trading at a slight premium to the S&P. And you know, that rerating versus the broader market is unlikely to happen again this year.
In terms of where are the most attractive spots in health care, I look at it as a spectrum, so from the left to the right. So in terms of the least attractive, I would say are the health insurers. They had a really good year in 2022, but looking to 2023 with hospital staffing shortages improving, we should see higher demand for elective surgery, higher volumes. That will drive higher claims and will weigh on insurance profits.
Also, at the same time, we are entering into the presidential election cycle over the next two years in the US. That historically weighs on valuation multiples for the health insurers. And we also have potential regulatory risk for Medicaid and Medicare Advantage. So we have to watch that.
In the middle of the spectrum, I would say are the pharma and biotech companies. The ones that are more attractive here, again, will be the ones that are levered to secular growth tailwinds, so the ones that are operating in oncology, so cancer, the ones operating in diabetes, obesity, that have these tailwinds, and stay away from the ones that had a big COVID tailwind the last two years.
And in terms of what can outperform this year, I would say the medical device companies, because we’re really going to see the mirror image of everything that happened last year. So with commodity prices declining, with shipping costs declining, with ship shortages improving, that will improve the margins for the medical device companies. And at the same time with hospitals doing more procedures, it’s going to be more demand for all the products they sell, ranging from heart valves to defibrillators and the rest of it. So they’ll be the one group I would say would do better next year.
Greg Bonnell: What about the dreaded R word, recession? You couldn’t sort of chat with someone near the final months of last year without them saying, it’s either a coin toss or now we see a recession. If that comes to pass, what does that mean for the health care sector?
Tarik Aeta: Yeah, so in terms of recession, the health care sector is typically fairly immune. And the reason for that is even if you look at a health care sector in the US, half of that spending is driven by government programs like Medicare and Medicaid. So whether the economy is doing well or the economy is doing poorly, that demand is going to be there year in, year out.
Historically, in a recession, health care tends to also post negative returns along with the market. But generally, returns do outperform the market, and health care valuation multiples will get pulled down with the rest of the market. But at least that strong base of earnings growth driven by tailwinds of demographics and innovation allows the sector to do better than the broader market.
Greg Bonnell: You mentioned COVID briefly off the top and the fact that, of course, we saw less demand for COVID products last year. What’s the situation with COVID right now? It doesn’t appear that it’s gone away, but what does it mean for the health care sector and those stocks?
Tarik Aeta: So if you look at the fall, we got this triple whammy of COVID, flu, RSV. We saw a wave. Looking to next year– I know people are talking about different variants at the moment, and what potential headwinds those can cause. But in my view, it really ever since last summer, we’ve transitioned from a pandemic stage for COVID to really an endemic stage. So COVID is here with us. It’s here to stay.
And on a go-forward basis, really the goal for vaccination and for antivirals is to protect those that are at highest risk. And even in Canada, every month, we still have 100, 200 Canadians pass due to COVID every month, so it is a real threat. But on a go-forward basis, I don’t expect to see the big, large waves caused by COVID as we’ve seen in the past.
Greg Bonnell: We mentioned that outperformance the health care sector had against the S&P 500, the broader read of the American market. The number I believe– correct me if I’m wrong– was 16%, outperformance of 16% last year, the widest margin in several years. What do we expect this year? Is it still attractive at these levels? If it had that kind of a performance, then investors think, is the run over?
Tarik Aeta: Yeah, so I think it really depends on your macro view. So if you are a view that we do enter into recession, definitely I think health care can continue to outperform going forward a year. If you are of the belief that we’re in a soft landing and later in the year, we start to see cyclicals and other areas of the market perform really well, health care probably would be left behind in the dust for the year.
That said, over a multi-year period, my view on the sector really hasn’t changed. It’s really the same two tailwinds that keep driving growth in this sector, and that’s demographics and continued innovation that drives growth and penetration of new products and services. And over a multi-year period, that should continue to drive health care outperformance. But really, in the short term, whether health care outperforms or underperforms is really more of– reflects what the broader market is doing. So in a bull market, health care tends to outperform a little bit less or underperforms a little bit, and bear markets you get these big outperformance.
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