Exploring the health care sector: U.S. and Canada

Matthew Ramenaden: Health care is less than 1% of the Canadian stock market but about 13% of the U.S. stock market. Can you help us understand some of the differences between the two markets and some of the characteristics of health care equities? 

Michal Marszal: The United States accounts for the largest proportion of global spending on health care and, as a result, offers the broadest exposure to this sector through an array of investment opportunities spanning biopharmaceuticals, medical technologies and health services. Health care equities exhibit unique properties within the global investment universe as they offer the potential for long-term sustainable growth based on demographic tailwinds combined with a steady cadence of innovation. They also have defensive characteristics due to non-cyclical demand for most of their products and services. 

Matthew: In Canada, the health care sector of the S&P TSX Composite currently contains four names. In the United States, the health care sector contains over 400 names across a variety of sub-sectors, with pharma, biotech and health care equipment being the big ones. How are you currently allocating capital across the sector?

Michal: Presently the global health care fund is well balanced across major sub-sectors within the space. I am allocating capital to some of the highest quality pharma and biotech names. There is also a significant allocation going toward technologies, both in research as well as therapeutics. The fund also has the ability to move into lower market capitalizations. Lastly, I am positioning the fund to take advantage of the most attractive opportunities in health services, not only through category leaders but also by investing in higher growth opportunities with strong secular tailwinds within global pharma research and manufacturing.

Matthew: As a portfolio manager focused on the global health care sector, you’re allocating over $700 million to one sector. What opportunities would you like to explore in health care, if you were allocating less capital than you are right now?

Michal: That will always be highly dependent on the individual security, which must be thoroughly explored both from the upside as well as downside perspective. However, I like biotechnology and medical technology companies. This is principally because of the significant amount of innovation that is currently taking place in those areas. Among those are companies specializing in oncology, neurology, or even newer emerging categories, such as genetic engineering, as well as research on aging. 

Matthew: The different ways investors can screen for health care stocks are as varied as the sector itself. These include approaches like growth or value, which in turn can range from discretionary to rules-based.

For example, biotech companies might have negative earnings for a long time, so an investor might need a high level of discretion to make sense of clinical trials, regulatory approvals and so forth.

At the other end of the spectrum, pharmaceutical and other large companies may have more predictable earnings, where investment strategies like value and quality can be starting points to screen for stocks in a rules-based manner. For example, James O’Shaughnessy shows in What Works on Wall Street that composite methods can work quite well in U.S. health care — that is, screening stocks by using a composite of several measures such as price-to-earnings and price-to-sales, rather than just one measure in isolation.¹

Are there any distinctive approaches you follow when looking at health care?

Michal: Investing always follows the same two rules that must be satisfied concurrently — bet against consensus and be right. Health care equities are no different. Every security that is included in the fund must offer a superior risk-adjusted return as compared to the benchmark. In general, companies that are able to generate excess value in this sector tend to operate in attractive end-markets with strong underlying long-term fundamental growth drivers. They exhibit highly differentiated, scalable features that are underpinned by a strong commitment to innovation and are managed in a prudent and effective manner, guided by a clear purpose.

Ultimately, however, all of the above must be translated into cash flow expectations, which allow for proper security pricing through proprietary modeling. This then guides position sizing in the fund, with special attention paid to multi-scenario stress testing to maintain a strong risk management framework on individual securities as well as at the total portfolio level.

Matthew: I recognize it can be difficult to pick the winners, but maybe investors can reduce their chance of holding the losers. Using the example again from What Works on Wall Street, U.S. health care companies with a high price-to-sales ratio or a negative shareholder yield² have tended to be poor performers over a one-year holding period. In a similar way, do you have any warning signs for health care stocks — signs that would be a red flag or give you pause for thought before investing? 

Michal: Key focus for me is fundamentals, where red flags are typically identified in deteriorating end-market fundamentals or worsening corporate governance leading to poor operational performance. Typical worrisome signs of such changes are convoluted management commentary — whether on earnings calls or in written “management discussion and analysis” — frequent earnings revisions, multiple corporate restructurings, overreliance on leverage combined with counterintuitive capital deployment, to name a few.

Matthew: Thanks, Michal, for sharing your insights on health care. This has highlighted some of the differences in the health care sector between Canada and the United States. As always, investors can reflect on their investment objectives and risk tolerance, to decide if investing in any particular sector of the stock market makes sense for them.

¹ James O’Shaughnessy, What Works on Wall Street (2011), chapter 24: Sector analysis. The chapter analyzes how strategies like value or growth have performed in each U.S. sector. Some strategies have worked well in certain sectors but haven’t worked at all in other sectors. This provides a more nuanced perspective than simply applying strategies like value or growth to the entire U.S. market.

² Shareholder yield is dividend yield plus buyback yield. All else equal, buyback yield is positive when a company buys back shares and negative when a company issues shares. Companies that are frequent or large issuers of shares may be in a weak position, since they are raising capital through equity, which is typically the most expensive form of capital for a company.