Is the Health Care Sector Healthy?

Over the last two years, the health care sector has underperformed both the technology sector and the MSCI World Index as a whole. The sector has typically been known as one with high profitability, high return on capital companies, so what has been driving the underperformance? Research Analyst Tim Wengerd joins the podcast to discuss that question and the outlook for the sector.

Important Disclosures:

For institutional investors only. TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly owned subsidiaries of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries. The information contained herein is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information is distributed with the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein as well as any risks associated with such proposal or services. Nothing in this presentation constitutes legal, tax, or accounting advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Certain information provided herein is based on third-party sources, and although believed to be accurate, has not been independently verified. Except as otherwise specified herein, TD Epoch is the source of all information contained in this document. TD Epoch assumes no liability for errors and omissions in the information contained herein. TD Epoch believes the information contained herein is accurate as of the date produce...

Transcript

Steve Bleiberg

Hello and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.

Welcome back to another episode of Actively Speaking. Our guest today is going to be Tim Wengerd from our Capital Reinvestment team. Oh Tim, you were last here, I think, to talk about GLP ones. Yeah, I remember when that was, maybe a year or so ago. So today we're, we're also going to talk about healthcare as we were when we talked about GLP ones, but more broadly speaking to want to set the background for this, the premise of this conversation is that if you look over the last two calendar years, 2023 and 2024, healthcare for the two years combined, somewhat surprisingly, has been the worst performing sector in the MSCI World Index. In in 2023 when the index was up excuse me. Oh, about, yeah, about 24%. The healthcare sector was up four.

Meanwhile, information technology was up 53% that year. In 2024, the world index rose about another 19%. Healthcare was up one, and the IT sector gained another 33% that year. So you put the two years together, the world index over calendar 23 and 24 was up about 47%. Information technology was up 104%, meaning it more than doubled and healthcare was up five. So what's been going on? I mean thereason I sort of mentioned it as a companion, well, partly because everybody knows it's been up so much with all the focus on, on AI, but these are both sectors that are kind of known for, you know, having lots of high profitability, high return on capital companies. So, and yet they suffer. I mean, they experienced very different fates over the last couple of years. So we're going to talk about what's been going on in the healthcare sector.

And then one other thing I'll say just to before we get started is it's important to note that the healthcare sector, it's a broad term, but it encompasses many different types of companies within the sector. Itmakes up about just over 11% or so of the world index these days. You know, about 40% of that or so maybe a little bit more is, is pharmaceutical companies, you know, drug companies, big namesyou'd all recognize. But then you've got these other segments within the sector, healthcare equipment and supplies. You've got biotech, you've got what's called life sciences tools and services. People make things like lab equipment and the devices that you know, if you're getting a drug that has to be injected, somebody's got to make the syringes, that's, that falls into that category. And then you've got the providers, you know, insurance companies, things like that, or hospitals. So it's lots of different types of companies. So, Tim, welcome.

Tim Wengerd

Thank you very much for having me back, Steve. So, as Steve was saying, there are lots of different sectors within healthcare, lots of different types of businesses within healthcare. I'll just kind of break it up and explain why they've all done terribly. Starting with managed care companies. So these are the large health insurance companies. So starting around mid-2023, managed care companies began reporting higher than expected utilization trends. And, you know, especially among older patients that may have delayed treatments and things like that during the pandemic. The pandemic's over, you know, let's, let's try to get our hips replaced and things like that. So that started around mid-2023 and generally higher utilizations caused the managed care companies to underperform for, especially from mid-2023 into 2024. And then, Biden ran into trouble which, which helped Medicare Advantage companies because Republicans are perceived to be more friendly to Medicare Advantage.

So that helped for part of the second half of 2024. So that was managed care. And then, you know, hospitals and care providers, the managed care companies were under underperforming because of higher utilization. You might expect that hospitals and care providers were doing well for the same reason, because people were using their services more. You know, then in the third quarter, once Republicans took the presidency, the Senate and the House, those stocks underperformed for the remainder of 2024. You know, why? Well, you know, because Republicans controlled the house, the Senate, and the Presidency, I think there were more concerns about subsidies for the health insurance exchanges. What's going to happen with Medicaid funding and things like that. So I think that hurt that sector, especially in the later end of 2024. Steve mentioned pharma and biotech is a large part of the weight in the benchmark within healthcare.

You know, really outside of one of the GLP one stocks performed very well, and there was another large biotech with a couple of immunology products that managed to keep up with the index. But outside of that, there really was not much to be excited about. And then thinking about biotech more broadly, just not just the top part of the index, you know, the biotech index as a whole has been flat over the last five years. You know, if it's IPO funding and follow on funding for biotech stocks, it is down roughly 50% from where we were during the pandemic. There are roughly 700 biotech stocks. Many of them are just small and they're still developing products, but about 200 of those are actually trading at negative enterprise values. They're trading below their cash values. And, you know, a lot of these companies, their original plans or their studies didn't work out, and they're a bit like zombies right now. And I would say just in biotech generally, it does feel a bit as if we haven't gotten a lot of innovation to the point where it's become commercial. You know, over the last 20 years, there's been a lot of incredible innovation within biotech, but it doesn't really feel like in the last few years that a lot of that has become commercial, especially for large markets. And we've seen cell and gene therapy companies struggle and, and that's really put a lot of pressure on biotech stocks. 

And then the last category I would touch on is life science tools. These are companies that are selling bioprocessing equipment to pharma companies and selling different tools to the biotech industry. And the pressures there have been, you know, during the pandemic, there was a lot of inventory build and a lot of funding went into biotech and into development. And in the last couple of years we've been burning through that inventory. So for life science tools companies that meant less sales as companies work through inventories. And then, you know, as I mentioned before, biotech's had a rough few years, so demand from smaller biotech companies and China has been particularly weak. So that was a lot. I'll stop there. 

Steve Bleiberg

So that, well, so that does a good job of explaining sort of what's been going on and why each of these segments within the within the sector has struggled a bit over the last couple years. So if we look ahead, arethere reasons to be optimistic about the healthcare sector?

Tim Wengerd

Yes, I am so glad you asked because it felt like the first part of this was a complete downer. But yeah, so there are, you know, what are the reasons to be optimistic going forward? You know, I think especially so far in 2025, it felt like parts of healthcare have been a safe place from cyclical elements, as healthcare in in general, the end market demand is a bit less cyclical. I mean, it's driven by needs for healthcare. So to the extent that there's a flight for safety and concerns about recession, healthcare could benefit in the short term. You know, another piece, at the top of the last section I spoke about how the insurance companies have underperformed and utilization has been higher. One of the reasons that the managed care companies underperformed was because of higher utilization. And some of these managed care companies, they run Medicare advantage. This is essentially like a private version of Medicare. And, you know, if you are a politician who has promised that you are not going to cut Medicare benefits and you're trying to find efficiencies, I think Medicare Advantage could turn out to offer some benefits togovernment officials and politicians because it lets the government offload financial risk to private insurers. So, instead of paying providers directly for every service that doctors are offering, the government pays plans a fixed per enrollee rate. And it's a way to offload some of the risk to manage care companies and shifts the burden of cost control to the insurers instead of having the government try and do it. And then the insurers will use tools like networks, prior authorizations, utilization reviews, things that a lot of consumers don't like, but it helps to keep spending down. And then the politicians can tout this as efficiency without directly slashing benefits and hiking taxes. 

So, with the new administration, we all know, or we probably heard about RFK Jr being appointed to head HHS, but you know, two of the other appointees that I think could actually help healthcare companies that have been investing in their pipelines are Jim O'Neill and Marty McGarry. So Jim O'Neill, he's in the past, he's very much pushed for policies to deregulate healthcare. Now some of them I don't think will necessarily get through. For example, he just advocated for a policy to essentially allow drugs onto the market after they, after they've been shown to be safe. So after a drug looks like it's safe, let's let it down to the market, and then we'll use real world data to show that it's effective. A policy like that would allow drugs onto the market years before the typical process allows them onto the market. So that's one of the policies; also means lower development costs if you don't have to spend as many years. Instead of a decade and $3 billion, maybe it's three or four years and a lot less money because the trials would be smaller. And then you're just trying to show that it's safe. And then, you know, once it's in the market, we'll look at actual outcomes as people choose to use the drug or not and see if it really is effective or not. Now, a policy like that, that would be a huge change. I'm not sure it's going to get through something like that. You know, legally, I don't even know if he could do that, because I think the FDA is required by law to actually make sure something is effective as well. So that would be a challenge legally, but directionally that shows where his, where his mind is going. He's worked in HHS before so he already has some familiarity with HHS. This is not new to him. 

The other one is Marty McCarey. So he has been very vocal about inefficiencies at FDA in the past, you know, especially where it looks like the FDA is being very slow or taking too long to approve a product. So he, as well as Jim O'Neill will probably push for speeding things up along. And I think, like, just at a high level, if you are a regulator like the FDA, you're probably type one errors where you allow a product onto the market and it causes harm. That's the thing you really want to avoid. So you probably lean too far in that direction, and you're more willing to deal with type two errors where you're slow to let a good product onto the market because you want tomake sure that it's safe and in the process, people that would benefit don't actually get that benefit. And I think these two will kind of try and move things, deregulate in a way to reduce those type two errors.

The, the other name people might know is Jay Bach, who is of course one of the authors of the Great Barrington Declaration that you know, five years ago during Covid, that that he was the subject of much, you know, criticism for, but now, now he's, I mean, vindicated, I would say mostly vindicated. And his positions were mostly indicated not the criticism of him. And now he's, he's I believe he's, isn't he going to be the head of the NIH? So he had his hearing last week, and it seemed to go pretty well, and I think he'll be approved. And so, so he'll run NIH and that's, you know, roughly $40 billion of research money. That's, that would go into healthcare research and bio biotech research. 

Steve Bleiberg

It's interesting that you bring that up. You know, I feel like so one of the books I read recently was Breakthrough by Katalin Kariko. She's the woman who did a lot of the research that led to the mRNA vaccines that we used during the pandemic. What jumped out at me about her story is that she spent basically her entire career studying mRNA. And for most of her career, she had no funding from NIH, based on the book. I don't think she had any funding. And then here it turned out to be one of the I would think, one of the biggest breakthroughs of the last 20 years. And she was effectively thrown out of her lab at Penn. But, and, and there are reasons for that. Like, you know, at the University of Pennsylvania at the time, a lot of funding was going to gene therapy and areas where the NIH wanted to allocate dollars, and there no money really for mRNA research. And I think like her story shows that NIH can be too risk averse. They want, they'll put money at things that look a bit more incremental that looked safe, that looked a bit more consensus. Whereas mRNA, at the time, in the early two thousands was, it was a bigger risk. With big potential payoffs. And it was hard for her. I mean, it was basically impossible for her to get funding. And I think changes at NIH in how research dollars are allocated could benefit the biotech space longer term.

Okay. Now, another name you mentioned you know, RFK, Robert F. Kennedy Jr. People might've heard of him and you know, he's got this, he's part of this movement that people refer to as MAHA, Make America Healthy Again. You know, on the surface of it you say, oh, that's great that people are healthy, isn't that good for healthcare, but well, wait a minute, if they're healthier, maybe they don't need to take as much you know, medicine or whatever. What is the impact of MAHA likely to be on the healthcare companies?

Tim Wengerd

So MAHA's biggest concern has been chronic illness. So you could think about MAHA caring a lot about the food system you know, the chemicals that end up in our food. There's, maybe you've heard of, the GRAS loophole generally recognized as safe is what GRAS stands for. And it essentially allowed food companies to decide if a chemical or an additive that they were putting in food was safe or not. So there's been a lot of attention that MAHA has drawn to that loophole, and that that will probably be an area that they focus on. And of course, RFK is very focused on vaccines. There was actually a big announcement this weekend about a big study that FDA is going to do on the safety of vaccines. How's it going to affect these companies? It's hard to say it's really gonna have a material effect, I think.

Steve Bleiberg

Yeah. If anything, it sounds like, as you say, so who makes the food additives? Well, those are chemical companies. Those are not healthcare companies or you know or the big food companies might have to change what they do, but yeah, it's not clear to me that it has an effect necessarily on like pharmaceutical companies or life science tools, companies, you know, chronic disease is, I mean, like cancer's not going to go away, you know? Right. Heart disease is not going togo away.

Tim Wengerd

Yeah, I mean, I think like so much of medicine has been focused on like the germ theory of disease and infectious diseases and whether it's viral or bacterial or whatever it is. But MAHA seems to very focused on the terrain theory of disease where, if you're living in a certain environment, the things that you're doing, the things that you're eating, the way you're living, those are the things that make you sick. And those are the things that we should be focused on. And I mean, to the extent that they can address those problems, like as a citizen, as someone who cares about his health, I think that would be fantastic. But, you know, I think the direct impact of MAHA, if anything, might be more on commercially available vaccines. You know, I read Vax-Unvax recently, and one of the things that RFK and the author point out is that a lot of the vaccines that are on the market, they haven't gone through placebo-controlled trials. From the FDA's point of view, it's hard for them to not vaccinate a group of people. If the vaccine works, if you have healthy people, are you going to put them at risk to test it? And I think from RFK's point of view, if you look at a bunch of studies, correlations will show that like populations that are unvaccinated longer term don't have the same chronic illnesses as those that are vaccinated. So that's his point of view. The correlation is not causation. So, you know, I think from companies that'll be affected, if anything, it might be commercially available vaccines.

Steve Bleiberg

Right. And then there's actually there's a piece in the Wall Street Journal also recently about people look at the rising rates, for example, of people classified as having autism. But that, part of that is, it may sound sort of, oh this can't be it, or this sounds callous to say it, but literally there have been changes in the financial incentives to, you know, to schools, for example, in reporting that they have more students who have a disability because it can mean more funding and there, it can be self-reporting incentives. Like you get, your child will get more time to take tests, if you can have them classified as having some sort of disability. So parents might have an incentive to actually want their child to be classified that way, whereas 30-40 years ago that that was not the case. So not to say there hasn't been any increase inany of these chronic diseases, but some of it can be things that would surprise you as to the things that can drive those numbers, I think, when people don't necessarily understand what what's going on sometimes.

It's also, we've talked about before, that when people do these studies on things, we talked about one recently, maybe it was something about alcohol or something, you know, and there are people talking about, well, the death rate is lower, you know, in this group of people than in that group of people. I always find that funny because, as far as I know, the death rate is still a hundred percent, you know it has a perfect record. Nobody's ever not died. You know, yet. And I understand that you're in these studies, they're talking about over a specific time period following a particular starting point, but in the end, everybody is still going to die as far as we know. Although, you know, maybe some of the people, the tech bros as they're called seem to be trying to overcome that. But yeah, well, good luck to them. I'm not sure I'd want to live to be, you know, 300, get kind of boring after that many years, I would think.

Tim Wengerd

Yeah, Brian Johnson is working on it. Trying to live forever. Like aADHD is like another disease category where it, I mean it, in the last 30 or 40 years, the category has like really taken off. You've got roughly 10% plus of high school students that have been diagnosed with it. And that's another category where the diagnosis, how it's diagnosed, has changed quite a bit. And products, there's a product available that provides advantages for people in school for studying. There can be incentives for people to be diagnosed.

Steve Bleiberg

Okay. any other any other thoughts before we close on any other thing that's got you particularly excited within healthcare?

Tim Wengerd

I mean, longer term, as countries become wealthier, as people's quality of life improves, generally they'll probably allocate more of their discretionary income to trying to stay healthy. You know, once you have food, once you have your basic needs met, then, you know, trying to live trying to improve the quality of your life becomes more important. Trying to live healthier and longer becomes more important. And that type of incentive, as you know, that type of drive as countries and as people become wealthier will benefit healthcare longer term.

Steve Bleiberg

Actually, I do have one more question. I just realized at the beginning I used the IT sector as a comparison against which I was comparing the returns in the healthcare sector. And I mentioned that one of the things that's been driving the strong returns in the IT sector is AI. Because people are focused on, well, who's going to be making this stuff? But there's the other question, who's going to be using this stuff? What's the impact of AI likely to be in healthcare?

Tim Wengerd

That's another area where I think AI can certainly help get new products to market faster. There's the, the drug discovery aspect of it, whether it's finding new molecules faster improving the quality of simulations and, you know, speeding up discovery in biotech, like that's one aspect of AI. And then there's another in diagnostics as well. There are plenty of applications where, where it comes to finding people who would benefit from treatment if it's, you know, imagingtests and things like that. There are a lot of AI applications there. And then there's operational efficiency within hospitals, within insurance companies. There's so much opportunity there, I think, for AI toimprove the quality of returns for healthcare companies longer term.

Steve Bleiberg

Okay. Well, we'll leave it there. Tim, thanks for joining me. Thanks everyone for listening and we'll be back with another episode sometime soon. Thank you.

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