The stocks to watch as the healthcare sector recovers

Healthcare had a lethargic 2023. Both the US and Australian healthcare sectors underperformed the broader market. Deal volumes were down globally while Ozempic hit more than waistlines, as CSL and ResMed’s share prices fell on concerns the wonder drug would stifle opportunities. 

In some ways, it felt like a continuation of the post-covid hangover we saw in 2022.

The sector then had an iron infusion, making a stunning return at the end of 2023 and the start of 2024.

Today, the S&P 500 Healthcare Index is up 5.61% on the year (compared to 5.28% for the S&P 500) (Source: S&P Global). In Australia, some of the S&P/ASX 200 Healthcare Index gains have been hit by news of CSL’s (ASX: CSL) failed phase 3 CSL112 tests, though it is still up from the start of the year.

Could we be about to see the return of the healthcare sector?

In part one of a two-part series, I'll explore what is happening in the space and the opportunities for investors, leaning on insights from Wilsons’ Dr Shane Storey and HB Biotechnology’s Charlie Williams. 

Part two will explore the spicier end of the healthcare sector, focusing on biotechnology and the role of AI - there are plenty of exciting things happening, so don't miss it. 

Behind the lacklustre performance in 2023

A challenging year was less about company fundamentals and more about the bigger macro picture. Investors were distracted by inflation and interest rate rises, which weighed on activity in the sector.

“Healthcare traditionally commands higher valuation metrics than other sectors, so rate rises over the last few years have been commensurately challenging. Invariably, adjusting for that entails an element of ‘catch-up’, so it took the market quite some time to absorb that as a new norm,” says Storey.

Williams notes that the Fed signalling a hold on interest rates was tied to a severe downturn in the US biotech market from September to October 2023, with biotech being viewed as the riskier end of healthcare.

Aside from that, and despite incredible innovation on the biotech front, investors were simply engrossed in other themes. AI and the Magnificent Seven namely - responsible for the extraordinary returns of the Nasdaq 100 and S&P 500 across 2023.

It's worth remembering that the sector is very broad and diversity can play into the performance.

“There’s a broad spectrum of what healthcare can mean. The defensive side is typically hospital and services that people don’t cut back on. Biotechnology can be more cyclical because if you don’t have the knowledge to understand the underlying assets, you are less likely to have the conviction to hold it in challenging times so investors will sell it and you’ll see valuations fall,” says Williams.

In short, people were less likely to hold onto biotechnology companies last year and more likely to hold bigger defensives, and this would have hit prices.

A change in fortunes leading to 2024

Just as macro factors were behind a challenging 2023, they have also been behind a surge in the healthcare sector more recently. 

“The idea that 2024 might see rate cuts has probably helped all sectors, so it’s too early to assess any relative benefit for healthcare,” says Storey.

He also believes the story around Ozempic and other obesity drugs reducing demand for treatments like Resmed’s (ASX: RMD) sleep apnoea therapy or CSL’s chronic kidney disease work has started to ease and support a lift in share prices.

Williams points out that biotech jumped 20% in late 2023, on a more dovish tone from the Fed – but believes the underlying fundamentals are looking promising. When investors are less concerned about the macro environment, they switch back to the fundamentals – and he believes we are embarking on a golden age of innovation.

Taking advantage of the challenges for value picks

Often as not, healthcare companies can sit at premium valuations - but the challenges of the past few years could be an opportunity for investors.

Service companies like Integral Diagnostics (ASX: IDX), Capitol Health (ASX: CAJ), Pacific Smiles Group (ASX: PSQ), Ramsay Healthcare (ASX: RHC) and medical device developers like Nanosonics (ASX: NAN) and Aroa Biosurgery (ASX: ARX) were hardest hit in terms of valuations.

“Healthcare service demand seems to be in decent share, but our sense is that it may take another six months or so for costs and margins to properly rebase for radiology, hospitals and dentistry,” says Storey.

His top pick of the small caps is Aroa Biosurgery because “their one-off R&D investment phase is largely done, and we think the earnings leverage they’ll generate will surprise a lot of investors”.

His top large-cap pick is CSL due to its excellent vaccine business, leading position in plasma and the HemGenix gene therapy asset for haemophilia B. Despite a challenging week for CSL, it remains a strong business with a solid pipeline of products.

Are you investing in healthcare companies for the coming year? Let us know where you see opportunities in the comments.