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December2011White paper

A checkup on the health-care sector

Kelsey Chen, Ph.D. Portfolio Manager, Equity Analyst Christopher J. Stevo, CFA Portfolio Manager, Equity Analyst

Key takeaways

While utilization trends are

important, the diversity of health-care subsectors offers investors a range of growth opportunities.

Challenges such as patent

expirations are prompting companies to seek new ways to grow earnings.

For any investor constructing a portfolio of health-care stocks, a major benefit is the diversity of the subsectors. Health care spans a wide range of industries globally, each with a unique set of opportunities. The sector continues to play a defensive role in investment portfolios, but many of its industries also offer compelling long-term growth potential. From biotechnology companies focused on personalized medicine to drug giants looking for innovative ways to combat the patent cliff, there are many reasons to be optimistic about investment opportunities in health-care stocks. At the same time, there are many challenges, not the least of which is investor uncertainty about cuts in government spending on health care worldwide.

The sectors exposure to

government spending and legislation is one of the greatest challenges facing health-care stocks today.

A notable decline in health-care utilization

For investors, the health-care sector has long been known for its defensive characteristics. Its safe-haven status often buoys its stocks through downturns or pullbacks in more cyclical or discretionary areas, such as automobile-, equipment-, or construction-related equities. The premise is simple: health-care products and services tend to stay in demand regardless of economic conditions. Even through recessionary periods, most people will not forgo important health procedures or treatments. Health-care stocks have maintained their defensive nature in recent years, outperforming the broader market through the global economic downturn of 20082009. And in 2011, the MSCI World Health Care Index has outperformed the MSCI World Index by 13.60% (as of September 30).

Over the next 10 years,

some of the most pronounced growth in health-care spending is projected for emerging markets such as China, India, and Brazil.


DEC EM B ER2011 | A checkup on the health-care sector

While stocks in the sector have remained relatively strong, we have seen a notable diversion from past patterns of health-care utilization. Following the downturn that began in 2008, doctor visits, elective surgeries, hospital admissions, and lab tests all declined (Figure 1). While such declines in utilization are not unusual during economic slowdowns, they have been more pronounced in recent years. Whats more, we have observed this trend even among those who remained employed and had health insurance coverage. While lower utilization puts pressure on some health-care industries, it can be beneficial for other subsectors. Managed care, for example, has been the

strongest-performing area in 2011, as lower utilization helps HMOs keep expenses under control. Low utilization has the opposite effect on device makers, drug companies, and hospitals, all of which face challenges when fewer people are spending money on health care. We expect utilization to remain at these relatively low levels while macroeconomic uncertainty persists. Trends could improve when we see more positive indications of an economic recovery and a better employment picture. Over the longer term, as the Patient Protection and Affordable Care Act takes effect, we anticipate that millions more people will have access to health insurance, which should also boost utilization.

Figure 1.Do I really need that surgery? Fewer people sought health-care services after the downturn Patient visits to physicians offices, change from prior year









Source: IMS Health.


Health-care reform: Jitters, then relief

The enactment of the Patient Protection and Affordable Care Act in March 2010 and the debate preceding it took its toll on the health-care sector. Investors do not like uncertainty or surprises, and until recently it had been difficult to assess the potential impact of healthcare reform on businesses. As a result, many firms lowered their earnings guidance in 2010. Health-care stocks: A tale of two quarters In 2011, investors gained some clarity and businesses had time to digest the numbers and get a better understanding of the legislations impact on their fundamentals. This clarity combined with the belief that much of the negative sentiment was already priced into health-care stocks resulted in a relief rally for the sector in 2011.

6% 3% 0% -3% -6% -9% -12% -15% 3/31/10 4/30/10 5/31/10

Q210 Reform is enacted investors are nervous S&P 500 Index S&P 500 Health Care Index


10% 8% 6% 4% 2% 0% -2% -4% -6% 3/31/11 4/30/11 5/31/11 6/30/11

Q211 One year later more clarity and a relief rally S&P 500 Index S&P 500 Health Care Index

Source: Putnam. The S&P 500 Index is an unmanaged index of common stock performance. You cannot invest directly in an index. Past performance is not indicative of future results. Performance shown is not representative of any particular investment. Investing in the health-care sector involves more risk than investing more broadly.

DEC EM B ER2011 | A checkup on the health-care sector

The macroeconomic challenge: Budget deficit pressures, political debates

From a macroeconomic and political perspective, the sectors exposure to government spending and legislation is one of the greatest challenges facing health-care stocks today. In 2009 and 2010, ongoing debate around U.S. health-care reform took its toll on the sector. Stocks struggled in the months preceding the passage of the Patient Protection and Affordable Care Act in March 2010, and did not begin to recover until investors gained a better understanding of the legislations impact on business fundamentals. However, just as reform worries eased, new concerns emerged related to the U.S. budget deficit. With the potential for more than $1 trillion in budget cuts over the next decade, Medicare which accounts for a significant portion of the U.S. budget is particularly vulnerable. The same pain is being felt in international markets and in Europe in particular, where debt crises have escalated and many governments are cutting health-care spending in an effort to reduce budget deficits.

for truly innovative products, but it is unclear how long this will continue, given the United Statess own deficit challenges. Combating the cliff For many pharmaceutical companies, the most significant headwind in recent years has been the so-called patent cliff. In 2011 and 2012, the patents on many of the worlds leading drugs are expiring, paving the way for lower-cost generic drugs. The loss of exclusivity for these branded drugs many of which are top sellers could result in significant revenue losses for their makers. It is important to note, however, that the patent cliff threat has been widely analyzed and anticipated by investors and businesses. It has been priced into the stocks for some time, and the effects of the patent expirations have played out as expected. At this point, the most important observation to make about the patent issue is that it has prompted companies to find new ways to sustain their long-term growth. We have been analyzing the strategies that companies have implemented to combat the effects of patent expirations. In some cases, cost-cutting measures introduced as a result of the recession have meant leaner, more efficient firms that continue to generate profits. Attractive valuations are also helping to mitigate the negative impact of the patent cliff. For many companies in the pharmaceutical sector, we are seeing historically low P/E ratios along with strong cash flows and attractive dividend yields.

Examining the subsectors

Despite the macroeconomic challenges, investors can find an array of growth opportunities across this diverse sector. At the same time, health-care stocks in most subsectors are attractively priced. Recent market downturns have led to historically low valuations, as measured by the S&P 500 Health Care Index (Figure 2). A closer look at the challenges and opportunities in each industry from pharmaceuticals and technology to managed care highlights the long-term potential for health-care equities. Pharmaceuticals: Pricing power, patents, and pipelines Within the pharmaceutical industry, pricing power the ability of drug companies to maintain or raise prices on their products is an important consideration. Recently, pricing power has been an issue for firms with significant exposure to Europe. Austerity measures in the region efforts to reduce budget deficits have meant imposing deeper price cuts on pharmaceuticals, which has hurt some drug stocks. In the United States, drug companies continue to have quite a bit of pricing power

Progression in the pipeline of truly innovative drugs, attractive valuations, and some good news with late-stage clinical trials for high-profile companies have all brought positive momentum to pharmaceutical stocks.


Whats in the pipeline? A key driver of growth for pharmaceutical firms is the pipeline new drugs that are in development, testing, or clinical trials. An important component of our analysis is the quality of a companys pipeline, and particularly the late-stage pipeline drugs that have progressed through the rigors of clinical trials. Recently, the early FDA approval of several truly innovative drugs has brought positive momentum to the industry, and we are optimistic that pipelines are shaping up to help drug companies combat the patent cliff. Another way for drug companies to enhance late-stage pipelines is by collaborating with biotechnology companies either by partnering to develop new products or through mergers and acquisitions. Today, many large pharmaceutical companies have healthy balance sheets and strong cash flows, and we expect some will put that

cash to work by either acquiring or forming partnerships with biotechnology companies with promising pipelines. In recent years, pharmaceutical M&A activity has been slow, due in part to the uncertainty of the macroeconomic environment. In the long term, however, the drive to make acquisitions and expand business may help pharmaceutical companies become more diversified and create more stable sources of income. Worldwide expansion Many of the large, global drug companies are increasing their focus on emerging markets to improve their topand bottom-line growth as U.S. and European sales slow. Emerging markets offer significant growth potential, and even as pharmaceutical companies cut jobs in the United States, they are adding to their head counts in emerging markets to capture growth opportunities.

Figure 2.Health-care valuations are near historic lows Valuations for companies in the health-care sector have become more attractive in recent years and have approached historic lows.
S&P 500 Index P/E ratio 40
P/E ratio (forward 12 months)

S&P 500 Health Care Index P/E ratio

35 30 25 20 15 10 5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Morningstar Direct.

DEC EM B ER2011 | A checkup on the health-care sector

Biotechnology: High-growth potential in small and mid caps One of the most exciting aspects of the health-care sector is the remarkable innovation of biotechnology companies. Rigorous research and development is leading to more technologically advanced products that offer vast improvements in the way illnesses and diseases are treated. As with the pharmaceutical industry, the power of the pipeline is a key driver of growth in biotechnology. While pharmaceutical firms develop more traditional chemical-based products, biotechnology companies work with living organisms to develop drugs and therapies. Biotech companies tend to devote more time and resources to research and development than traditional drug manufacturers. Many biotechnology companies, particularly in the small- and mid-cap space, are not yet profitable. As a result, they are more vulnerable to market volatility and have struggled in the recent macroeconomic environment. While robust pipelines of innovative compounds may offer considerable longterm growth potential for biotech companies, investors recently have been less willing to take a risk on the outcome of clinical trials. For large-cap biotech companies, we expect growth to remain slow over the near term, as there is a scarcity of promising late-stage compounds and an overall lack of M&A activity. For small- and mid-cap companies, a wider array of high-growth product opportunities makes these stocks more attractive in our view in part because many companies have become appealing targets for acquisition.

Drug development gets personal The future of product development in pharmaceuticals and biotechnology lies in personalized medicine which, put simply, is to tailor a drug or compound based on a persons genetic makeup. A recent example, approved by the FDA, is a compound that targets lung cancer patients with a rare genetic abnormality. While these patients represent a small portion approximately 5% of the lung-cancer patient population, directly targeting a specific gene mutation has boosted the products efficacy. The product, which is in pill form, has tested extremely well in shrinking and stabilizing tumors in these patients. We are seeing more evidence that pinpointing specific patient populations helps to improve R&D productivity. Although such personalized products offer benefits for fewer patients, their higher success rates can enhance pricing power for the companies that develop them.

From biotechnology companies focused on personalized medicine to drug giants looking for innovative ways to combat the patent cliff, there are many reasons to be optimistic about investment opportunities in health-care stocks.


The opportunity in generic drugs

Outside the United States, many markets still have relatively low penetration rates for generic drugs. These drugs can provide significant cost savings for patients and health-care systems, and the growth potential in these markets may represent an attractive investment opportunity. Increased utilization could benefit companies that specialize in generic drugs, as well as large pharmaceutical firms that partner with generic companies or create generic divisions within their own businesses.

Generic drug use is relatively low in many international markets

Japan Italy Spain Hungary Australia Turkey France Brazil United Kingdom Germany Canada United States 0% 20% 40% 60% 80% 24% 40% 41% 46%

51% 52% 65% 71% 75% 81% 89% 100%

Source: IMS Health.

The biotech patent cliff

Biosimilars generic versions of biotechnology drugs also represent an attractive opportunity. An estimated $86 billion in biotech products will lose patent protection by 2020, offering substantial potential for companies that can develop biosimilar products. Barriers to entry are high in this segment of the market, due to the complexity of the compounds and the typically lengthy and challenging approval process.

90% of biotechnology drugs will have gone off patent by 2020

Drugs representing $86 billion in sales will have lost patent protection by 2020

$17 billion

$45 billion

$24 billion

$93 billion all biologics

Patents expired in 2009 or earlier

Source: TEVA Pharmaceutical Industries.

Patents expiring 20102015

Patents expiring 20162020

DEC EM B ER2011 | A checkup on the health-care sector

Medical technology: Managing product life cycles Declines in utilization trends have dampened the performance of medical technology stocks those of companies that develop devices such as coronary stents, artificial heart valves, and replacement hips and knees. As volumes have slowed, these companies have struggled with pricing pressure as they compete for market share. We believe most medical technology companies will continue to struggle with slower growth until utilization trends pick up. For device companies, rather than the threat of generic competition, the challenge is product life cycle management ensuring that their devices do not become obsolete. While medical technology firms dont roll out brand-new products as frequently as biotech companies, they must continually improve the features of their devices to gain market share and pricing power, and to ensure that their products continue to offer a competitive edge.

Managed care: A beneficiary of lower utilization The global economic downturn and the resulting decline in utilization of health-care products and services has been most beneficial for managed-care companies. HMO earnings exceeded estimates in 2011, and all managed-care companies raised their guidance for the full year, driven mainly by lower-than-expected cost trends a measure of how much businesses are paying to provide medical services for their employees. When fewer people visit the doctor, elect to have surgery, or otherwise cut back on health-related spending, the result is lower expenses for health insurers. A recent challenge for managed-care companies was the effect of the health-care laws medical loss ratio (MLR) provision. The provision requires companies to spend 80% to 85% of premium dollars on medicalcare and health-care quality improvement. While still a concern, it appears that the provision may not be as big a burden for these companies as initially feared. Another segment of the health-care services industry hospitals has not fared as well in the lower-utilization environment, as declines in patient volumes hurt hospital revenues. Hospital stocks have also been pressured by investor worries over potential cuts to Medicare reimbursements.

For device companies, rather than the threat of generic competition, the challenge is product life cycle management ensuring that their devices do not become obsolete.


A large, underserved need in emerging markets

Over the next 10 years, some of the greatest growth in health-care spending is projected for emerging markets such as China, India, and Brazil. For many reasons, growth opportunities are abundant in developing economies, but selecting health-care stocks, particularly among the smaller-cap companies based in these regions, is not without its challenges. Growth opportunities abound as wealth increases In rapidly growing economies, rising wealth and higher levels of disposable income are fueling increasing demand for medical products and services from the same consumers who are buying more homes, cars, and televisions. As they grow wealthier, many of these countries are adopting a more western lifestyle, with less physical activity and higher caloric intake. At the same time, many of these countries have much higher levels of tobacco consumption. As a result, we are seeing a large, underserved need for treatments of problems such as heart disease, diabetes, and smoking-related ailments. In emerging markets, where GDP is projected to grow rapidly, we expect that health-care spending will keep pace with and in some cases exceed GDP growth (Figure 3). One example of the need: Diabetes and cancer in China China provides a great illustration of the growth potential of emerging markets. According to the International Diabetes Federation (IDF), China has more people with diabetes estimated at 92.4 million than any other

Figure 3.In the United States and many emerging markets, health-care spending is expected to grow faster than GDP
Projected GDP growth, 20102020 Projected health-care spending growth, 20102020

167% 57% 100% USA China India 45% 62% 140% 115%



Source for projections: 2010 PriceWaterhouseCoopers, LLP.

DEC EM B ER2011 | A checkup on the health-care sector

nation in the world. At the same time, the IDF estimates that more than 60% of these diabetics are undiagnosed and untreated. Also worth noting is the prevalence of cancer in China. The disease is now the leading cause of death in Chinas urban and rural areas, followed by cardiovascular and cerebral vascular diseases.1 From 2003 to 2008, the number of cancer patients increased by 56.6%. There is a clear need for prevention and treatment strategies for these diseases, and as wealth in China grows, so do the opportunities for companies that provide health-care products and services.

While higher income levels are prompting individuals in China to spend more on health care, government spending is providing an additional boost. In recent years, the government of China has significantly increased its spending in the health-care sector (Figure 4) and has implemented system reforms to greatly expand health insurance coverage. These reforms should lead to higher expenditures, particularly in areas such as pharmaceuticals and devices, which bodes well for health-care companies with exposure to China.

1 Ministry of Health of PRC, Citi Investment Research and Analysis.

Figure 4.Government health-care spending in China Annual expenditures in renminbi (RMB)


400 RMB (billion)

300 200 100 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 (through 9/30)

Sources: Ministry of Finance, China; Morgan Stanley Research.



Large multinationals have low exposure to emerging markets Compared with other industries, health-care companies have relatively low exposure to emerging markets. For example, if you look at sales data for leading global consumer goods companies, you will find a significant portion of sales in some cases more than 50% are from emerging markets. Within the health-care sector, that concentration is much lower. A French pharmaceutical giant with one of the highest exposures, for example, derived only 30% of its 2010 sales from emerging markets. And most other global health-care companies have significantly less exposure. Challenges for investors Investors can gain exposure to emerging markets by targeting developed companies with exposure to these regions, or by investing in companies that are based in emerging markets. Investing in large, established healthcare companies offers many advantages. Their larger market capitalizations mean their shares are easier to trade. In addition, most of these companies have solid corporate governance policies and lower regulatory compliance risks. On the other hand, they may have lower growth potential than companies based in emerging markets. In many cases, valuations and growth potential are attractive for emerging-market health-care companies. However, these stocks pose volatility and liquidity risks, and they can present greater regulatory compliance risks because the health-care industry is not as strictly regulated in these markets. The investable universe of emerging-market health-care companies is relatively new; many publicly traded companies have only been listed in the past five years or so. Ideally, a diversified health-care portfolio should gain exposure to emerging markets through a range of developed and developing market stocks.

Kelsey Chen holds an M.B.A. from the Wharton School of the University of Pennsylvania, a Ph.D. from the University of Texas Medical School, and a B.S. from Wuhan University in Wuhan, China. She joined Putnam in 2000 and has been in the investment industry since 1999. Christopher J. Stevo has an M.B.A. from The University of Chicago Booth School of Business and a B.S. from the Wharton School of the University of Pennsylvania. A CFA charterholder, he has been in the investment industry since he joined Putnam in 1999.


DEC EM B ER2011 | A checkup on the health-care sector

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