How to trade the health care break out

Key Concepts

• Healthcare Sector Performance: Recent strong performance, best week since June 2022.
• Quality vs. Momentum Investing: Shift in market focus from momentum to quality.
• XBI (SPDR S&P Biotech ETF): An ETF tracking the biotech sector.
• Value-Based Care: A healthcare delivery model where providers are paid based on patient health outcomes, shifting risk.
• Disintermediation: The process of removing intermediaries in a supply chain or market.
• Clearing Event: An event that resolves uncertainty or provides clarity, often leading to renewed interest or investment.
• Binary Drug Risk / Molecule Risk: The high-stakes risk associated with the success or failure of a single drug or molecule in development.
• Contract Research Organizations (CROs): Companies that provide research services to the pharmaceutical, biotechnology, and medical device industries.
• Medtech: Medical technology, encompassing devices, diagnostics, and digital health solutions.
• 3D Printing for Orthopedics: An application of additive manufacturing in medical devices for bone and joint-related conditions.

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Healthcare Sector Resurgence and Investment Outlook

The healthcare sector recently experienced its best week since June 2022, with the large-cap healthcare ETF achieving its best five-day gain. Analyst Jonathan Krinsky noted that this "breakout feels different," suggesting a potentially sustained positive trend. A significant catalyst for this renewed optimism was the announced Pfizer deal, which generated positive sentiment in the space for the first time in a long while.

Investment Strategies and Specific Picks

Investor Joe Terranova believes the market is shifting from a focus on "momentum" to "quality," a trend he expects will directly benefit the healthcare sector. He is actively building exposure in this area:

• Merck: Joe recently initiated a new position in Merck, citing it as a quality play.
• McKesson: He also holds an existing position in McKesson.
• XBI (SPDR S&P Biotech ETF): Joe plans to buy XBI on the close, viewing it as being "in the midst of a multiyear breakout" over the next 6 to 9 months. He intends to use a very wide stop loss, risking down to approximately $92 from the current $103, emphasizing the need to size the position accordingly.
• Veeva Systems: Joe is looking to personally invest in Veeva Systems, joining another investor, Josh. He highlights Veeva as a technology-based healthcare name, which is also held in his ETF.

The "Broken" Healthcare System and Technology's Role

While bullish on certain segments, Joe also presents a critical view of the broader healthcare system, stating, "healthcare is broken." He draws a parallel to the technology sector before the internet led to the disintermediation of old-line companies like Oracle, Dell, and IBM. He argues that the "old establishment" within healthcare is struggling, evidenced by UnitedHealth's earnings.

The shift towards "value-based care" is identified as a "complete risk model," transferring risk from government and other entities to healthcare practices. This systemic change is leading to cutbacks in services by insurance plans, with some no longer covering pain management or epidurals. Consequently, Joe advocates for investing in technology companies like Veeva, which are creating new models to navigate this evolving landscape. Despite his critical view, he still owns UnitedHealth, noting it's up 40% since his purchase, and plans to exit when its momentum dies.

Bifurcation and Sub-Sector Opportunities

The discussion acknowledges a potential "bifurcation" within healthcare investing. While the overall system may be broken, specific sub-sectors present opportunities:

• Pharma and Biotech: Joe believes these areas "should do okay." He notes that pharma might be tougher for larger companies due to the constant need for new drug discovery.
• Biotech (XBI): Seen as a good opportunity, especially in an environment where yields press lower, leading to a "search for yield."

The Impact of the Pfizer Deal and Pharmaceutical Profitability

The Pfizer deal with the administration is considered a "clearing event" for Big Pharma, suggesting that other companies might also be able to negotiate similar agreements. However, a significant concern raised is the uncertainty surrounding the ultimate profitability for large pharmaceutical companies. Drug discovery is a lengthy, expensive process with no guaranteed payoff.

Alternative Investment Approaches in Healthcare

From a private markets perspective (Partners Group), alternative strategies are preferred to mitigate direct drug development risk:

• Contract Research Organizations (CROs): These are favored investments because they "supply all the services to all the pharmaceutical companies as well as biotech who make that discovery possible." This approach allows investors to participate in drug development without taking on the "binary drug risk" or "molecule risk" associated with individual drug trials.
• Biotech Trading: While acknowledged as a potentially "great trade" if yields move lower, it comes with high volatility and risk (e.g., "up 50% day or a down 70% day depending on how that trial goes"). Investors are advised to "approach that one with care."
• Medtech: This field is considered "really interesting." An example of a recent investment is a company specializing in "3D printing for orthopedics," highlighting innovation in medical devices.

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Synthesis and Conclusion

The healthcare sector is experiencing a significant turnaround, driven by specific catalysts and a potential market shift towards quality. While there's optimism for certain segments like biotech and technology-enabled healthcare, the broader "old establishment" is seen as a "broken system" undergoing fundamental changes, including a move to value-based care and service cutbacks. Investors are advised to be selective, focusing on innovative technology companies (e.g., Veeva), quality pharmaceutical names (e.g., Merck), and biotech (e.g., XBI) with careful risk management. Alternative strategies, such as investing in CROs or specialized medtech companies (e.g., 3D printing for orthopedics), offer ways to participate in the sector's growth while mitigating the high risks associated with direct drug discovery. The profitability of large pharmaceutical companies remains a key uncertainty despite recent positive developments.