Like the broader equity market, healthcare stocks experienced bouts of volatility during the third quarter. But attractive valuations, continued innovation and an uptick in merger and acquisitions could help lift the sector, says Portfolio Manager Andy Acker.

Key takeaways:

• Like the broader equity market, healthcare stocks experienced volatility during the third quarter, though for sector-specific reasons.
• In particular, a sharp pullback in small- and mid-cap biotech stocks that started in February continued through mid-August.
• However, low valuations and continued innovation have led to an uptick in mergers and acquisitions, which could help support the sector. In addition, other headwinds could prove transitory.

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Andy Acker: Q3 continued to see significant volatility for the markets, and healthcare was no different, although probably for different reasons than the rest of the market. In particular, we saw a continued sell-off in biotech stocks, especially small- and mid-cap biotech stocks, that really started in February and proceeded through the middle of August.

We think there were three key reasons for that sell-off. First, we have still continued uncertainty about drug-pricing policy. And there are worries about what that might do for drug pricing in the United States. We think those concerns are significantly overblown. In particular, one of the most concerning pieces of policy from the House [of Representatives], we think, is very unlikely to make it through the Senate. And given the very narrow majority for Democrats in the Senate, they really need 100% of votes to make that happen. So, we think resolution there could be helpful for the sector.

We have also seen a slowdown in merger and acquisition (M&A) activity in the first half of the year. That only recently started to pick up again, with several multibillion-dollar deals that have been announced in just the last few months.

And finally, the Food and Drug Administration (FDA) remains without leadership and continues to be quite active in reviewing COVID applications. That has created some uncertainty about recent approvals and some delays around approvals. These are all factors that we think could change in the coming months that could lead to an improved outlook for biotech going forward.

Biotech and pharmaceutical stocks are trading near all-time lows as far as P/E multiples and, we think, have very low expectations. And we think this sets up the healthcare sector for a strong period of absolute and relative performance going forward.

We think the need for M&A activity in the sector remains high. The top 20 biopharmaceutical companies are generating over $150 billion in free cash flow per year. And most of the innovation is coming from small- and mid-cap biotech stocks. So, we think M&A will recover, that will be supportive for many of these stocks. Valuations are near all-time lows, which we think also will be supportive. And importantly, the innovation in the sector remains extremely high. We are seeing advances in many different areas, from gene editing to gene therapies to new precision oncology treatments; and that is not just in therapeutics but also in medical devices, with advances in robotic surgery and advances especially in diabetes, with new continuous glucose monitors and glucose pumps that can replace the function of the pancreas for diabetic patients.

So, we remain extremely excited about the innovation we are seeing in the sector. We think the valuations are attractive, and we think this really sets up well for long-term, patient investors.

Price-to-earnings (P/E) ratio – measures share price compared to earnings per share for a stock or stocks in a portfolio.

Volatility – The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.