Lara Castleton: Hello, and thank you for joining this episode of Global Perspectives, a podcast created to share insights from our investment professionals and the implications they have for investors. I’m your host for the day, Lara Castleton.

As short-term market predictions remain uncertain, we think it’s helpful for investors to take a step back and look past the noise. Ali Dibadj, our firm’s CEO, outlines that the three long-term macro drivers he sees shaping the investing landscape for the next decade are geopolitical realignment, demographic drivers, and the rise of the cost of capital. Today, we’re going to address the second and narrow in on aging populations.

Predictions are hard to nail [down] in our industry, but the one thing that never fails is we are all getting older. As investors think about this megatrend, healthcare – and, in particular, the small- and mid-cap companies that are driving innovation in the sector – can offer attractive opportunities.

To dig into this, I’m thrilled to be joined by Andy Acker, Brian Demain, and Jonathan Coleman, three portfolio managers who have each been at the firm since the ‘90s. Gentlemen, thank you for being here.

Andy Acker: Thanks.

Jonathan Coleman: Thanks.

Brian Demain: Thanks for having us.

Castleton: I think it’s possible that you all three have been working at the firm longer than maybe some of our listeners have been alive. So, I do apologize for aging you, but given the topic of this episode, I thought it might be appropriate. Please forgive me.

Andy, I want to turn to you first, portfolio manager on our healthcare and biotech team. You have long talked about how healthcare can be one of the best ways to capitalize on aging demographics. Can you help just set the stage, and then why that is?

Acker: Sure, well, first of all, think about aging demographics. Just in the global population, those that are over age 60 are expected to double by 2050 to over two billion people. And we’re going to have one in six people by 2050 that are over age 65.

So, why does that matter? Because the elderly are subject to chronic diseases, and as we get older, we’re subject to more and more of these diseases. In fact, the elderly spend three times as much on healthcare and four times as much on medicines as the rest of the population. So, we have always viewed this as a long-term inexorable driver of higher healthcare spending, and this is often where much of the innovation in the sector is focused. How do we address these unmet medical needs so we can all live much older and longer and healthier lives?

Castleton: And are there particular sectors then – as we think about healthcare, there’s obviously multiple sectors underneath the hood – are there particular ones that are specifically levered towards the aging population?

Acker: Sure, absolutely. So, we think about, for example, biotechnology companies. They’re driving actually much of the innovation in the sector. And a lot of this is coming from small- and mid-cap biotech companies. In fact, 65% of the pipeline today is being developed by small- and mid-cap biotech companies that are not well represented in market indices. So that’s one area.

Of course, we also have medical devices, and we’re developing new technologies that are helping to address diseases of aging, everything from orthopedics to robotic surgeries. All of these procedures continue to get better and better. And then, of course, we also have the tools companies – the life science tools companies that are helping to develop many of these new technologies and represent the picks and shovels to the miners. So, all of these areas, we’re finding great opportunities.

Castleton: Okay, great. And then, Jonathan, you are portfolio manager on our small and mid-cap team. Why would investors maybe want to look towards the small-cap space when thinking about this trend?

Coleman: I think Andy hit on some of the themes that I would highlight that are particularly relevant in small cap. I’d say innovation is a little bit on steroids in the small-cap space, and you see it particularly within the biotech and the medical device area.

One of the great things about the U.S. economy is its innovative spirit and it’s very concentrated within the healthcare space, within biotech and med devices. So, we see lots of opportunities for very innovative, early stage companies. And then the rewards for being right when you invest at a very early stage are just particularly outsized. And so, very attractive to get in early in the small-cap space.

Castleton: Okay, and Brian, you’re also portfolio manager on the small/mid-cap team, more of an emphasis on midcaps in your space. So, same question as to Jonathan, but why look into the mid-cap space, and are there any nuances there versus small caps?

Demain: Yes, for midcap in healthcare, like midcap in other sectors, it sits between small and large in terms of some of the dynamics. So, if you look at the biotechs in the mid-cap space, they tend to be companies that have maybe one commercial drug but are ready to launch the second one. So, you have an established cash-flowing asset, but you’ve got a growth driver on top of that.

Or in areas like devices or life science tools, they’re going after more established markets, but maybe they already have a product on the market. So, you can still find that innovative growth, but you’ve generally got a base of cash flow and an existing business underpinning your asset valuation.

Castleton: Great. Okay, so we’ve set the stage a little bit. Andy, thank you for those statistics at the beginning. Very clear that globally, aging populations is a mega theme. Let’s get a little bit more specific in each of your spaces to healthcare in particular. So, for you, can you all each provide a growth outlook that you see within healthcare, catering to the elderly, starting with you, Andy?

Acker: Yes, so let’s think about Alzheimer’s disease. This has been a huge unmet medical need. And when you think about aging, every five years that we age, our risk of developing dementia doubles. So, this is one of the diseases most tied to aging, and already, there are 55 million people worldwide that suffer from dementia. More than half of those have Alzheimer’s disease. And for the last 20-plus years, we’ve been trying to develop disease-modifying therapies without any success.

That changed last year. In 2023, we got the first ever disease-modifying therapy. This is an antibody that can actually go into the brain and remove the plaque that is believed to be the initiating cause of Alzheimer’s disease, and for the first time, we’re seeing an improvement in outcome. So, we’re seeing a slowing of progression for patients.

So, the first therapy was approved last year. We expect, in 2024, the next therapy will be approved. And this is really just the beginning. As you start to get therapies, then we can build upon that, develop new therapies that are hopefully going to add additional efficacy. And all of us, as we age, are hoping for these therapies because we really need them. And so, these are enormous markets, and if we can stop, really, and maybe even prevent dementia and Alzheimer’s disease, these would be enormous market opportunities that would have huge potential for society.

Castleton: Great, yes, that’s definitely an important one as we think about catering to the elderly. Are there any other new therapeutics that you have your eye on?

Acker: Yes, so, Alzheimer’s is one. Cancer is another. Forty percent of us will develop cancer at some point in our lifetimes. And again, the risk increases rapidly as we get older. But now, we have all-new technologies that we’re developing for cancer, all-new modalities of treating this. So, we have everything from cell-based therapies to engineered antibodies.

So, for example, instead of just giving chemotherapy – which we’ve been doing for about 70 years, which can kill cancer cells but unfortunately kills a lot of our healthy cells, as well – now we have precision-guided missiles, antibody drug conjugates. We can attach a chemotherapy molecule to a targeted antibody, deliver it directly to cancer cells, and that results in both better efficacy but also better safety and tolerability. We’re seeing some of these therapies that are launching right now that are highly successful in the marketplace for things like ovarian cancer and breast cancer and, hopefully, lung cancer as well, coming soon. So, huge advances there.

These cell-based therapies, you can actually take a patient’s immune cells out of their body, genetically engineer them to identify cancer cells, and reinfuse them into a patient. Last year, we were seeing benefits on the order of 75% in terms of lowering the risk of progression or death relative to the best therapies today in areas like multiple myeloma.

So, these are areas that are just starting to take off, and many of the developments are coming from small- and mid-cap companies. And some of those end up getting acquired by larger companies at, typically, substantial premiums.

Castleton: That’s a great transition to Jonathan. You mentioned earlier, a lot of this innovation starts at the micro- and the small-cap level. So, what are some of the specific growth opportunities that you’re focused on?

Coleman: I’d say one area where we find compelling opportunities is in the surgical implant area. Andy was talking about the penalty for getting older and our bodies start to break down. There are a host of companies that are providing implants that allow us to live longer healthier lives.

Acker: I have one of those implants, by the way.

Coleman: One of the areas that’s particularly exciting is in some robotic surgery solutions that go into spinal implants. And the really compelling thing about this is if you take any cohort of surgeons, you’re going to have some exceptional rock-star surgeons, and you’re going to have a broad bell curve with the average surgeons and then unfortunately maybe some below-average surgeons. But what robotic surgery allows you to do is take the average surgeon into that elite level. And that’s very exciting, both from a patient outcome standpoint, as well the healthcare landscape.

Castleton: And those are companies that are driven mostly in that small-cap, at the moment, space.

Coleman: There are a number of compelling companies in the small-cap space that are pursuing these approaches.

Castleton: Yes, great.

Coleman: So, we’re excited about that.

Castleton: And Brian, midcap – as we jump up to your realm – growth opportunities, particularly again catering to the elderly, anything that you’re really focused on?

Demain: Yes, it plays out all through the sector, but a couple of examples to point to. One would be urology. And a lot of these urological conditions – prostate health, overactive bladder, that sort of thing – are more prevalent as you get older, and there’s a lot of innovation around surgeries to manage those things. Those tend to be midsize companies going after those.

Another thing I’d point to is, as Andy talks about the precision-guided missile therapeutics, to manufacture the drugs that are effectively precision-guided missiles is a lot more complicated than manufacturing the oral pills that were the drivers of the healthcare industry the last 20 or 30 years. And so, an area we call bioprocessing – and so, this is selling the equipment that goes into the production of these very complicated antibodies and gene therapies and the like – is an area that we’ve found opportunity in the mid-cap space, as well.

Castleton: Thank you, these are all really compelling ideas. Andy, if we go back to you, maybe from an implementation perspective as well, just how do you think about small- and mid-cap companies within your space?

Acker: Sure, well, I think the first thing you have to think about is there’s more volatility when you’re investing in small- and mid-cap stocks than in large-cap stocks. And that can be good and bad, but it’s an area where it really lends itself to stock selection and also to risk management.

And so, if you think about therapeutics, for example, the framework that we use is called the 90/90 rule. And this refers to the clinical and commercial risks of developing a new therapy.

So, the first part represents the fact that 90% of the drugs that begin human clinical testing will never make it all the way to market. So, you’re investing where you’re trying to find the one out of 10 that can make it. And so, typically, we’re not going to invest in the earliest stages of development because the risk is often too high. But as the company becomes de-risked and then gets later stage in development, then a real understanding of the science and the business behind these products can be very advantageous in terms of selecting the right stocks, or at least that’s what we hope.

And then the second element of the 90/90 rule is that commercial risk. And there, what we found is consensus estimates from Wall Street are wrong 90% of the time in terms of predicting new product launches. So again, we try to…we’re never going to be perfect, but if we can be more accurate than the market at predicting which drugs will ultimately make it to the market and which ones will be commercially successful, that can drive a lot of value.

The other element is really managing the risk, a lot of times through position size. But Jonathan, do you have thoughts on that as well?

Coleman: Yes, I think in the small-cap space one of the things that we always pay attention to is, are there multiple ways that we could win? And so, many of these companies, as I’ve talked about, are very compelling. They’re very early stage growth companies. Oftentimes, in the universe you’re having to bet on one thing going right.

What we try to do through a deep due diligence process with the team is identify the companies that have multiple drivers, so we don’t have to bet on just one trial or one medical device coming out and getting approval and that being the valuation driver for the company. If we have a portfolio of optionality, then we’re betting on five, six, seven things, and we know that a couple of them will go right, even if not all of them hit.

Demain: And I think it’s important to use portfolio construction as a risk management tool in the healthcare space. And so, we like to emphasize best risk-rewards towards the top of the portfolio, but we also like to consider the idiosyncratic risk volatility of any given security.

And so, companies with established cash-flow streams can have as bigger positions, but the more emerging growth companies, maybe the earlier stage biotech company, is going to be more in the middle and tail of a diversified portfolio.

Castleton: Great, thank you, that makes sense. So, as we think about this trend, clearly it is a very long-duration macro trend we can take advantage of for the next decade or so. But what are some things that investors maybe should consider in the near term? I’ll go to each of you again, starting with Andy.

Acker: Sure, well, if we think about 2024, we’re getting the first implementation of the IRA, the Inflation Reduction Act, and that creates some uncertainty for investors. There’s a lot of discussion about drug price negotiation, which is happening right now and will be implemented for the first 10 drugs in 2026. Fortunately, most of the initial 10 drugs that have been chosen were already close to patent expiration anyway. So, we think that will really mitigate their impact.

But I think there’s still some uncertainties about exactly how this will play out. Right now, there’s still a difference between how small molecule pills are treated versus biologics, when pills get nine years of exclusivity before negotiations while biologics get 13 years. So, that’s creating some distortions in the market. There was a bill recently introduced to actually correct that, what we view as a flaw in the law, that hopefully can be fixed.

On the other hand, there are positives in that law that I think are not well appreciated. Especially, probably most importantly, is that for seniors who historically have had no out-of-pocket maximums – even if they were given a life-saving cancer therapy, for example, they could pay maybe $5,000 or $10,000 out of pocket for that medicine, which many patients unfortunately can’t afford. This bill will actually correct that and improve access to medicines for the elderly. This year, that limit is around $3,000 per patient per year, no matter how many therapies they take. And next year, that will go down to $2,000 per patient out of pocket. So, we think that will actually improve access for seniors. And it’s a really positive step to improve access for much-needed medicines and something we hope would expand to the rest of the population but at least will be helping seniors starting this year.

Castleton: And so, I continually hear when I speak with clients about the election this year. It’s one of their biggest concerns. So, for you, you’re not necessarily seeing major risks…

Acker: Yes, it’s interesting.

Castleton: …or risky headlines.

Acker: Yes, usually, elections are a negative for therapeutics because pharma has historically been a punching bag, I guess, if you will. But in this case, I think it’s a little different because the two leading candidates have both already been president, and we’ve seen exactly what they’ve done. And a law was passed, the IRA, so we’re still sorting through that. But because they’ve both been president already, we’re not expecting major changes. And so, I think the rhetoric has been a little bit lower than I think in the past it has been.

Castleton: Okay, a little bit of a unique situation there. Jonathan, 2023 was the one where the market expected a recession, and that never came. Today, we’re pricing in the soft landing. But just how do you view, near term, small- and micro-cap companies, particularly in healthcare?

Coleman: So, I’d say recession is still one of the most debated topics in the market today. I’m certainly not an economist, so I won’t take a strong view on that. But I think one of the aspects that’s very encouraging about the healthcare sector that we’ve talked about in this podcast is the fact that you get relatively attractive growth based on very predictable demographic trends that are not going to change. So, this is a sector that is relatively a-cyclical. However, though, if we were to get a recession, you have the benefit of the fact that it’s unlikely to be cyclical at all, and so, you can kind of win in multiple ways. You get the demographic tailwind and then you get the a-cylicality. So, we like that.

Castleton: Yes, and something that I hear on client calls is the concern around just the Index in general. Now, taking a step back within small caps, [there is] a growing number of unprofitable companies, but there’s also a lot of M&A [merger and acquisition] potential. Do you see benefits to both of those?

Coleman: So, the M&A opportunity is one that’s very compelling and exciting as a small-cap investor. While large-cap companies have certainly developed new drugs, as a general rule, they’re looking to small-cap innovative companies to augment their pipelines, particularly when small-cap companies have gotten to a point of de-risking the development pipeline, whether that’s approval of a drug candidate or maybe it’s a phase 3 clinical pivotal trial that has substantially de-risked the development pathway by showing that the drug is efficacious. So, those are always opportunities in small cap, and we certainly have been able to benefit from that.

Castleton: Great, and Brian, what about you? We often talk about how midcaps do end up being that sweet spot of the equity landscape. How are you thinking about your space in the near term?

Demain: Yes, as regards healthcare, it’s interesting. Healthcare has delivered unexceptional performance over the last couple of years relative to some other growthy sectors. And if you pull out the GLP [weight-loss drug][i] darlings, the performance of the rest of the sector’s actually been even more challenged.

In midcap, there are a number of companies that the market often considers as GLP losers. If a lot of the population ends up on these weight-losing drugs, the thesis is that will lead to less consumption of certain areas of healthcare. We’ve studied that extensively, and actually it’s a lot more complicated than that. There are certain circumstances where there’ll be more patients because weight loss will enable people to have certain types of surgeries or those types of things.

And so, I think we look across the mid-cap space and we see a lot of very reasonably valued, durable growth franchises without a lot of economic sensitivity that are not the companies people are excited about at the moment. But we think, over time, value will reflect their earnings growth.

Acker: I think Jonathan mentioned the defensive characteristics of the sector. I think that’s especially relevant because the consensus view has shifted dramatically in the last year to an expectation of a soft landing, and yet we’ve had an inverted yield curve and declining money supply. And these are factors that historically have led to recession with a high probability. So, if we end up with a significantly slowing economy or recession, I think the healthcare sector is a really good place to be.

And then I think the other element is because healthcare recently has underperformed, as Brian mentioned, we are seeing a lot of very attractive valuations that we believe could lead to an increase in M&A activity. And in fact, in Q4 of 2023, there were nine deals announced of over $1 billion in the healthcare sector, which is more like what you see in a typical year, not in a quarter. And there’s already been a couple of deals year to date. So, we’re seeing that trend continue.

And so, the combination of low valuations, defensive characteristics, high innovation…I should mention, in 2023, that was the best year ever for new product approvals; 73 new medicines were approved. And in the last five years, the number of new approvals has been up about 100%. So, high innovation, defensive characteristics, low valuations, we think this all bodes very well for the sector moving forward.

Castleton: Well, thank you all for your insights today. It sounds like a tremendous amount of exciting opportunities long term but also just potentially good resilience for investors in the near term, as well. There’s a lot of tenure and talent amongst you three. I know you work very closely together. Given the amount of due diligence and fundamental analysis that’s needed in each of your respective spaces, we’re thankful for your expertise.

And for investors, finding the winners and losers amidst your healthcare and SMID-cap allocations is crucial, not only for the potential near-term volatility we might face but as we think of these shifting demographics for the years ahead.

Thank you all for joining. You can download other episodes of Global Perspectives wherever you get your podcasts or visit janushenderson.com for more insights. I’m Lara Castleton. See you next time.

¹ GLP refers to GLP-1 agonists, a new class of medications that help lower blood sugar levels and promote weight loss by mimicking hormones in the gut.

A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields.

Idiosyncratic risks are factors that are specific to a particular company and have little or no correlation with market risk.

Volatility measures risk using the dispersion of returns for a given investment.