Commentary

Key Takeaways

• Two mid cap biotech companies presented positive clinical data for its cancer treatments, suggesting strong commercial potential.
• M&A activity remained robust, particularly in the services and life science tools areas.
• Regulators continued a strong 2017 pattern of drug approvals in the U.S. and Europe.

Market Overview

The health care sector, as measured by the MSCI World Healthcare Index (Net), returned 2.2% in May and outperformed the S&P 500 Index (+1.4%). The sector was led primarily by services companies, including managed care (+7%), contract research organizations (+5%) and clinical laboratories (+2%). Medical devices, dental companies, and life science tools also offered positive returns. Participants in the pharmaceutical distribution and payment channel continued to underperform the market and the sector, losing 8%, due to another round of downward earnings revisions. Biotechnology shares also underperformed the sector and offered negative returns in May, although mid cap shares were least impacted.

Data presented at the American Society of Clinical Oncology (ASCO) had a mixed impact on portfolio holdings Roche, Bristol-Myers Squibb, Incyte and bluebird bio.

Roche presented disappointing data from the APHINITY trial of Perjeta in early stage HER2+ breast cancer. Perjeta reduced the risk of recurrence by 19%, which is on the low end of what is believed to be clinically meaningful. We still expect regulatory approval for this indication and some commercial use, but the commercial opportunity will be smaller than what we had hoped for. We continue to recommend maintaining some exposure to Roche but are not advocating adding on the weakness.

Incyte presented strong data for its next generation immuno-oncology drug, epacadostat, suggesting that adding epacadostat to a PD-1 antibody increases response rates in multiple tumor types. Incyte is starting Phase III trials with its partners Merck and Bristol-Myers Squibb, and we believe epacadostat has the potential to be a multibillion dollar product.

"The latest approval for Merck's Keytruda its first-mover advantage in first-line lung cancer to cover approximately three-quarters of patients."

Updated Phase I data for the combination of Bristol-Myers Squibb’s Opdivo and Yervoy in lung cancer generated controversy at ASCO as the results suggested that there was a minimal survival benefit of the combination over Opdivo alone. Our view is that investors are over-interpreting a small dataset. These data do not materially change our outlook on the ongoing Phase III trial of the combination in lung cancer and we remain optimistic about this trial, which will read out sometime over the next year, as well as AstraZeneca’s combination trial, which will read out in mid-2017.

Finally, bluebird bio and Celgene presented strong updated data for bb2121, an engineered T cell product for multiple myeloma, with a 100% response rate in the 15 patients treated with the three highest doses.

The health care sector remained active from a mergers and acquisitions perspective, primarily among services and life sciences tools companies. Thermo Fisher Scientific agreed to purchase Patheon for $7 billion to enter the market for pharmaceutical contract manufacturing services. VWR agreed to purchase reagent and fine chemical manufacturer Avantor Performance Materials for $6.3 billion. Finally, contract research organization INC Research agreed to purchase contract sales organization InVentiv Health from private equity owners for $4.6 billion.

We also note that Bioverativ announced the acquisition of privately held True North Therapeutics for up to $825 million. Although smaller in size, we believe this deal could prove to be transformative for Bioverativ.

We expect to see continued consolidation in the health care sector as the need for growth and access to inexpensive capital remains intact. Deal activity could be further accelerated by access to offshore cash balances among large capitalization pharmaceutical and biotechnology companies as a result of Republican-led tax reform.

Capital raising for health care companies remained robust in May. Five companies made their debut in the U.S. and four went public overseas, cumulatively raising over $1 billion. There were 29 secondary stock offerings last month, 18 in the U.S. and 11 internationally. Altogether, companies raised almost $6 billion, including a $2.5 billion stock sale by Becton Dickinson. We expect both IPO and secondary activity to remain healthy through the balance of the year, although we would expect a seasonal lull in issuance during the late summer.

Innovation in the health care sector remains strong, as measured by new drug approvals. The FDA approved three new products in May, including AstraZeneca’s immuno-oncology drug Imfinzi for bladder cancer, Mitsubishi Tanabe’s Radicava to treat ALS, and Sanofi and Regeneron’s Kevzara for rheumatoid arthritis. Merck’s Keytruda was also approved for use in combination with chemotherapy in first-line non-squamous lung cancer regardless of PD-L1 biostatus. This approval extends Keytruda’s first-mover advantage in first-line lung cancer to cover approximately three-quarters of patients.

Regulators in Europe recommended six new drugs for approval: COD.ON’s Spherox cartilage repair, Dompé Farmaceutici’s Oxervate for ocular healing, Gedeon Richter’s Reagila to treat schizophrenia, LEO Pharma’s Kyntheum for psoriasis, Chiesi Farmaceutici’s Trimbow triple combination for smoker’s cough, and Vifor Pharma’s Veltassa to lower high potassium. European authorities also recommended two new biosimilars for approval, copies of Eli Lilly’s Humalog and Roche and Biogen’s Rituxan.

Outlook

Our long-term optimism about the health care sector in general and, in particular, the large cap biotechnology/pharmaceuticals group remains strong. We continue to seek investments in companies that are finding innovative therapies targeting large unmet needs and those that help reduce overall health care expenditures. We continue to advocate positions in companies with uncorrelated catalysts, clinical read-outs, and M&A to generate attractive returns.

Large scale changes in U.S. government policies appear less likely to materially impact health care stocks. We remain watchful, however, of Republican efforts to revive reform initiatives, including policies for government reimbursement of pharmaceuticals. It is still probable that Republicans make important changes to U.S. tax policies. Companies with primarily U.S.-based businesses could benefit substantially from new tax policies.

The underlying fundamentals of the biopharmaceutical industry remain healthy, and we continue to recommend significant exposure to the group. The innovation story remains intact, and pricing pressure remains contained to highly competitive areas. We believe that innovative areas such as oncology and orphan diseases will remain protected from pricing pressure and continue to advocate investments in these areas. Large cap biopharmaceutical valuations are supported by strong cash flows and underappreciated pipelines. Large cap pharmaceuticals companies have generally returned to positive revenue and earnings growth, which are uncorrelated with the global economy, and are often a bellwether defensive play during periods of broader financial market uncertainty. We are beginning to see better values in biopharmaceuticals and look to take advantage of continued volatility to incrementally increase exposure to our core positions and initiate positions in high-quality, small and mid cap biotechnology innovators.

"Large scale changes in U.S. government policies appear less likely to materially impact health care stocks."

Managed care industry fundamentals remain strong, including growth for government programs and moderate utilization in core commercial and government businesses. Pricing pressure on branded drugs is also an incremental positive for managed care. Our enthusiasm for the industry has moderated somewhat because we saw significant value creation from proposed consolidation, which will now not be consummated. That said, we continue to allocate capital to managed care, emphasizing government-oriented businesses. Finally, we do not believe the current turmoil in the market for individual coverage will have a material impact on the long-term earnings potential of the industry.

The pharmaceutical value chain, which includes drug distributors, PBMs and prescription drug retailers, has experienced a substantial correction since the middle of 2015 as the industry undergoes a difficult transition away from healthy profit growth due to generics. This transition has resulted in intense competition through the value chain, and there is limited visibility into how severe or long the price competition could persist. While we actively reevaluate our generally negative stance on the group, we remain cautious until the companies reduce longer term growth targets and investors more fully revise their expectations.

We expect more moderate performance for the life science tools group, where valuations already reflect an improving end-market environment. We also continue to expect in-line or underperforming results for the health care technology, contract research organization and diagnostic laboratory industry sub-sectors.