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The Morningstar® Wide Moat Focus IndexSM (the “Index”) has had an overweight position to the healthcare sector relative to the S&P 500 Index at many times historically. Often, its overweight has swung to an underweight if companies in the sector begin to appear less attractively priced based on the Index’s quarterly review process, which is intended to identify opportunities to allocate to undervalued wide moat stocks. In recent years, there has been a persistent overweight to health care stocks ranging from modest to significant. The Index’s overweight to healthcare registered at approximately 4% at the end of July but was as high as 10% earlier in the year and even higher in early 2018. This overweight is driven in large part by pharmaceutical and biotechnology companies.
Morningstar’s healthcare strategist, Karen Andersen, and director of healthcare equity research, Damien Conover issued a report last week, “Innovation Supports Growth at Big Pharma/Big Biotech Companies,” covering many recent and current members of the Index.
Drug companies tend to benefit from intangible assets, a source of economic moat, in the form of intellectual property, but may also reap the rewards from investment in innovation. Not only do many of these companies benefit from long-term patents on existing drugs, their research and development efforts to release new drugs can help offset margin pressures on existing drugs when patents expire and generic versions enter the market.
“Innovation is the central building block for the strong economic moats in the drug and biotechnology industry, supporting drug pricing power and launch trajectories. However, drug sales fall significantly following patent expirations, making the continuous cycle of new drugs essential to the industry’s economic moats,” stated Conover and Andersen.
They further explained that they believe wide moat drug company pipelines are positioned to support 5% annual sales growth, helping to offset upcoming patent losses and further reaffirming the companies’ moats.
Morningstar Analyst Research
Merck’s oncology portfolio (led by Keytruda) and diversification with strong vaccine and animal health units support strong long-term growth potential despite new competition.
Patents, economies of scale and a powerful intellectual base buoy Merck's business and keep it well shielded from the competition. As the bedrock of Merck's wide moat, patent protection should continue to keep competitors at bay while the company strives to introduce the next generation of drugs. Further, the company's enormous cash flows support a powerful salesforce that not only sells currently marketed drugs, but also serves as a deterrent for developing drug companies seeking to launch competing products. The cash flows also put the company in the rare position of being able to support the approximately $800 million in R&D needed on average to bring a new drug to the market.
Bristol’s Celgene acquisition brought strong Revlimid cash flows and a late-stage pipeline launching in 2020-21 to counter Opdivo’s lung cancer disappointments and Bristol’s thinner pipeline.
Based on a wide lineup of patent-protected drugs, an entrenched salesforce and economies of scale, Bristol holds a wide economic moat. The patent protection allows the firm to price its drugs at levels that translate into superior returns on invested capital compared with its cost (particularly in cancer drugs, an area of focus for Bristol). The patents also provide Bristol with ample time to bring forward the next generation of new drugs. Additionally, several of Bristol's currently marketed drugs are biologics, which create additional hurdles for generic firms, as the cost of developing and marketing biosimilars is much higher than for typical generic small molecules.
Pfizer’s immunology pipeline, led by atopic dermatitis drug abrocitinib along with an established and innovative vaccine platform, supports steady growth.
Patents, economies of scale and a powerful distribution network support Pfizer’s wide moat. Pfizer’s patent-protected drugs carry strong pricing power that enables the firm to generate returns on invested capital in excess of its cost of capital. The patents give the company time to develop the next generation of drugs before generic competition arises. Additionally, while Pfizer holds a diversified product portfolio, there is some product concentration, with the company’s largest product, Prevnar, representing just over 10% of total sales. However, we don't expect typical generic competition for the vaccine, due to complex manufacturing and relatively low prices for the product. We expect new products will mitigate the eventual generic competition of other key drugs. Also, Pfizer’s operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales.
Source: Morningstar Equity Research. Price/Fair Values as of July 31, 2020. Past performance is no guarantee of future results. For illustrative purposes only. Not a recommendation to buy or sell any security. Visit our fund page to view daily fund and index holdings.
President Donald Trump signed several executive orders on 24 July 2020 targeting drug prices, which made for headlines, but Morningstar analysts see the orders creating only modest pricing headwinds and slightly higher uncertainty for drug firms. In short, it is not expected that the orders will significantly affect Morningstar’s fair value estimates or economic moat ratings.
One order allows the import of drugs from Canada in an attempt to undercut U.S. pricing, which, according to Morningstar, is close to double that of international prices. However, two similar legislative attempts to enact the same pricing pressure failed previously at implementation due to safety concerns. A second order targeted drug rebates within the supply chain, but Morningstar believes it is unclear how eliminating drug rebates would affect net drug prices in the current complex system. Lastly, Morningstar does not believe the third order providing for insulin and epinephrine discounts will significantly impact drug companies.
Other proposals and potential orders have been floated that may impact drug companies, but uncertainty remains.
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