Hi everyone, this is Matt Reynolds from Capital Group here in Australia. And today, I'm going to talk a little bit about the health care sector. With sharp rotations occurring in the market, investors are looking once more to fundamentals and valuations – rather than mere multiple expansion – in order to deliver strong investment results. However, valuation alone isn't really an investment thesis.

The stronger contenders for equity portfolios are those companies that can self-fund their innovation and growth – and enjoy diverse revenue streams that are underpinned by a strong growing global demand.

Health care is one sector where investors can expect to find companies with these characteristics.

Now looking back, the health care sector has done well in down markets. When the All Country World Index has done poorly, and by poorly I mean falling 15% or more on a total return basis, the health care sector has outpaced the market eight out of the last eight times this has happened[1]. This suggests that there is the potential for the health care sector to offer a degree of resilience during a prolonged period of equity market volatility that we're now experiencing.

Valuations in the health care sector, while volatile, continue to also be attractive relative to the broader market. This is particularly the case for pharmaceuticals, where the discount to the broader index is higher than for other parts of the Health care sector.

Now, I would argue that pharmaceuticals are going through a really a golden age of innovation and growth. The number of novel drugs reaching the US market has been increasing over the last 15 to 20 years. But the last five years have seen a marked step-up in approvals, with the FDA (US Food and Drug Administration) approving 51 new drugs on average each year. This compares with an average of around 29 a year in the 2007 to 2018 period.

In addition, many of the pharmaceutical companies remain very well capitalised. Looking back at the last several years and more recently, pharmaceutical companies’ cash on the balance sheet has risen and stayed high. Having cash on the balance sheet is important in a period where rates are rising and the cost of capital is going up. In a volatile market environment, a strong balance sheet could prove to be its own source of resilience.

But let's step through a few examples of the types of investments in the health care sector, where we can see innovation and the potential for growth going forward. I will talk through the pharmaceutical, bio-pharmaceutical, devices and instruments sectors, and even leave something at the end for your pet.

I’ve got a couple of company examples to share in each area to bring to life the types of attributes our analysts and portfolio managers are looking for, and also to help make the point that we invest selectively in companies not in broad-brushed approach sectors.

And I'll start with a topical subject – obesity. In many respects, obesity is a global health emergency, with more than 650 million people around the world clinically obese, and over 2 billion are considered overweight. By 2030, 18% of the world's adults are expected to be obese, up from around 12.8% In recent data.

In the US, the current obesity rate is over 36% and obesity is responsible for 4.7 million premature deaths each year. It's a significant cost, with obesity accounted for around 14% of the US’s annual health care expenditure.

A major risk resulting from obesity is Type 2 diabetes. Globally more than 530 million adults are diabetic. There is a growing global market for drugs and devices to treat and manage Type 2 diabetes. The addressable market for diabetes treatments is substantial - an estimated US$15 billion per annum by 2030.

And there is a new generation of drugs that can reduce a patient's body weight by as much as 20 to 25% – a level of weight loss on par with the impact of bariatric surgery. Eli Lilly has already introduced these agents for the treatment of Type 2 diabetes. These drugs work by mimicking naturally occurring hormones that help people feel full after eating. These are incredibly effective medicines that not only reduce weight, but also help to bring a pre-diabetic patient’s sugars under control and offer other potential benefits as well.

Whilst there are risks attached to these companies and their stocks - such as high market expectations, reimbursement rates and treatment impacts - the developments could transform the entire landscape of metabolic diseases around the world.

Another area of innovation to highlight are emergent technologies such as genetic medicines, which are leading to faster breakthroughs. Investors have poured an incredible amount of capital into the biotech and pharmaceutical industries over the last several years. One key advancement has been the development of technologies that allow intervention in disease pathways at the level of a patient's genetic sequence or ‘blueprint’.

Through gene sequencing and data processing, drug developers can apply highly specific and precise interventions, like gene therapy, where they transplant normal genes in place of missing or defective ones to address the disease.

The mRNA-based COVID vaccines are an example of how targeting a pathogen genetically can create an effective medicine very quickly, compared to the prior way of identifying therapies through extensive experimentation.

COVID became an accelerant for innovation, condensing into two years of work what the industry might have previously needed 10 years to accomplish.

This new approach to drug development is likely to lead to higher success rates and greater numbers of drugs coming to market at a faster pace.

Another emerging technology is RNAi therapeutics. RNAi is a natural biological process that regulates gene expression, by interfering with messenger RNA, which carries the DNA’s instructions for making new proteins. This will be important for a wide range of diseases.

An example of a company in a biopharmaceutical industry is. Vertex has an attractive growth profile by specialising in treatments for cystic fibrosis (CF). The company has multiple medicines to treat the underlying causes of cystic fibrosis with the potential to treat 90% of CF patients worldwide. The company has had four drugs approved since 2012, and in the short term has developed a strong CF franchise.

However, there are multiple pipeline opportunities beyond CF and the company's main operating expenditure is invested in R&D and external innovation, whilst limiting its spend on selling expenses and infrastructure. This is helping to underpin a franchise that shows high operating margins and significant cash flow.

Away from pharmaceuticals, but still in the health care sector, are companies that supply innovative devices and instruments into potentially very large addressable markets. In devices, Abbott Labs has an innovative product that allows bloodless glucose monitoring for those suffering from diabetes via a patch on the arm. This allows for real-time monitoring of insulin levels by medical professionals.

Consistent with my comments earlier, patients with diabetes represent a huge addressable market – around 450 million – and this is expected to increase to over 600 million by 2045. Interestingly, it is estimated that more than half of these sufferers are currently undiagnosed.

The adoption curve for these devices, which are wireless and painless, has been very strong – beyond what our health care analysts have seen in other medical technologies, and there are now over 4 million active users globally of this type of technology.

Another example would beIntuitive Surgical, which makes robots that surgeons use to perform surgeries. This is cutting-edge medical technology that can lead to better patient outcomes and lower costs for the provider stakeholders. What is interesting about this health care company from an investor's perspective, is its high level of recurring revenue. The robotic machines that are sold by Intuitive are expensive at around US$2.5 million dollars per unit, but each surgery requires the use of instruments and accessories that are effectively consumables.

As long-term investors, we are particularly interested in the recurring revenue aspects of their business model. Revenues from replaced instruments, accessories and services provided represent around 70% of the company's revenue stream, and this revenue base has grown at around 13% a year for the last several years. This is an attractive business model with a clear pathway for growth ahead of it given the large total addressable market.

Whilst both these product companies could be seen as having a reasonably narrow product set, there are companies that are more broad-based, more ‘picks and shovels’ suppliers to the health care and life sciences industries. An example here will be Thermo Fisher.

Thermo Fisher's potential is shaped more by the overall quantum of biotechnology research, development and manufacturing, not so much by the success of any one instrument or device. Its broad range of products and services means that it can be a one-stop-shop for its health care industry customers. Thermo’s global footprint means it can operate in a multi-local manner and be close to its customers. It effectively presents as a local company in the markets it serves worldwide.

I would also point out its scale with over 400,000 customers, meaning that it can be a cost leader. It sells remarkable range of products, from the one cent pipette right through to the multi-million-dollar DNA sequencing machines. As drug development and releases become more frequent, Thermo Fisher has the opportunity to serve this growth.

And finally, I promised to comment on the pets. The pet health care and livestock pharmaceutical industry is a market worth over US$40 billion per annum. Animal health care is an important but often overlooked market by health care investors generally.

Zoetisis a global leader in this market, with growth characteristics driven by population growth, a rising middle class and increased urbanisation. Zoetis has a durable portfolio of products – over 300 product lines with an average market life of 29 years. It has leading brands with 90% revenue from species in which Zoetis is a market leader. And its innovation track record is excellent with over 1100 new products in the last five years.

Innovation and large growing addressable markets are as much features of animal health as they are for human health. So, there are lots of interesting areas to invest in on a company-by-company basis. And I'll be clear that I'm not actually recommending any of these individual companies, more so they are examples of the types of attributes of investments that could show a degree of resiliency in a volatile market. These attributes can be summarised as:

• Innovative products to meet unmet medical needs
• Large and growing addressable markets
• Essential suppliers to industry leaders; and
• High levels of recurring revenues.

Thanks very much for listening. This is Matt Reynolds, reminding you that the most valuable asset is a long-term perspective. We are also always trying to get better so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at Capital ideas podcast Australia at Capital Ideas Podcast Australia.

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1. Data as at 30 June 2022. Refers to returns for MSCI ACWI health care sector for the last eight periods in which the S&P 500 declined by more than 15% on a total return basis. Sources: Capital Group, FactSet, MSCI