Healthcare continues to generate political controversy. So should investors stay away? Absolutely not. What’s important is to target companies that are positioned to deliver long-term growth no matter what happens to the US healthcare system.

President Trump is determined to replace Obamacare to fulfill one of his central campaign promises. His proposals for the American Health Care Act are aimed at creating a system that would be “better and cheaper” than his predecessor’s.

As equity investors, we don’t take a stand in the political debate about the healthcare system. However, our search for US equity opportunities requires us to monitor developments while studying company fundamentals in order to determine whether there are long-term winners in a complicated and changing sector. Healthcare stocks have rallied by 10.9% this year through May, outpacing the S&P 500 Index’s 8.7%, so we believe investors who ignore the sector may be paying a hefty opportunity cost, in our view.

The Longevity Factor

Analyzing the healthcare sector must begin with some core facts. The good news is that Americans are generally living longer. The bad news is that extended life expectancies add costs to the healthcare system. So it’s possible to provide better care, and it’s possible to provide cheaper care, but it will be very challenging to do both, in our view.

US healthcare spending is very high compared to that of the rest of the world. Healthcare spending in the US accounted for 17% of GDP in 2016, much higher than the 6%–11% that many other developed countries spend and up from approximately 13% of GDP in 2000, according to the Organisation for Economic Co-operation and Development’s online database. Prescription drug spending is often seen as the culprit in skyrocketing US healthcare costs, yet it only represents 11% of total healthcare spending. In fact, the biggest absolute buckets of spending are hospital care at 34% of the total and physician services at 21%, based on data from the Centers for Medicare and Medicaid Services. So the question really is: how do we control healthcare costs without reducing the quality of care?

Who Buys the Most Drugs?

This question is further complicated when we look at which age groups incur the heaviest costs. People over 50 years old account for 70% of total drug spending. This age group represents only 35% of the total population, but 91% of the total population increase in the US over the last five years, according to a report last month by QuintilesIMS. So using drug costs as a proxy for overall healthcare spending creates a natural upward bias to healthcare costs as we age. This issue isn’t easily solved given that people are living longer.

How do these trends fit in with the current proposals? The proposal that passed the House in early May would modestly cut the cost to the US government over a 10-year period, according to the Congressional Budget Office. To do so, 23 million fewer people would have insurance in 2026 compared to current projections. Most probably, this would involve shifting the cost burden toward older and sicker patients, though the details are still sketchy and some major coverage decisions will be thrown back to the states.

If older citizens consume more healthcare, it might place an undue burden specifically on those aged 50 to 65. In other words, the system would revert to the pre-Obamacare health insurance pricing model. It is too soon to say whether the bill will secure the approval of Congress. But in any case, investors need to be prepared for this, or any potential change, since the current system is untenable in the long term.

Investing in Healthcare: What to Consider

Amid the uncertainty, what can investors do? Look for companies that have differentiated products and services and are not relying on drug pricing as their primary driver of growth. Investment candidates can include:

• US medical companies that derive most of their revenues from outside the US. Companies that generate significant income from countries that spend below the developed-world average may benefit from faster spending increases in the future.
• Companies that are classified in the healthcare sector but won’t be affected by changes to the system. For example, think about companies that provide medicines for pets and livestock.
• Companies that can enable cost reduction and can help provide solutions to the US healthcare conundrum. Examples include companies that provide outsourcing services for clinical trials, which can help bring drugs to market faster and more cheaply than companies which are doing all of the testing in house.
• Drugmakers with unique products that will justify higher costs for the benefits they deliver, even in an environment of potential drug-pricing controls.

Healthcare stocks have done well so far this year, despite the noise in the sector. And after underperforming the market last year, many stocks in the sector still offer relatively attractive valuations along with solid growth profiles. To identify stocks that can deliver strong long-term returns, investors need to keep a finger on the pulse of the political debate—while targeting companies that can rise above it.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.