Healthcare stocks to supplement your retirement

This article is part of the Morningstar Retirement Week special report. 

The Wuhan coronavirus outbreak created a short-term bump in healthcare stocks bringing the sector back in the spotlight. However, it’s the long-term prospects and industry fundamentals that continue to drive investing decisions of prudent investors, particularly those investing for retirement.

The ability to outperform in any economic environment makes healthcare stocks more popular among those nearing or in retirement, who tend to play it safe. The sector appears particularly attractive as a pillar of stability at a time when slowing economic growth and challenging geopolitical events are dragging down the performance of other industries.

Risk-averse retirement-age investors may want to consider adding or expanding exposure to healthcare through select names. These companies have strong product portfolios, rich pipelines, a sizeable margin of safety, and to top it all off, the prospect of income generation through juicy dividends. These fundamentals, and not short-term sentiment, inform equity analyses of stocks in Morningstar’s healthcare coverage. 

Leading U.S. healthcare services firm, CVS Health (CVS) is the largest pharmacy benefit manager that processes about 2 billion adjusted claims annually. It also has a sizable pharmacy operation, including nearly 10,000 retail pharmacy locations across the U.S.

“As a top-tier healthcare-focused retail store, pharmacy benefit manager, and insurer, CVS possesses enough scale-related cost advantages to generate economic profits for the long run,” says a Morningstar equity report.

The healthcare major’s ROICs, the report notes, “should remain above its capital costs throughout our explicit 10-year forecast period.”

The firm has spent over a decade positioning itself as a leader in healthcare services through strategic acquisitions. “CVS’ top-tier retail pharmacy, health insurer, and PBM franchises create the potential to improve health outcomes and even bend the healthcare cost curve,” says Morningstar equity analyst, Julie Utterback, who puts the stock’s fair value at US$92.

These efforts could lead to “double-digit annualized earnings growth in the longer term,” she adds

The company is uniquely positioned to improve health outcomes through its vast retail network. “CVS aims to provide a convenient way for people to check their health conditions,” says Utterback, pointing out the company plans to introduce its HealthHub concept to more than 1,500 stores that will feature “care concierges, nurse practitioners, and dietitians in addition to pharmacists already on staff at these stores.”

One of the world’s largest pharmaceutical firms, Pfizer (PFE) has a diverse product portfolio including life-saving drugs. The company rang up US$50 billion selling healthcare products, chemicals, prescription drugs and vaccines. International markets, especially emerging markets, account for nearly half of its sales.

The company’s sheer size creates significant competitive advantages in drug development. “This unmatched heft, combined with a broad portfolio of patent-protected drugs, has helped Pfizer build a wide economic moat around its business,” says a Morningstar equity report.

Pfizer’s deep financial resources and research capabilities are supportive of the development of new drugs. “After many years of struggling to bring out important new drugs, Pfizer is now launching several potential blockbusters in cancer, heart disease, and immunology,” says Morningstar sector director, Damien Conover, who pegs the stock’s fair value at US$46.

Patents, economies of scale, and a powerful distribution network underpin Pfizer’s competitive prowess. “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,” says Conover, noting the patents shield the company from generic competition and buy time to develop the next generation of drugs.

Further, owing to its leading salesforces in emerging markets, Pfizer is well-positioned to benefit from the dramatically increasing wealth in Brazil, Russia, India, China, and Turkey.

German healthcare and agriculture conglomerate, Bayer (BAYRY) makes antibiotics, cardiovascular, oncology, central nervous system drugs, over-the-counter medications, diagnostics, animal health and crop protection products. Healthcare provides more than half of the company’s sales.

The healthcare group boasts sustainable competitive advantage which was further boosted by the sale of no-moat Covestro. “In the healthcare division, Bayer’s strong lineup of recently launched drugs and solid exposure to biologics should support steady long-term growth,” says a Morningstar equity report.

The healthcare heavyweight’s hemophilia franchise consists of biologics whose manufacturing complexity creates a barrier to entry for generics. Morningstar sector strategist Karen Andersen says, “strong demand for cardiovascular drug Xarelto and ophthalmology drug Eylea should continue to drive growth.”

Bayer’s healthcare segment also includes a consumer health business that sells Aspirin, the iconic brand that “continues to produce strong sales even after decades of generic competition,” says Andersen.

Apart from a diverse portfolio of patent-protected drugs, the company also has a strong global sales force that can attract smaller drug firms to partner with Bayer. Such partnerships enhance Bayer's internal drug-development efforts, says Andersen, who recently lowered the stock’s fair value to US$29 from US$31 to reflect legal costs and currency fluctuations, but forecasted “Bayer is well-positioned for growth through 2022,” before heavy patent losses on some drugs in 2023 crimp margin.

Biopharmaceutical behemoth, Gilead Sciences (GILD) develops and markets therapies to treat life-threatening infectious diseases. The core of its portfolio is focused on HIV and hepatitis B and C. The drugmaker’s recent acquisitions have expanded its focus to include pulmonary and cardiovascular diseases and cancer.

“Gilead Sciences generates stellar profit margins with its HIV and HCV portfolio, which requires only a small salesforce and inexpensive manufacturing,” says a Morningstar equity report.

The drugmaker’s portfolio and pipeline merit a wide economic moat. “Patent protection on newer HIV regimens and Gilead’s continued dominance in the hepatitis C market will be enough to ensure strong returns for the next couple of decades,” the report says.

However, the firm needs “HCV market stabilization, strong continued innovation in HIV, solid pipeline data, and smart future acquisitions to return to growth,” argues Anderson, who appraises the stock to be worth US$84. 

As the demand for its blockbuster HCV drug Sovaldi starts to taper, Gilead is building a pipeline outside of HIV and HCV. To achieve strong growth, however, the company will need more acquisitions like Kite, which boosted Gilead’s exposure to cell therapy in oncology, Anderson says.

A key part of Gilead's R&D strategy is the firm’s expertise in infectious diseases and single-pill formulations, which creates intangible assets and is supportive of the firm's wide moat, adds Anderson.