Sound opportunity in healthcare investment but the ride may be bumpy

All segments of the healthcare theme - pharma, hospitals, diagnostics and health insurance - are expected to grow rapidly over the long term

Two fund houses have recently launched funds based on the healthcare theme. One is ICICI Prudential Mutual Fund, which has launched the Pharma, Healthcare and Diagnostics (PHD) Fund and the other is Mirae Asset Management, which has launched the Mirae Asset Healthcare Fund. Three funds based on the healthcare theme already exist. While they have given sound returns over the longer (five-year) term (see table), their performance over the one- and three-year horizons has been poor. Investors need to carefully weigh the opportunities within the segment vis-a-vis the risks before deciding to bet on this theme.

Growth opportunities exist: India, which has established itself as a global manufacturing and research hub in pharma, contributes around 10 per cent of world production by volume. Around 70 per cent of the sector's revenue comes from the sale of generic drugs, of which around 50 per cent comes from exports. India's pharma sector has a major cost advantage. The cost of setting up a production plant in India is 40 per cent lower than in Western countries, and labour costs are 50-55 per cent less. India also has the second largest number of US Food & Drug Administration (FDA)-approved manufacturing plants outside the US and 2,633 FDA-approved drug products.

While the domestic market continues to grow and provide stability to cash flows, the exports market, specifically the US market, has been facing headwinds due to delays in US FDA approvals.

However, the long-term trend is positive. The volume share of Indian pharma companies in the US generic market has gone up from 20 per cent in 2010 to 35 per cent in 2017. In terms of value, their share stands at 19 per cent. Indian companies are now focusing more on building up a basket of speciality and complex generic products that would be difficult for rivals to replicate. The research and development expenditure of the top 10 Indian companies has gone up eight times over the past seven years.

There was also a marked reduction in the number of regulatory alerts in 2017, and Indian companies have also dealt with many of these alerts effectively over the past year. "The delayed product approvals should also start coming through now," says Kunal Bajaj, CEO and founder, Clearfunds.com, a Sebi-registered online investment adviser.

The pharma sector's underperformance over the past couple of years has resulted in the valuation gap between the Nifty Pharma Index and the Nifty narrowing down significantly in the past few years. "The past two-three years have not been good for the pharma sector, which makes it the best of times to invest in it. The US FDA issues are getting resolved. The peak of margin reduction due to pricing pressures is behind us. The rupee, which has been stable for several years, is depreciating now," says S Naren, executive director and chief investment officer, ICICI Prudential Mutual Fund.

Next, let us turn to the opportunities within the healthcare sector. At 4.8 per cent of GDP, India's current expenditure on healthcare is much lower than that of the other major economies (China 5.5 per cent; Canada 10.6 per cent; and the US 17.2 per cent). While the percentage of the elderly population in India is small (6 per cent aged 65 and above), in absolute terms the number is bigger than the population of many countries.

Healthcare is also an under-served market. Bed density in India is one bed per 1000 people, compared to the global average of 2.9 beds per 1000 population. India will need 3 million beds to achieve the target of three beds per 1000 population by 2025.

Rising income levels, growth in life expectancy, increased health awareness, improvement in treatment technologies, and increasing penetration of health insurance are factors that have made the healthcare sector one of the fastest growing in the country. Demand for healthcare will also grow due to the rising incidence of lifestyle diseases being caused by growing pollution levels in cities, rich diets, sedentary lifestyles, and rising stress levels among the urban population.

The strength of India's healthcare services sector is that many hospitals here offer high-quality health services at a much lower price than in the developed economies. This has led to the growth of medical tourism at a compounded annual growth rate (CAGR) of 20 per cent between 2013 and 2016.

At 11.3 per cent, the level of healthcare inflation in India is high. This is expected to fuel the growth of diagnostic and preventive services on the one hand, and the insurance industry on the other. The organised segment of the Indian diagnostic industry has been growing at an estimated 15 per cent. This growth rate is expected to accelerate in the future as doctors resort more to evidence-based treatment.

In India, out of pocket expenses as a percentage of total healthcare spending is high at 58 per cent. This indicates that health insurance has a lot of scope to grow. The premium of the health insurance segment has been growing at a CAGR of 25 per cent between 2007 and 2016. The contribution of health insurance premium stood at 13 per cent of total non-life insurance premium in 2007 and had grown to 28 per cent by FY16.

Thus, all the segments -- pharma, healthcare, diagnostics and health insurance -- offer plenty of opportunities over the long term.

Concentration of risk: There are, however, a few risks that investors will face when investing in the healthcare sector. "The larger companies in the pharma space are seeing pressures in their US generics businesses. Revenues were affected last year by pricing pressures in the US as well as delayed product launches. The hospital sector typically has a long gestation period for new hospitals along with leveraged balance sheets. Also, the growth in revenue of diagnostic companies is very promotion led at present," says Bajaj.

Since thematic funds take concentrated exposures to a segment of the economy, they can go through challenging times. Investors should have an investment horizon of not less than five years to overcome these troughs. Also, don't take exposure beyond 5-7 per cent of your equity portfolio to a single theme. Finally, wait for the new fund offers to establish a track record before you invest in them.