We have updated the inputs to the Cornerstone Capital Sector Strategy Model in which we rank the ten GICs in the MSCI All Country World Index (ACWI). Figure 1 summarizes the most recent rankings.
Figure 1: Cornerstone Capital Global Markets Equity Strategy Model
Relative to the previous rankings (published in the June edition of the Cornerstone Journal of Sustainable Finance & Banking), our sector strategy is now less cyclical and more defensive:
- We are now only overweight Information Technology (Figure 2). Consumer Discretionary was downgraded from Overweight to Neutral, while Industrials remain Neutral. A number of factors led to the downgrade of the Consumer Discretionary sector, most notably a rise in the number of downward earnings revisions. Then, too, margins in the Consumer Discretionary sector — as well as in the Industrials and Materials sectors — have rebounded strongly from their 2011 lows, suggesting the potential for downside surprises.
- We are no longer underweight Consumer Staples, while the ranking of the Health Care sector has improved (although it is still Neutral). The relative valuation of the Consumer Staples sector has become more favorable while earnings revisions (although still downward) have become less negative. As for Health Care, its relative earnings momentum has improved, while earnings revisions have also become less of a negative.
- We remain Underweight Materials, and are now also Underweight Utilities and Energy. A key factor here is that the relative valuations of the Utilities and Energy sectors have both become less attractive.
Figure 2: Cornerstone Capital Global Sector Strategy Model
Ranking Sectors by Weighting Valuation, ESG Scores and Earnings
A Focus on Health Care
As noted above, the ranking of Health Care in our sector strategy model has improved materially. Almost three quarters (72%) of the MSCI ACWI Health Care Index is comprised of the Pharmaceuticals and Biotechnology sectors. However, the lines between the “pharmaceuticals” and “biotechnology” sectors are becoming increasingly blurred. With 35-40% of the earnings of global large cap pharmaceutical companies coming from biologics, it is probably more accurate to refer to these companies as operating in the “biopharma” industry.
A shift in corporate focus has played a key role in the emergence of biopharma. The “old” business model of large cap pharmaceutical companies, which was in place from about the 1990s to the mid-2000s, had five elements to it:
• Strategy: A focus on primary care areas.
• Drug development: A focus on “small molecule” drugs (i.e., non-biologics taken orally). As their patents expired, these drugs faced intense competition from the manufacturers of generics.
• Research & Development: A “shotgun” approach to R&D, with many projects underway at a given point in time with a goal of developing a handful of “blockbusters.”
• Mergers & Acquisitions: Mega deals like Pfizer/Wyeth and Merck/Schering-Plough.
• Business model: A diversified Health Care model.
The “new” business model, which emerged in the late 2000s, modified those elements as follows:
• Strategy: A focus on specialty care areas, which offer relatively high margins.
• Drug development: A focus on “large molecule” drugs (i.e., biologics.)
• Research & Development: More targeted R&D focused on specialty care areas.
• Mergers & Acquisitions: More “bolt-on” M&A deals typically involving smaller biotech companies such as Bristol-Myers Squibb/Medarex, Eli Lilly/Imclone and Novartis/Chiron.
• Business model: A pure drugs business model. One consequence of a less diversified structure has been a large number of divestments lately, for example, Abbott Laboratories split in two and spun off its research pharmaceuticals business as a new entity (AbbVie); GlaxoSmithKline sold its Ribena and Lucozade drinks businesses and Novartis sold its blood transfusion diagnostics unit.
The ongoing shift to biologics in the biopharma sector is likely positive for secular earnings growth for a number of reasons:
• Longer product lives: Product cycles are relatively long in biotech, typically greater than ten years. Given the technical complexities involved, biologics are not easily replicated by generic manufacturers.
• New product areas: In large part because of the growth of biologics, the FDA has approved a significant number of new drugs in recent years – 27 New Molecular Entities in 2013 and 39 in 2012; by contrast, in 2002 only 17 were approved. In terms of new product areas, immunotherapy is a new way of treating cancer, which involves turning the body’s immune system against cancer cells. Some analysts see immunotherapy doing to cancer what new therapies did to HIV, dramatically transforming life expectancies.
• A better pricing environment: Although biotech products are typically very expensive, the level of innovation being delivered by many new biotech therapies likely justifies the cost.
In summary then, the Health Care sector is becoming increasingly attractive:
• From a tactical perspective — as measured by the Cornerstone Capital sector model.
• From a strategic perspective — the emergence of biopharma.
Earlier this year Cornerstone hosted a Global Pharmaceutical Luncheon with a special guest from Novo Nordisk. Read more about our takeaways from this event and the biopharma business model and ESG.