Healthcare Investing: Beyond the Rotation

Second-Quarter Results Reveal an Improving Healthcare Backdrop

Last month, we contended that the extraordinary concentration of capital in the AI trade had stretched the distance between the market’s attention and Healthcare fundamentals to an unsustainable degree. Since then, Healthcare’s relative performance has improved as investors have begun to look beyond the market’s narrowest areas of leadership.

Some of the initial move may have reflected short covering, the unwinding of extreme underweights and a search for relative value. Those forces can start a rotation, but only durable fundamental improvement can sustain it.

Second-quarter reporting therefore represented an important early test. On that standard, Healthcare passed.

According to FactSet, with 88% of S&P 500 companies having reported as we go to print, 98% of reporting Healthcare companies have exceeded consensus earnings estimates and 96% have exceeded revenue estimates—the highest rates of any sector. Aggregate earnings came in 18.3% above expectations, while the sector’s blended revenue growth rate reached 7.7%, compared with 4.6% expected at the end of June.

These results provide encouraging evidence of broadening earnings strength and a more investable backdrop. They do not, however, amount to a blanket endorsement of every company in the sector. From here, discernment will be critical.

Looking beneath the headline

At first glance, the headline tells a more sober story: blended Healthcare earnings are still being reported as declining 6.7% year over year in the second quarter, making it the only S&P 500 sector reporting a decline. That figure, however, was heavily influenced by the accounting treatment of acquired in-process research and development at two large biopharma companies.

When a pharmaceutical company acquires a development-stage asset rather than an operating business, much of the purchase price is generally expensed at closing and may remain in the adjusted earnings figures used to calculate sector growth. Gilead recorded $11.2 billion of acquired IPR&D expense during the quarter even as revenue grew 10%, while Merck’s adjusted results included a $5.7 billion charge related to its acquisition of Terns Pharmaceuticals.

FactSet calculates that excluding Gilead and Merck, the sector’s blended earnings growth rate would have been 17.9%.

To be clear, external innovation is a real cost of renewing a mature pharmaceutical portfolio, particularly as major products approach loss of exclusivity. But concentrating large, episodic investments in one quarter can make current operating performance appear materially weaker than it is.

The conclusion is thus straightforward: the headline decline understates Healthcare’s operating breadth and results across most of the sector were stronger than expected.

Why the improvement could prove sustainable

The breadth matters. FactSet reported double-digit earnings growth in four of Healthcare’s six GICS industries: Health Care Providers and Services grew 30%, Health Care Equipment and Supplies 12%, Health Care Technology 11%, and Life Sciences Tools and Services 11%. The two declining industries were Pharmaceuticals and Biotechnology, where the acquisition charges were concentrated.

The results also revealed several positive operating patterns:

• Procedure demand remained generally healthy, supporting solid organic growth across MedTech despite residual concerns about utilization and deferred elective care.
• Differentiated medicines translated clinical innovation into strong commercial growth across major therapeutic areas.
• Life Science Tools and R&D infrastructure companies showed meaningful signs of stabilization after a prolonged downturn.
• Managed Care margins continued to recover, while distributors and other Healthcare Services businesses benefited from durable utilization and drug-demand trends.
• Healthcare Technology also delivered double-digit earnings growth, reinforcing the scalability of software, data and technology-enabled care models.

These businesses have different economic engines, so strength across several at once is noteworthy. Most also benefit from durable demand tied to aging populations, rising chronic-disease prevalence and large unmet medical needs. Healthcare should also be an important, if uneven, AI beneficiary as the technology improves drug discovery and development, diagnostics and prevention, and care-delivery productivity.

Critically, the policy backdrop appears more stable than it did earlier in the year. Debate is likely to intensify as the Midterms approach (and we will address it in greater depth in our upcoming policy outlook). But the principal pressure points around drug pricing, insurance coverage, program reimbursement and government research funding are now more discrete and identifiable. That creates a better environment for assessing policy exposure company by company and underwriting investments across the sector.

Relative valuations also remain supportive even after the rebound. Healthcare continues to trade at a sizable discount to the broader market, and the sector’s S&P 500 weighting remains near a historic trough despite Healthcare’s growing share of economic activity.

Why selectivity still matters

Even as the broader backdrop has improved, dispersion within each subsector remains substantial. In such an environment, security selection going forward should matter more, not less.

Companies with differentiated products, durable or recurring demand driving compelling organic growth, improving margins, the capacity to deploy capital to enhance value, and expectations that still leave room for upside should deliver the strongest outcomes. On the other hand, companies with significant product-cycle or execution gaps even when levered to healthy end markets, and those with heightened policy, reimbursement, pipeline, or China risks, especially where stock prices reflect benign to bullish scenarios, would seem poised to underperform.

These are not exceptions to the broader improvement. Rather, they explain how the opportunity set must be approached. Healthcare is not a single economic exposure. Its companies differ materially in policy sensitivity, competitive intensity, innovation cycles, balance-sheet strength and the degree to which management controls the outcome. Valuation remains the final discipline: even an excellent company can be a poor investment when expectations already discount too much success.

Second-quarter earnings provided an important milestone, clarifying where opportunities may lie, and where dispersion is likely to persist, across Healthcare’s diverse subsectors. We have incorporated those lessons into our positioning. A less hostile backdrop can create the opportunity. However, as in prior investment cycles, owning the right companies will determine the outcome.