Key takeaways:
- We expect changes in leadership among stocks in healthcare services.
- Providers that previously struggled with high labor costs and decreased utilization during the pandemic may benefit from the reversal of those trends.
- The funding environment for biotech will likely create mixed outcomes for contract research organizations, but bigger companies should fare better.
- Managed care organization (MCO) stocks were leaders among healthcare research and services companies last year, when investors prized defensive traits. While MCO company fundamentals remain strong, changing market preferences and the regulatory climate may cause these stocks to lag this year.
Last year, economic concerns drove investors to some of the most defensive stocks in healthcare research and services, including managed care organizations. We expect the tide to turn in 2023, with last year’s laggards poised to lead. For example, some of the companies that struggled with high labor costs and decreased utilization during the pandemic may begin to benefit from normalization in healthcare demand and pay. At the same time, the defensive stocks that did well in 2022 may face a tougher market environment.
Providers benefit from labor costs and utilization
Healthcare providers faced numerous challenges during the COVID-19 pandemic and its aftermath. Labor costs skyrocketed as many facilities were forced to employ short-term staff and offer higher wages as competition for workers grew more intense. At the same time, utilization for services dropped as providers canceled non-essential procedures and some healthcare consumers grew wary of healthcare facilities.
With many of these COVID-era trends reversing, healthcare providers appear poised to become leaders among healthcare research and services stocks. Wage growth for nurses seems to be normalizing, with surveys suggesting a 4-5% wage increase in 2023, down from 8% in 2022. The use of expensive short-term contract nurses also is declining.
The pandemic-induced decrease in healthcare utilization also appears to have peaked. This year, volumes should exceed pre-COVID levels for the first time. Inpatient volumes for all specialties are expected to reach 102% of 2019 levels, and outpatient elective procedure volumes are expected to reach 105% of pre-pandemic levels, according to our physician survey. At the same time, healthcare providers may see reimbursements increase as they renegotiate rates with payers and pass along higher labor costs.
With this constructive backdrop, HCA Healthcare (HCA) and Universal Health Services, Inc. (UHS) are our top picks in the healthcare provider group. HCA has strong, deep networks in its markets and we believe earnings will improve as labor costs normalize and demand recovers. UHS also has the potential to outperform if labor challenges improve thanks to its best-in-class acute hospitals and high demand for behavioral services. Low leverage and solid cash should provide UHS the option to reinvest back in the business, or pursue share repurchases, dividends, and bolt-on M&A.
CROs will continue to see mixed results
The changing economic environment is creating mixed conditions for contract research organizations (CROs) that rely on biotech innovation. The biotech funding environment has been challenging as investors have pulled back amid concerns about rising interest rates and economic conditions. Smaller CROs that cater to less established biotechs which depend on venture capital funding could see significant challenges. In contrast, larger biotechs have strong drug pipelines and cash on hand to fund research trials, which should support demand for leading CROs.
IQVIA Holdings Inc. (IQV) remains our top pick. IQV’s market-leading positioning, advanced technology capabilities and strong relationships with established biopharma and biotech companies could propel IQV’s CRO business growth above the industry average, even against a slowing market backdrop.
Managed care stocks may be out of style despite strong fundamentals
Managed care organizations (MCOs) offer the same strong fundamentals that supported their performance last year. However, these stocks face a different market environment.
In 2022, investors were seeking defensive investments amid concerns about rising rates and the potential for a recession. MCOs performed well as investors valued their earnings visibility and limited risk from inflation and currency fluctuations. Recently, investors have grown less concerned about a recession as inflation shows signs of moderating and the market is rotating to favor more economically sensitive companies.
While this changing outlook could create more volatility in the group, these companies still have good earnings visibility and remain well-positioned fundamentally. We particularly like Elevance Health Inc (ELV). The company offers long-term growth potential thanks in part to its diversification into healthcare services and is regaining share in its pharmacy division.
In healthcare research and services, there are opportunities for investors to play offense and defense. While changing market conditions are providing headwinds for some types of companies, the space includes many companies with strong fundamentals for selective investors.