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For any investor constructing a portolio o health-care stocks, a major benet
is the diversity o the subsectors. Health care spans a wide range o industries
globally, each with a unique set o opportunities. The sector continues to playa deensive role in investment portolios, but many o its industries also oer
compelling long-term growth potential. From biotechnology companies ocused
on personalized medicine to drug giants looking or innovative ways to combat
the patent cli, there are many reasons to be optimistic about investment
opportunities in health-care stocks. At the same time, there are many challenges,
not the least o which is investor uncertainty about cuts in government spending
on health care worldwide.
A notable decline in health-care utilization
For investors, the health-care sector has long been known or its deensive char-acteristics. Its sae-haven status oten buoys its stocks through downturns or
pullbacks in more cyclical or discretionary areas, such as automobile-, equipment-,
or construction-related equities. The premise is simple: health-care products and
services tend to stay in demand regardless o economic conditions. Even through
recessionary periods, most people will not orgo important health procedures or
treatments.
Health-care stocks have maintained their deensive nature in recent years,
outperorming the broader market through the global economic downturn o
20082009. And in 2011, the MSCI World Health Care Index has outperormed
the MSCI World Index by 13.60% (as o September 30).
December 2011 White paper
A checkup on the
health-care sector
While utilization trends are
important, the diversity ohealth-care subsectors
ofers investors a range o
growth opportunities.
Challenges such as patent
expirations are prompting
companies to seek new
ways to grow earnings.
The sectors exposure to
government spending and
legislation is one o the
greatest challenges acing
health-care stocks today.
Over the next 10 years,
some o the most
pronounced growth in
health-care spending is
projected or emerging
markets such as China,
India, and Brazil.
Kelsey Chen, Ph.D.
Portfolio Manager, Equity Analyst
Christopher J. Stevo, CFA
Portfolio Manager, Equity Analyst
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DECEMBER 2011 | A checkup on the health-care sector
While stocks in the sector have remained relatively
strong, we have seen a notable diversion rom past
patterns o health-care utilization. Following the down-
turn that began in 2008, doctor visits, elective surgeries,
hospital admissions, and lab tests all declined (Figure 1).
While such declines in utilization are not unusual duringeconomic slowdowns, they have been more pronounced
in recent years. Whats more, we have observed this
trend even among those who remained employed and
had health insurance coverage.
While lower utilization puts pressure on some
health-care industries, it can be benecial or other
subsectors. Managed care, or example, has been the
strongest-perorming area in 2011, as lower utilization
helps HMOs keep expenses under control. Low utiliza-
tion has the opposite eect on device makers, drug
companies, and hospitals, all o which ace challenges
when ewer people are spending money on health care.
We expect utilization to remain at these relatively lowlevels while macroeconomic uncertainty persists. Trends
could improve when we see more positive indications
o an economic recovery and a better employment
picture. Over the longer term, as the Patient Protection
and Aordable Care Act takes eect, we anticipate that
millions more people will have access to health insurance,
which should also boost utilization.
Figure 1. Do I really need that surgery? Fewer people sought health-care services
ater the downturn
Patient visits to physicians oces, change rom prior year
-6%
-3%
0%
3%
6%
2011201020092008
Source: IMS Health.
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Health-care reorm: Jitters, then relie
The enactment o the Patient Protection and Aordable
Care Act in March 2010 and the debate preceding
it took its toll on the health-care sector. Investors do
not like uncertainty or surprises, and until recently it had
been dicult to assess the potential impact o health-
care reorm on businesses. As a result, many rms
lowered their earnings guidance in 2010.
In 2011, investors gained some clarity and businesses
had time to digest the numbers and get a better
understanding o the legislations impact on their unda-
mentals. This clarity combined with the belie that
much o the negative sentiment was already priced into
health-care stocks resulted in a relie rally or the
sector in 2011.
Health-care stocks: A tale o two quarters
-15%
-12%
-9%
-6%
-3%
0%
3%
6%
6/30/105/31/104/30/103/31/10
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
6/30/115/31/114/30/113/31/11
Q210
Reform is enacted
investors are nervous
S&P 500 Index
S&P 500 Health Care
Index
Q211
One year later
more clarity and
a relief rally
S&P 500 Index
S&P 500 Health Care
Index
Source: Putnam. The S&P 500 Index is an unmanaged index o common stock perormance. You cannot invest directly in an index. Past perormance is
not indicative o uture results. Perormance shown is not representative o any particular investment. Investing in the health-care sector involves more
risk than investing more broadly.
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DECEMBER 2011 | A checkup on the health-care sector
The macroeconomic challenge: Budget
deicit pressures, political debates
From a macroeconomic and political perspective, the
sectors exposure to government spending and legisla-
tion is one o the greatest challenges acing health-care
stocks today. In 2009 and 2010, ongoing debate around
U.S. health-care reorm took its toll on the sector. Stocks
struggled in the months preceding the passage o the
Patient Protection and Aordable Care Act in March 2010,
and did not begin to recover until investors gained a better
understanding o the legislations impact on business
undamentals. However, just as reorm worries eased, new
concerns emerged related to the U.S. budget decit. With
the potential or more than $1 trillion in budget cuts over
the next decade, Medicare which accounts or a signi-
cant portion o the U.S. budget is particularly vulnerable.
The same pain is being elt in international markets and
in Europe in particular, where debt crises have escalated
and many governments are cutting health-care spending
in an eort to reduce budget decits.
Examining the subsectors
Despite the macroeconomic challenges, investors can nd
an array o growth opportunities across this diverse sector.
At the same time, health-care stocks in most subsectors
are attractively priced. Recent market downturns have led
to historically low valuations, as measured by the S&P 500
Health Care Index (Figure 2). A closer look at the challenges
and opportunities in each industry rom pharmaceu-
ticals and technology to managed care highlights the
long-term potential or health-care equities.
Pharmaceuticals: Pricing power, patents,
and pipelines
Within the pharmaceutical industry, pricing power the
ability o drug companies to maintain or raise prices on
their products is an important consideration. Recently,
pricing power has been an issue or rms with signi-
cant exposure to Europe. Austerity measures in the
region eorts to reduce budget decits have meant
imposing deeper price cuts on pharmaceuticals, which
has hurt some drug stocks. In the United States, drug
companies continue to have quite a bit o pricing power
or truly innovative products, but it is unclear how long
this will continue, given the United Statess own
decit challenges.
Combating the clif
For many pharmaceutical companies, the most signi-
cant headwind in recent years has been the so-called
patent cli. In 2011 and 2012, the patents on many o
the worlds leading drugs are expiring, paving the way
or lower-cost generic drugs. The loss o exclusivity or
these branded drugs many o which are top sellers
could result in signicant revenue losses or their makers.
It is important to note, however, that the patent cli
threat has been widely analyzed and anticipated by
investors and businesses. It has been priced into the
stocks or some time, and the eects o the patent expi-rations have played out as expected. At this point, the
most important observation to make about the patent
issue is that it has prompted companies to nd new ways
to sustain their long-term growth.
We have been analyzing the strategies that companies
have implemented to combat the eects o patent
expirations. In some cases, cost-cutting measures intro-
duced as a result o the recession have meant leaner,
more ecient rms that continue to generate prots.
Attractive valuations are also helping to mitigate thenegative impact o the patent cli. For many companies
in the pharmaceutical sector, we are seeing historically
low P/E ratios along with strong cash fows and attrac-
tive dividend yields.
Progression in the pipeline o
truly innovative drugs, attractive
valuations, and some good news
with late-stage clinical trials or
high-proile companies have all
brought positive momentum to
pharmaceutical stocks.
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Whats in the pipeline?
A key driver o growth or pharmaceutical rms is the
pipeline new drugs that are in development, testing,
or clinical trials. An important component o our analysis
is the quality o a companys pipeline, and particularly
the late-stage pipeline drugs that have progressedthrough the rigors o clinical trials. Recently, the early
FDA approval o several truly innovative drugs has
brought positive momentum to the industry, and we
are optimistic that pipelines are shaping up to help drug
companies combat the patent cli.
Another way or drug companies to enhance late-stage
pipelines is by collaborating with biotechnology compa-
nies either by partnering to develop new products or
through mergers and acquisitions. Today, many large
pharmaceutical companies have healthy balance sheets
and strong cash fows, and we expect some will put that
cash to work by either acquiring or orming partnerships
with biotechnology companies with promising pipelines.
In recent years, pharmaceutical M&A activity has been
slow, due in part to the uncertainty o the macroeco-
nomic environment. In the long term, however, the drive
to make acquisitions and expand business may helppharmaceutical companies become more diversied
and create more stable sources o income.
Worldwide expansion
Many o the large, global drug companies are increasing
their ocus on emerging markets to improve their top-
and bottom-line growth as U.S. and European sales slow.
Emerging markets oer signicant growth potential, and
even as pharmaceutical companies cut jobs in the United
States, they are adding to their head counts in emerging
markets to capture growth opportunities.
Figure 2. Health-care valuations are near historic lows
Valuations or companies in the health-care sector have become more attractive in recent years
and have approached historic lows.
5
10
15
20
25
30
35
40
S&P 500 Health Care Index P/E ratioS&P 500 Index P/E ratio
201120102009200820072006200520042003200220012000
P/Eratio(forward12mon
ths)
Source: Morningstar Direct.
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DECEMBER 2011 | A checkup on the health-care sector
Biotechnology: High-growth potential in small
and mid caps
One o the most exciting aspects o the health-care
sector is the remarkable innovation o biotechnology
companies. Rigorous research and development is
leading to more technologically advanced products
that oer vast improvements in the way illnesses
and diseases are treated. As with the pharmaceutical
industry, the power o the pipeline is a key driver o
growth in biotechnology.
While pharmaceutical rms develop more traditional
chemical-based products, biotechnology companies
work with living organisms to develop drugs and thera-
pies. Biotech companies tend to devote more time and
resources to research and development than traditional
drug manuacturers. Many biotechnology companies,
particularly in the small- and mid-cap space, are not
yet protable. As a result, they are more vulnerable
to market volatility and have struggled in the recent
macroeconomic environment. While robust pipelines
o innovative compounds may oer considerable long-
term growth potential or biotech companies, investors
recently have been less willing to take a risk on the
outcome o clinical trials.
For large-cap biotech companies, we expect growth
to remain slow over the near term, as there is a scarcity
o promising late-stage compounds and an overall lack
o M&A activity. For small- and mid-cap companies,
a wider array o high-growth product opportunities
makes these stocks more attractive in our view in
part because many companies have become appealing
targets or acquisition.
Drug development gets personal
The uture o product development in pharmaceuticals
and biotechnology lies in personalized medicine
which, put simply, is to tailor a drug or compound
based on a persons genetic makeup.
A recent example, approved by the FDA, is a compound
that targets lung cancer patients with a rare genetic
abnormality. While these patients represent a small
portion approximately 5% o the lung-cancer
patient population, directly targeting a specic gene
mutation has boosted the products ecacy. The product,
which is in pill orm, has tested extremely well in shrinking
and stabilizing tumors in these patients.
We are seeing more evidence that pinpointing specic
patient populations helps to improve R&D productivity.Although such personalized products oer benets or
ewer patients, their higher success rates can enhance
pricing power or the companies that develop them.
From biotechnology companies
ocused on personalized
medicine to drug giants lookingor innovative ways to combat
the patent cli, there are many
reasons to be optimistic about
investment opportunities in
health-care stocks.
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The opportunity in generic drugs
Outside the United States, many markets still have rela-
tively low penetration rates or generic drugs. These
drugs can provide signicant cost savings or patients
and health-care systems, and the growth potential in
these markets may represent an attractive investment
opportunity. Increased utilization could benet
companies that specialize in generic drugs, as
well as large pharmaceutical rms that partner
with generic companies or create generic divisions
within their own businesses.
Generic drug use is relatively low in many international markets
0% 20% 40% 60% 80% 100%
United States
Canada
Germany
United Kingdom
Brazil
France
Turkey
Australia
Hungary
Spain
Italy
Japan
81%
89%
75%
24%
40%
46%
50%
41%
51%
65%
52%
71%
Source: IMS Health.
The biotech patent cli
Biosimilars generic versions o biotechnology drugs
also represent an attractive opportunity. An estimated
$86 billion in biotech products will lose patent protection
by 2020, oering substantial potential or companies
that can develop biosimilar products. Barriers to entry
are high in this segment o the market, due to the
complexity o the compounds and the typically lengthy
and challenging approval process.
90% o biotechnology drugs will have gone o patent by 2020
Patents expiring
20162020
Patents expiring
20102015
Patents expired in
2009 or earlier
$93 billion
all biologics
$17
billion
$45
billion
$24
billion
Drugs representing $86 billion in sales will have lost patent protection by 2020
Source: TEVA Pharmaceutical Industries.
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Medical technology: Managing product
lie cycles
Declines in utilization trends have dampened the
perormance o medical technology stocks those
o companies that develop devices such as coronary
stents, articial heart valves, and replacement hips
and knees. As volumes have slowed, these companies
have struggled with pricing pressure as they compete
or market share. We believe most medical technology
companies will continue to struggle with slower growth
until utilization trends pick up.
For device companies, rather than the threat o generic
competition, the challenge is product lie cycle manage-
ment ensuring that their devices do not become
obsolete. While medical technology rms dont roll
out brand-new products as requently as biotech
companies, they must continually improve the eatures
o their devices to gain market share and pricing power,
and to ensure that their products continue to oer a
competitive edge.
Managed care: A benefciary o
lower utilization
The global economic downturn and the resulting
decline in utilization o health-care products and
services has been most benecial or managed-care
companies. HMO earnings exceeded estimates in 2011,
and all managed-care companies raised their guidance
or the ull year, driven mainly by lower-than-expected
cost trends a measure o how much businesses are
paying to provide medical services or their employees.
When ewer people visit the doctor, elect to have
surgery, or otherwise cut back on health-related
spending, the result is lower expenses or health insurers.
A recent challenge or managed-care companies was
the eect o the health-care laws medical loss ratio
(MLR) provision. The provision requires companies to
spend 80% to 85% o premium dollars on medical-
care and health-care quality improvement. While still a
concern, it appears that the provision may not be as big a
burden or these companies as initially eared.
Another segment o the health-care services industry
hospitals has not ared as well in the lower-utilization
environment, as declines in patient volumes hurt hospital
revenues. Hospital stocks have also been pressured by
investor worries over potential cuts to Medicare
reimbursements.
For device companies, rather than the threat o generic competition,
the challenge is product lie cycle management ensuring that their
devices do not become obsolete.
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Over the next 10 years, some o the greatest growth in
health-care spending is projected or emerging markets
such as China, India, and Brazil. For many reasons,
growth opportunities are abundant in developing
economies, but selecting health-care stocks, particu-
larly among the smaller-cap companies based in these
regions, is not without its challenges.
Growth opportunities abound as
wealth increases
In rapidly growing economies, rising wealth and higher
levels o disposable income are ueling increasing
demand or medical products and services rom the
same consumers who are buying more homes, cars,
and televisions. As they grow wealthier, many o these
countries are adopting a more western liestyle, with less
physical activity and higher caloric intake. At the same
time, many o these countries have much higher levels o
tobacco consumption. As a result, we are seeing a large,
underserved need or treatments o problems such as
heart disease, diabetes, and smoking-related ailments.
In emerging markets, where GDP is projected to grow
rapidly, we expect that health-care spending will keep
pace with and in some cases exceed GDP growth
(Figure 3).
One example o the need: Diabetes and cancer
in China
China provides a great illustration o the growth poten-
tial o emerging markets. According to the International
Diabetes Federation (IDF), China has more people with
diabetes estimated at 92.4 million than any other
Projected GDP growth, 20102020
Source for projections: 2010 PriceWaterhouseCoopers, LLP.
Brazil
38%
45%62%
100%
140% 115%
167%
57%
USA
India
China
Projected health-care spending growth, 20102020
A large, underserved need in emerging markets
Figure 3. In the United States and many emerging markets, health-care spending is expected to
grow aster than GDP
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DECEMBER 2011 | A checkup on the health-care sector
nation in the world. At the same time, the IDF estimates
that more than 60% o these diabetics are undiagnosed
and untreated. Also worth noting is the prevalence o
cancer in China. The disease is now the leading cause
o death in Chinas urban and rural areas, ollowed by
cardiovascular and cerebral vascular diseases.1
From2003 to 2008, the number o cancer patients increased
by 56.6%. There is a clear need or prevention and treat-
ment strategies or these diseases, and as wealth in
China grows, so do the opportunities or companies that
provide health-care products and services.
1Ministry o Health o PRC, Citi Investment Research and Analysis.
While higher income levels are prompting individuals
in China to spend more on health care, government
spending is providing an additional boost. In recent
years, the government o China has signicantly
increased its spending in the health-care sector (Figure 4)
and has implemented system reorms to greatly expandhealth insurance coverage. These reorms should lead
to higher expenditures, particularly in areas such as
pharmaceuticals and devices, which bodes well or
health-care companies with exposure to China.
Figure 4. Government health-care spending in China
Annual expenditures in renminbi (RMB)
0
100
200
300
400
500
2011 (through 9/30)201020092008200720062005200420032002
RMB
(billio
n)
Sources: Ministry o Finance, China; Morgan Stanley Research.
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Large multinationals have low exposure to
emerging markets
Compared with other industries, health-care compa-
nies have relatively low exposure to emerging markets.
For example, i you look at sales data or leading global
consumer goods companies, you will nd a signicant
portion o sales in some cases more than 50% are
rom emerging markets. Within the health-care sector,
that concentration is much lower. A French phar-
maceutical giant with one o the highest exposures,
or example, derived only 30% o its 2010 sales rom
emerging markets. And most other global health-care
companies have signicantly less exposure.
Challenges or investors
Investors can gain exposure to emerging markets by
targeting developed companies with exposure to these
regions, or by investing in companies that are based in
emerging markets. Investing in large, established health-
care companies oers many advantages. Their larger
market capitalizations mean their shares are easier to
trade. In addition, most o these companies have solid
corporate governance policies and lower regulatory
compliance risks. On the other hand, they may have
lower growth potential than companies based in
emerging markets.
In many cases, valuations and growth potential are
attractive or emerging-market health-care companies.
However, these stocks pose volatility and liquidity risks,
and they can present greater regulatory compliance
risks because the health-care industry is not as strictly
regulated in these markets. The investable universe o
emerging-market health-care companies is relatively
new; many publicly traded companies have only been
listed in the past ve years or so. Ideally, a diversied
health-care portolio should gain exposure to emerging
markets through a range o developed and developing
market stocks.
Kelsey Chen holds an M.B.A. rom
the Wharton School o the University o
Pennsylvania, a Ph.D. rom the University o
Texas Medical School, and a B.S. rom Wuhan
University in Wuhan, China. She joined Putnam
in 2000 and has been in the investment industrysince 1999.
Christopher J. Stevo has an M.B.A. rom
The University o Chicago Booth School o
Business and a B.S. rom the Wharton School o
the University o Pennsylvania. A CFA charter-
holder, he has been in the investment industry
since he joined Putnam in 1999.
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DECEMBER 2011 | A checkup on the health-care sector
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