Today I bring you two useful perspectives that aren’t the usual doom and gloom which seems so pervasive. The first comes from the managers behind the Worldwide Healthcare Trust PLC, OrbiMed run by Trevor M. Polischuk. Here’s one insider take on how the healthcare industry is reacting to the viral surge…

  • “The diagnostics industry has worked quickly to ramp up production of testing capabilities. In addition to the initial kits developed by WHO and CDC (which use components from Qiagen and Danaher), several commercial vendors with large infectious disease testing platforms have received expedited FDA approval for tests, including Roche, Hologic and Thermo Fisher. There will likely be other diagnostics companies that receive FDA approval, though the near-term focus is scaling production and throughput of existing facilities to allow for increasing testing capacity.
  • The potential emergence of an effective vaccine to thwart the spread of COVID-19 would be clearly welcomed by the world. There are nearly a dozen novel programs ongoing in the industry to do just that and, importantly, various different mechanistic approaches are being pursued. Innovation here is coming from both global national companies like Pfizer and smaller, biotechnology companies like Moderna. In China, the dominant domestic vaccine manufacturer, CanSino Biologics, may soon be starting their own clinical trial for a coronavirus vaccine.
  • Many companies are accelerating their efforts in the anti-viral space in hopes of creating a treatment to help already infected patients. One of the global leaders in viral therapy, California-based Gilead Sciences, Inc. is leading this charge. Other efforts to treat patients are coming from all corners of the industry and the globe. In Japan, Takeda’s recent acquisition of Shire and their plasma derived therapy business has led to an investigational new treatment to boost the immune function of infected COVID-19 patients. Chugai’s anti-inflammatory drug, Actemra, may also be useful in treating infected patients who are suffering from severe lung dysfunction resulting from coronavirus.
  • Whilst the healthcare industry moves into the forefront of the war against COVID-19, we are cautious on the sustainability of commercial opportunity that the coronavirus may offer the biopharma players. Rather, our focus remains on the positive fundamentals of the industry – its near term defensive qualities and long term growth prospects driven by innovation and societal secular demand.”

Discounting too much?

Analysts at the DWS Research Institute have just put out an interesting note called “History Lessons : Why do markets sell-off and then rebound”.

It’s an attempt to pin some hard numbers around how the fear factor affects valuations. Any experienced investor knows that its not collapsing earnings that cause share prices to crater – what’s driving it is real fear. As the analysts put it, “in this market sell-off, share prices should have fallen by only 5% if earnings were to fall by a similar magnitude to 2008 and 9% if there was to be a total loss of earnings for the next two years.”.

The point here is equally obvious – earnings usually rebound at some point. According to DWS, “looking at the S&P 500 since 1995, we note that its EPS fell by less than 50% after both the dotcom bubble and the great financial crisis. There was a similar fall in the earnings of the MSCI World as well. These earnings, however, were back at pre-crisis levels within two years of the dot-com bubble and within four years of the great financial crisis.”

The missing ingredient in valuations is that fear factor, driving up the equity risk premia and the discount rate applied to the earnings. This fear factor changes and one way of measuring that change is to look at the discount rate according to DWS. They reckon that investors in the non-financial part of the market “demand a long-term real return of 5.4% (the fair value discount rate). During the great financial crisis when investors became very bearish, the discount rate increased to 5.9%. At the lowest point of risk aversion, investors demanded a rate of return of 4.7%. The discount rate now is 5.2%” [ The analysis is based on the CROCI coverage of close to 1000 companies representing 85% of equity markets].

The table below starts to map out how this discount rate maps dynamically on to the MSCI World index. If we assume that the discount rate moves up to 6%, and we then further assume that we have a recession that is worse than the GFC and that EPS growth is negative for two years, we end up with a fair price for the MSCI World at 1483. The last time I looked, the MSCI World index was trading at 1673, a 31% decline from its peak value. Under this extreme scenario, we could easily see another 10% fall in the MSCI index before we hit ‘fair’ value although that would imply a rather dramatic set of assumptions for a short term shock.