My colleague Matthew McAleer and I have examined a transaction that may have altered the valuations of some of our health-care positions.
AbbVie Inc. launched a new drug to treat hepatitis C. The other competitor in the hepatitis C treatment space is Gilead Sciences Inc. (NASDAQ:GILD). Recently, a major pharmaceutical distribution company, Express Scripts Holding Company (NASDAQ:ESRX) made a contractual offer to AbbVie for its hepatitis C drug, with a discounted pricing structure.
Here is the issue. Gilead occupied the space, had the treatment, and was the dominant player in the hepatitis C drug treatment arena. AbbVie came in with a competitive product at roughly the same pricing. It was not disruptive with regard to its pricing model, but it presented buyers of these products with two choices. Express Scripts was using Gilead, but they cut a new pricing deal at a discounted rate with AbbVie as a sole source. We do not know what the discount rate is.
The takeaway from this anecdotal event is that pharmaceutical pricing is under pressure. The fact that we have seen one such deal suggests there may be more. Translate that to stock market and ETF strategies, and we can see where this might be going.
Health-care ETFs depend on the underlying performance of their component stocks, and those stocks depend on two elements. The first is pricing power, the ability to maintain profit margins on many different components and chemical constructions and approved treatments. Some of these are very highly priced and must now be considered vulnerable.
The second element is that some pharmaceutical companies derive a large fraction of their earnings abroad and face currency translations that could be less than robust due to the strength of the dollar. The combination of the two elements creates some additional risk to earnings and profit margins in this sector.
Cumberland Advisors’ response in our US ETF portfolio was to immediately sell (NYSE:XPH) (SPDR Pharmaceuticals ETF) and (ARCA:XLV) (Health Care Select Sector SPDR). We are now underweight the health care sector as we watch pricing pressures unfold. We enter 2015 concerned about a sector that had previously delivered stellar stock market returns.
David R. Kotok, Chairman and Chief Investment Officer.