Here’s To Your Health Q&A

Executive Summary

• Health care equities have generally outperformed broader equities over the past 12 months as investors have favored the sector’s less economically sensitive, more defensive profile amidst a backdrop of elevated uncertainty.
• In addition, select pharmaceuticals and biotechnology companies have generated strong returns given positive news pertaining to new drug launches and pipeline developments.
• As investors continue to look to the potential nearer- and longer-term advantages of health care equities, questions have increased surrounding the space.

We recently had an opportunity to sit down with Matthew Renna, Partner and Portfolio Manager of Westfield Capital Management Company, L.P. (Westfield) to talk through some of the questions facing health care equity investors in today’s environment. Westfield is a 20+ year Harbor subadvisory partner with a rich history of health care investing across the market capitalization spectrum. Please see below for the discussion’s details, as well as key investment considerations for the road ahead.

---

Joe Duffy: Matthew, we really appreciate your time today and look forward to your health care investment perspectives.

Matthew Renna: Joe, thank you for the opportunity to discuss the health care investment backdrop on behalf of Westfield. Health care is a sector that we are very passionate about, and one in which we have a strong history of returns. Our team has worked together for a long time, continues to have a consistent process of diligence, and we are seeing some tremendous value in our space that excites us as we close out 2022.

Joe Duffy: Let’s start off with key health care industry considerations within today’s investment environment. Within a backdrop of slowing global growth, tighter financial conditions, and elevated inflation, what are some of the higher-level investment implications for different health care industries (e.g., health care providers & services, health care equipment & supplies, biotechnology, etc.) that investors should consider? Where is your team finding the strongest investment opportunities within the current environment?

Matthew Renna: Your question is both insightful and timely, as it is one that we have been talking a lot about with clients as of late. If you were to look at health care at a very high level, you would see some fairly significant outperformance versus the broader market year to date (YTD). That is because 2022 has followed somewhat of an intuitive path, as investors flocked to safety amidst an onerous macro backdrop, bidding up some pockets of health care such as large cap pharma, HMO’s, distributors and select biotech stocks. However, the high-level performance is actually quite misleading, as leadership has been very narrow, centered around the safest of safe havens. Looking under the hood, you will find a number of subsectors that as a whole are down greater than 30% YTD, including biotechnology, life science tools, Contract Research Organizations (CRO), Contract Development and Manufacturing Organizations (CDMO), and high growth medical technology. These are the growth buckets that provide the best hunting grounds for 2023 in our opinion. Overall, we remain big believers in the current cycle of innovation across the health care continuum, but we are mindful of areas that were previously over capitalized and need to work through a natural rationalization process. These may be great opportunities for patient growth investors, but timing will be key.

Joe Duffy: The Inflation Reduction Act is set to lower drug prices for millions of people in the U.S. However, pharmaceutical companies have warned that provisions such as the government’s ability to negotiate pricing for the costliest treatments could hinder future innovation and new drug development. What is your team hearing from company management teams pertaining to future research & development spending plans? What are your team’s thoughts on potential resulting regulatory impacts for pharma/biotech companies looking ahead?

Matthew Renna: The Inflation Reduction Act (IRA) has been a frustrating dynamic to watch unfold, and we think in its current form will ultimately lead to a stifling of innovation. It is likely going to be increasingly difficult, for small cap companies in particular, to justify investing in small molecules if the government is intent on shortening the runway to generate an adequate return. Now don’t get us wrong, history would suggest that some level of price scrutiny is needed to avoid the “bad actors” who price gauge on non-innovative assets, but we think the structure of the IRA is misguided. Specifically, quality innovation that improves patient outcomes should be rewarded, not penalized, and unfortunately, we think one of the unintended consequences of the IRA is going to be upward pressure on the initial listing price for new drugs (essentially the industry’s attempt to blunt the negative net present value impact of the IRA). Ultimately, we think this places a premium on companies with innovative products that add true value to all stakeholders and suggests that more complex, non-small molecule drugs are inherently more valuable than they were at the start of the year. As is often the case, the devil is in the details when it comes to the IRA in that much of the law’s ultimate impact will depend on the complex rulemaking to be done before the 2026 implementation with a lot of latitude to make the provisions of the law more or less onerous to industry. Thus, which party wins in 2024 will dictate much of what actually happens on the ground. Republicans remain staunchly opposed to the law in the context of a closely divided electorate, suggesting a high probability that the law could be changed significantly prior to implementation.

Joe Duffy: The COVID-19 crisis ushered in swift changes across the health care industry including wider adoption of telemedicine, as well as vaccine development and deployment advances. Can you please touch on some of the strongest health care investment opportunities that have resulted from COVID-19 impacts? Conversely, what are some of the biggest risks to consider in the post-crisis era within the health care space?

Matthew Renna: The pandemic brought tremendous investment opportunities within the health care sector — from Polymerase Chain Reaction (PCR) testing plays or vaccine developers and manufacturers, to telemedicine, contract research organizations and life science tools companies. The success of the vaccines generally validated the approach of engineering at the cellular level, a technology which holds vast promise across many therapeutic categories. Additionally, the pandemic may have permanently altered care patterns in health care services and very likely accelerated the move to put the consumer at the center of the services paradigm, a trend which goes hand-in-hand with health care encounters moving to more convenient, lower acuity settings. Taken together, essentially as long as your business was relatively insulated from COVID-19, and not tied to procedure volumes, it was the Golden Age for health care alpha. Sadly, the endemic phase has not been so friendly to many of the COVID-19 winners. Excess capacity, difficult comps, capital flows to recovery plays and generalized sentiment has left the vast majority of the “COVID-19 complex” in a state of severe multiple compression. To us, this presents a huge opportunity in companies who have been unfairly penalized. You probably won’t see us sifting through any COVID-19 pure play businesses, but to the extent that a great U.S. health care diversified business is coming off a COVID-19 windfall, is beginning to annualize difficult comps, and is trading at a 5-7-year trough valuation, you will likely find us kicking the tires for 2023 or adding to positions that we already own.

Joe Duffy: Smaller cap biotechnology stocks are often considered as highly volatile, even lottery-like from a potential performance perspective. How does your team balance risk/reward within this space, particularly as many of these companies are not yet profitable?

Matthew Renna: Without question, some of the greatest opportunities for alpha generation in health care come from the small cap biotechnology sector. Westfield has a long history of success in this subsector, but it is certainly not without volatility and occasional failure. It is important to distinguish between two broad baskets in therapeutics – the commercial stage companies in which we see revenue generating assets, and the pre-commercial stage companies. It is the latter basket that requires the more pragmatic approach. At Westfield, we try to avoid single asset companies as well as those that are pre-phase 2 or proof of concept stage. We will certainly monitor these companies and will come up with a framework that would enable a possible eventual investment — essentially a point in time and/or fact pattern that would warrant a favorable risk adjusted return for our investors. Instead, we try to focus on post proof of concept companies, particularly those who have multiple assets in the pipeline, to mitigate risk. We look for companies who are well capitalized and who have a competitive edge for innovation. Put another way, the ultimate profile for a development stage biotechnology Westfield holding is a platform of innovation with multiple shots on goal that is fully funded to profitability.

Joe Duffy: The health care sector has been home to major trends over the last several years such as personalized medicine, digitization of health care, artificial intelligence used in drug discovery, etc. What are some of the emerging themes and trends that your team believes will drive strong disruption (and growth) within the health care industry looking out in the years ahead?

Matthew Renna: It is certainly not challenging to find potentially disruptive businesses in health care, but it is perhaps a bit more challenging to find those businesses with a sustainable competitive advantage that are both de-risked from a technology perspective and reasonably valued. From a thematic perspective, we are invested in areas of targeted oncology, liquid biopsy, gene therapy, orphan diseases, value-based care and consumerization of medical technology. We would point out that some of the themes you have listed are key priorities for some of our more established, larger cap, diversified companies — and although not a pure play investment strategy, they are central components to these companies’ growth prospects and competitive advantage.

Joe Duffy: Matthew, thank you very much for joining us; your thoughts and insights are greatly appreciated. Based on your comments, some of the key highlights health care investors should likely consider are as follows:

• Health care equity performance leadership in 2022 has been fairly narrow given a flight to safety trade. Subsectors that have exhibited relative weakness including biotechnology, life science tools, Contract Research Organizations (CRO), Contract Development and Manufacturing Organizations (CDMO), and high growth medical technology may likely provide fertile grounds for active, long-term investment consideration.
• An unintended consequence of the Inflation Reduction Act (IRA) could likely be upward pressure on the initial listing price for new drugs, placing a premium on companies with innovative products that add true value. However, the law’s ultimate impact likely depends on rulemaking to be done before its 2026 implementation.
• COVID-19 provided tailwinds for select health care companies, however the endemic phase hasn’t been kind to many COVID winners given excess capacity, difficult comps, and other impacts. Within this environment, diversified health care companies that have been unfairly penalized could likely provide strong investment prospects looking ahead.
• Within the more volatile small cap biotech space, Westfield seeks post proof of concept companies with multiple assets in the pipeline to mitigate risk. Ultimately, the team is seeking platforms of innovation with multiple shots on goal that are fully funded to profitability.
• Health care is home to disruption and Westfield seeks companies with sustainable competitive advantages that are both de-risked from a technology perspective and reasonably valued. Themes such as targeted oncology, liquid biopsy, gene therapy, orphan diseases, value-based care and consumerization of medical technology likely represent compelling long-term growth opportunities.

For more information, please access our website or contact us.

---

Important Information

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses.

The views expressed herein are those of Harbor Capital Advisors, Inc. and Westfield Capital Management Company, L.P. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice or a recommendation to buy or sell any particular security or to adopt any investment strategy.

Harbor Capital Advisors, Inc.

2576316