Healthcare Sector: The prescription for what ails your portfolio?

Recent headlines have raised concerns about elevated valuations of AI-related stocks and the risks of an increasingly concentrated market. As a result, many investors are looking for ways to derisk their portfolios through broader diversification. At Foster Victor, our investment process focuses on identifying companies with fundamentally sound business models and attractive risk-reward profiles. Through this lens, healthcare stands out as sector worth revisiting.

Historically, the healthcare sector has delivered returns comparable to the technology sector, but with significantly lower volatility. As depicted in the chart below, from 1989 to 2019, healthcare stocks, driven by a combination of innovation and defensiveness, performed similarly to tech stocks.

On top of these relatively strong returns, healthcare stocks also exhibited a high degree of resilience, outperforming the broader market during periods of drawdowns.

However, since 2020, the story has been much different, with healthcare stocks underperforming the broader market and the tech heavy “Magnificent Seven.” This underperformance has pushed valuations to decadal lows, raising the question: Is now the time to revisit healthcare stocks?

Sector Underperformance: Key Drivers
To answer that question, we need to understand what has driven the recent weakness and whether those factors are temporary or structural. Equally important is a closer examination of the healthcare sector’s key industries, as each faces unique challenges and opportunities. Healthcare stocks now trade at a steep discount to the broader market, with this valuation compression being driven across multiple industries within the healthcare sector. The healthcare sector isn’t homogeneous, however, and one needs to look at each of the key industries to better understand the sector’s recent challenges.

Biotechnology:
Once a deep well of innovation and growth, biotech has struggled in recent years. Since 2017, earnings growth has been negative, and since 2018, 80% of biotech IPOs have underperformed or failed to meet expectations. This wave of IPOs, many from early-stage companies with limited pipelines, has contributed to increased sector volatility and waning investor confidence. Compounding these challenges is an elevated level of failed drug trials, which have eroded capital and shaken investor sentiment on the sector’s ability to deliver new therapies. As a result, valuations across biotech are now near historic lows, setting the stage for a rebound, particularly if M&A activity picks up. Importantly, the need for innovation remains urgent, with many diseases still lacking effective treatments. Biotech companies with robust platforms and differentiated approaches are well-positioned to address these unmet medical needs, offering long-term opportunities for investors willing to look beyond the current turbulence.

Pharmaceuticals:
Even factoring in the GLP-1 boom, pharma stocks have delivered only modest gains, generating just under 5% annualized returns from December 2019 through July 2025. Slowing earnings growth and looming patent cliffs for major drugs like Humira, Keytruda or Eliquis are key concerns. While many pharmaceutical firms have built sizable acquisition war chests, the pool of viable targets is limited, largely due to the recent struggles in the biotech space.

Drug pricing reform is another headwind. U.S. drug prices remain 2.5x–3.0x higher than OECD peers. Bipartisan proposals, including Most Favored Nation (MFN) pricing, could reduce prices by 5%–10% and cut pharma earnings by up to 9% by 2031. With six bills already advancing in the Senate, there’s real legislative momentum and mounting risk for the pharmaceutical space.

Digging deeper into the data, large-cap pharma’s forward P/E of 14x is inflated by Eli Lilly’s 24x multiple. Excluding Lilly, peers like Merck, Pfizer, and Bristol Myers Squibb trade at just 8x–9x forward earnings. These discounted valuations could be a real opportunity if firms can stabilize growth and navigate legislative and regulatory challenges effectively.

Managed Care:
The managed care group, which includes major health insurance providers such as Humana and United Health, has faced significant challenges in recent years. Returns in managed care have collapsed due to regulatory headwinds, legal judgments favoring providers, and scrutiny over AI-driven claim denials. Mounting costs have been another headwind. According to McKinsey, both payers and providers have seen their profit margins slide sharply, driven by a combination of rising medical costs, labor shortages, and reimbursement challenges. The passage of the “Big Beautiful Bill” has intensified these pressures due to cuts in Medicaid and ACA funding. Looking forward, managed care providers are planning to request 20-30% rate increases to offset rising costs and restore margins. While the headwinds are substantial, the managed care sector’s ability to adapt through pricing adjustments, operational improvements, and technology investments could pave the way for a recovery.

Rising Costs versus Innovation Needs:

As seen in the chart above, the U.S. spends significantly more per capita than many developed nations. In 2022, total healthcare spending reached $4.5 trillion, or 17% of U.S. GDP in 2022, and health costs have only continued to rise since. These escalating costs are contributing to rising budgetary pressures at both the federal and household levels. Despite the high levels of spending, many unmet medical needs remain. With an aging population and a rising prevalence of chronic conditions, the demand for healthcare services continues to escalate rapidly. This creates a critical tension between the need to control costs while still encouraging innovation that improves outcomes and saves lives.

Healthcare Sector: Opportunities
Despite recent struggles, the long-term case for healthcare remains compelling. A rapidly aging global population is expected to drive sustained demand for medical services. At the same time, cancer, heart disease, stroke, mental health, and rare diseases present significant unmet needs and offer opportunities for innovation. Globally, access to care in underserved populations remains a critical challenge and represents another growth opportunity for companies focused on scalable, cost-effective solutions.

Key areas of opportunity include:

Biotech M&A Targets:

Facing looming patent cliffs and gaps in product pipelines, large-cap pharmaceutical firms are increasingly turning to strategic acquisitions to sustain growth. With significant dealmaking capacity, many are targeting biotech companies with promising Phase 2 or 3 trial results or FDA approvals to help replenish their pipelines. Beyond M&A, the biotech space is advancing in areas with high mortality and unmet needs, including Alzheimer’s, cancer, cardiovascular, and autoimmune diseases, making it a potential driver of future growth.

Medical Device Companies:

Disciplined R&D and strategic acquisitions have helped distinguish top performing medical device companies from their peers. Firms investing greater than 10% of sales into R&D have seen strong revenue growth, rising returns on capital, and solid shareholder returns, highlighting the value of focused innovation. A 2024 study by EY further supports this, showing that medtech companies that proactively invest in differentiated R&D pipelines and innovation have achieved stronger total shareholder returns. These investments reduce perceived investor risk and act as a multiplier for long-term value creation.

Generic and Biosimilar Producers:

If patent reform gains traction, generic and biosimilar firms could benefit from faster market access. While generics account for 90% of prescriptions by volume, they represent just 17.5% of total drug spending, highlighting the potential for growth, especially in cost-sensitive markets.

Drug Discovery Companies:

Drug development remains a key driver of healthcare innovation, and AI is helping to accelerate progress in this space. The explosion of genetic data and advances in next-generation computing are helping researchers speed up the identification of promising compounds and streamline clinical trials. Emerging technologies like RNA interference (RNAi) therapeutics are also gaining traction, offering new treatment pathways by silencing disease causing genes. Meanwhile, progress in gene editing systems, such as CRISPR, is also particularly interesting. A major milestone was recently achieved with the first FDA approval of a CRISPR-based therapy for sickle cell disease, signaling a new era in precision medicine. These breakthroughs highlight the sector’s potential to address unmet medical needs and deliver transformative therapies.

Final Thoughts:
Healthcare may not be the market’s current darling, but its combination of low valuations, long-term demand drivers, and pockets of innovation make it a sector worth watching. For investors seeking diversification and resilience, healthcare could be the prescription for a healthier portfolio.

At Foster Victor, our investment process is rooted in identifying companies with fundamentally sound business models and attractive risk-reward profiles. This disciplined approach helps us uncover opportunities in sectors that may be overlooked by the broader market but offer long-term potential. Healthcare is one such area, where recent underperformance has created compelling entry points, especially for investors focused on fundamentals rather than momentum.