Small is beautiful in this evergreen theme

Aditya Khemka

AVP (Equity Investments)

DSP Mutual Fund

  • DSP Healthcare Fund will have a portfolio that is well diversified across all healthcare verticals – including pharma, hospitals, diagnostics, health insurance and will also have an overseas exposure to participate in the growth stories of some international healthcare stocks.
  • Smaller pharma companies are on a firmer footing than their larger counterparts in a very interesting turn of events – and Aditya takes us through why and how his fund will capitalize on this
  • Aditya explains exactly how Ayushman Bharat will impact the healthcare sector and how he expects the business dynamics to play out in this massive initiative

WF: Healthcare stocks have seen a good run recently on the back of rupee depreciation. Is there a longer term secular argument beyond the current tactical one in the healthcare sector?

Aditya - The rupee had touched about Rs. 74 – Rs. 75 per dollar (from earlier levels of Rs. 65/dollar) about 3-4 weeks back, they have tapered down to Rs. 70 per dollar. While the healthcare sector focus is partially due to the currency fluctuation, the main reason for the focus on this sector is primarily due to improving fundamentals – particularly among midcap healthcare stocks. There are lot of secular arguments at this moment for different sectors within the healthcare theme. There are plenty of opportunities, different companies are positioned in different ways (it will be incorrect to paint all of them with the same set of arguments or rationale).

WF: What is the rationale for broadening the geographic scope to US, Europe, Brazil, Argentina and India? Will the stock picking strategy differ based on the geography considered? How will the broader risks such as currency risk, geo-political risk etc., be managed?

Aditya – The mandate currently allows us to invest upto 25% in any other geography other than India. We are unlikely to breach this ceiling since, there are tax implications on breaching this ceiling. We will be initiating exposure towards other geographies with a smaller percentage, around 5% - 10% and overtime intend to scale up the percentage as we get more comfortable. The reason for broadening the scope across geographies’ is backed by research which we conducted on US healthcare sector. We mapped the performance of US healthcare sector with that of the performance in Indian healthcare sector. The US healthcare sector is represented by Dow Jones healthcare Index, in India we have the BSE healthcare index. The observations indicate that in the last 10 years, both indices have given about 19% CAGR returns, the volatility of Indian healthcare index has been around 16.6% and the volatility in the US healthcare index is around 15.9%. The US healthcare index is less volatile than the Indian healthcare index. The correlation of US healthcare and domestic healthcare is almost negligible. Hence, when a portfolio is created out of the two, while there has been no compromise on the returns since both have provided more or less similar returns, there is lower volatility because they have a correlation which is very low or are negatively correlated. This ensures better stability on the portfolio performance aspect. One of the frequent pushbacks that the fund manager often gets on a sectoral or thematic fund is that there is too much risk associated with a sectoral or thematic fund since, they are dependent on a key set of variables, when the variables turn favorable, the entire portfolio moves up and vice versa happens if the variables turn unfavorable. This aspect is being countered by diversifying our portfolio by adding US based stocks for the time being. This will ensure that volatility arising due to this aspect is contained. The overseas exposure in the initial cut of the portfolio will be kept below 10%, it would depend on the comfort level that we achieve on the investment trend and pricing points we manage in the new geography. It is essentially a function of multiple things, getting the right stock at the right price is the key philosophy that we do not intend to compromise on.

WF: In the first cut of the portfolio, what are the sub-sectors you are keen on adding in the portfolio?

Aditya – Two things that we intend to highlight here, with regard to segmentation of the portfolio. Whatever, pharma funds that exist currently in the mutual fund universe have exposure to the extent of 85% - 90% into pharma stocks exclusively, with only 8% - 10% allocations to hospitals and diagnostics. In DSP Healthcare Fund, we will endeavor to have a fair weightage across pharma, hospitals, diagnostics, health insurance and also overseas healthcare stocks. Our fund will thus be different from the typical pharma sector funds that are currently available.

There are many factors which can trigger the growth in earnings for the sector, there are initiatives like ‘Ayushman Bharat’ which could offer long term growth prospects for the healthcare stocks especially stocks in the hospitals and diagnostics space.

WF: What impact might “Modicare” or Ayushman Bharat have on the healthcare sector? How big is this theme from a structural perspective?

Aditya – There is considerable ground work being done with respect to this initiative. Recently, there was news in the media which indicated that around 300,000 patients who availed services offered under the ‘Ayushman Bharat’ initiative. Almost 70% of the volumes went to private hospitals. The plan or initiative is to cover ~10 crore families in India. Given that the average size of a family is typically 4 people, you have about 40 crore people getting health insurance. With the advent of health insurance, the affordability will go up. With the affordability going up, the people who always had healthcare issues, but were never able to address it medically due to affordability reasons will now be able to address it effectively. This will inturn mean more volumes for the healthcare sector. Within the healthcare sector, 70% of the hospitals belong to Government, 30% of the hospitals are run by private. Majority of Government hospitals are not in great shape, they are not equipped enough to cater to many of the medical challenges faced by the patients. This indicates that a majority of the business is likely to be handled by private sector. There is a likelihood that 70% of the volume is likely to be catered by the private sector hospitals. There are pricing concerns which are raised by the private sector hospitals (e.g. The ceiling laid by the Government on pricing of stents). Our understanding is that many private hospitals have started the practice of bundled pricing – without giving break-up, to get around the Government controls on pricing of components for individual procedures. Our belief is that these pricing issues will eventually settle down to levels where the Government is comfortable and where private hospitals can make reasonable RoE. The fact is that costs of surgeries in India are very low compared to world averages, and quality in private hospitals is very good. No policy will ultimately seek to shut down private hospitals – so some equilibrium on pricing will eventually be reached. The bigger picture therefore is of substantial increase in volumes for private hospitals, at reasonable margins.

WF: Many pharma stocks ran into problems with selling generics in the US market – either on account of stiff competition or issues with US FDA. Are these issues now behind us or will they continue to impair growth prospects of Indian pharma companies?

Aditya – Ironically, only larger pharma companies have had US FDA problems, only a handful of small and midcap companies faced the US FDA problems. Although, the larger pharma companies have the funds to ensure compliance, in some cases, their processes have become outdated and therefore non-complaint. We need to remember that the FDA regulations are updated regularly. Either, the companies failed to align their processes appropriately to the FDA regulations in the first place or they failed to upgrade their processes in accordance to the changes in the FDA regulations. This is the primary reason for the non-compliance of large pharma companies. The midcap and smallcap companies designed their processes after the non-compliance issue of larger companies came to light and hence they have managed to design it in compliance with the US – FDA regulations. Most of the largecap companies have been able to resolve the issues very quickly, hence it is apparent that the FDA issue is behind us – although there may be some intermittent noise of some US FDA issue here and there. However, there may be no significant regulatory reactions from this point forward. The outcome of this issue, is that the companies have learnt that the cost of non-compliance has far reaching implications as compared to the cost of building a process which is thoroughly FDA compliant.

The second aspect that we will discuss is the pricing situation in US. The pricing situation has been diluted, especially from the perspective of what it was (FY 16 – 17) vs. what it is now. Within the pricing issue, there are 2 buckets, there are a bunch of products called the complex generics which have lower competition, they also have a higher entry barrier. The pricing pressure on these products is significantly higher as compared to the plain generics (lower entry barrier). This is counter-intuitive, since one would perceive the products with higher competition is likely to have higher pricing pressure. In pharma, pricing pressure is a function of supply. Many global players shifted away from plain vanilla generics due to low prices and focused on complex generics – leading to supply pressure in complex generics. Many of our large cap pharma companies operate in this complex generics space – out of expectations of better margins – which has become a challenge now. Meanwhile, with supply reducing in vanilla generics, small and midcap pharma companies that have seized this opportunity, are finding an easier ride in the US, compared to their large cap peers. Our fund aims to identify some of the better quality mid and small cap pharma stocks that are playing this trend well.

WF: Should this fund be positioned as a tactical allocation in investor portfolios or is there a case for it to be considered as a long term core holding?

Aditya – Over the last 10 years, BSE healthcare index has outperformed BSE Sensex 6 out of 10 times. Last 10 years, have seen 2 market cycles, the good pricing cycle which lasted between 2012 – 2015 and not-so-good pricing cycle which lasted between 2015 – 2018, healthcare index has managed to sustain its performance across both these market cycles. From a global perspective, pharma is the only sector where we have sustainable competitors in India. Even IT, despite conducive environment is unable to sustain a healthy growth rate in earnings due to severe competition from International counterparts. In pharma, we are gaining considerable volume share globally, pricing has been an issue over the past 3 years. This is a segment where there are sustainable competitive players. India is called the pharmacy of the world. When we see that there is a competitive advantage, as an investor, there is no need to make a tactical allocation in the portfolio towards such sector. The sector is likely to create value for the shareholder over the long haul and hence, should be considered as part of the core holding with a long term perspective.

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