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Finding great healthcare stocks means finding “game-changing innovation,” says Ann Gallo, senior vice-president and partner at Wellington Management Company in Boston, Massachusetts.

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That’s more than a cliché; it’s a business requirement, especially as costs rise relative to reimbursement.

Medical technology companies used to “get away with incremental innovation,” explains Gallo. They expanded their margins and grew “by tweaking existing models in a slightly favourable way, as opposed to putting forth groundbreaking innovation.”

Those days are gone.

“Like we’re seeing in biopharma [and] in med technology, unless you have real groundbreaking innovation, the type of […] reimbursement that [companies] desire will not be achieved,” says Gallo, who manages the Renaissance Global Health Care Fund.

She looks for innovation that decreases cost. There are ways for companies to provide a standard of care that’s equal to – or even better than – what people get currently, “but at a lower cost and in a more efficient manner,” says Gallo, who points out that identifying companies with these types of innovations creates “an all-weather portfolio.”

But she’s cautious: an “incredible wave” of innovation is a tailwind for the healthcare sector, as is growing wealth in emerging markets, Gallo says. But the aging of populations presents both advantages and disadvantages.

As demand increases, “cost is an issue,” for example. “We need to find a way to pay for the demand that we’re going to see continually as the world ages and wants to make use of this great innovation we’re seeing throughout the pipelines,” Gallo explains.

Science meets business

Groundbreaking innovation can be found in diabetes treatment and transcatheter aortic valve replacement (TAVR), says Gallo. For example, the latter addresses aortic stenosis in a new way, instead of making incremental changes to stents. Gallo cites Boston Scientific as an innovator in the TAVR market.

Company size also matters, with innovation having a greater impact on a smaller company. She also notes company consolidation helps drive innovation.

“One thing we look for is the relative size of the market and the size of the potential opportunity to the market cap of the company,” says Gallo.

An example is Penumbra, which has a product for ischemic stroke. “It’s a relatively smaller-cap company, and it is meaningfully ahead of others in this very attractive market where there’s a huge unmet need.”

Assessing both innovation and company size means “we have a barbell approach when looking for med tech names in the portfolios,” says Gallo.

“I’m looking for relatively smaller-cap [or] mid-cap companies that have truly groundbreaking innovation for which we’re going to see a big transformative impact on the stock price if we’re right about the capabilities and attractiveness of the technology, the size of the market and the take-up rate.”

Cost-effective innovation can be the result when med tech companies observe that their hospital customers are under increasing cost pressure, says Gallo. As a result, these companies aim to up their value propositions.

For example, in addition to its scientific innovation, Boston Scientific is “thinking about its value proposition differently […] to enable its [hospital] customers that are under increasing [cost] pressure to do what they do now but quicker, cheaper and better.”

Not new, but improved

Innovation can also be found in the delivery of healthcare products and services.

“Currently, the majority of the U.S. healthcare system is reimbursed on a fee-for-service basis, which, unfortunately, […] creates incentives to do more — use higher-priced products and services, and treat as much as possible. What we are moving to, and hope to move to, is a system that doesn’t reimburse based on volume, but based on value.”

As a result, Gallo sees advancement in payment models, medical homes and shared risk.

Citing her firm’s investment in a telehealth company, she says, “There’s a lot of investment going into technologies that can be used at home, for instance, in an attempt to keep people out of hospitals.”

Such innovation “sounds easier than it is,” she says. “You need to get payers to agree to reimburse, get doctors signed up to facilitate this interaction and get the patients comfortable with […] not visiting a provider in person.”

Another example of services innovation is evident in the increasing number of urgent care centres popping up in the U.S. This is occurring “in an attempt to keep people from going to the emergency room when situations arise,” which cuts down on overcrowding and strained resources.

More than one winner

Healthcare innovation isn’t a zero-sum game, says Gallo, because multiple companies can address an unmet need. For example, there are many companies working in immuno-oncology that you can invest in; her firm holds Bristol-Myers Squibb and others.

“People talk about cancer as if it’s one disease; it’s not. It’s hundreds of different diseases,” says Gallo. And, “More common than not, if there is a large market of unmet need, […] you’re going to have more than one way to play.”

Originally published on Advisor.ca
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