Though Morningstar views the healthcare sectors in both the US and Australia as fairly valued overall, there is a handful of buying opportunities among drug-makers and other businesses in both countries.

In North America, Morningstar's US Healthcare Index increased by around 1 per cent in the June quarter, and 9 per cent year-to-date, trailing the market over both intervals, says Chicago-based director of equity strategy, Damien Conover.

The muted growth is largely due to concern around healthcare pricing pressures, after US President Donald Trump on 24 June proposed changes around pricing transparency across the industry.

“We’re fundamentally changing the nature of the health-care marketplace,” Trump told reporters at the White House in late June. “Prices will come down by numbers you can’t even believe.”

Coming soon after the US President launched his re-election campaign for 2020, the executive order is part of his latest push to make healthcare costs more visible, boost competition and reduce regulation.

Many medical insurers and other healthcare-allied businesses saw a sharp sell-off following the announcement – a New York Stock Exchange sub-index of insurers fell 1.1 per cent the following day.

"But in drug manufacturing, we believe the market is still ascribing too much valuation pressure on the industry due to potential negative drug pricing regulations," says Morningstar's Conover.

Top picks in Aussie healthcare

Closer to home, many of Australia's largest listed pharmaceutical, biotechnology and other health-related stocks have very high exposure to the US market – such as names like CSL, Mayne Pharmaceuticals and ResMed.

But Morningstar's preferred stocks in the segment are Healius (ASX: HLS), Sigma Healthcare (ASX: SIG) and Australian Pharmaceutical Industries (ASX: API), which each hold four-stars.

Healius, a medical centre operator and diagnostics service provider, crossed into four-star territory on 28 June, when its share priced dipped to just over $3. It was trading at $3.06 at the close of trade on 9 July - a 23 per cent discount to Morningstar's $3.50 fair value estimate.

The company's large-scale medical centres generate dependable earnings, and its pathology division in particular enjoys competitive advantages, says Morningstar equity analyst Daniel Ragonese.

Though the overall company is not considered as holding a moat, "we consider Healius' pathology business to have a narrow moat, because of its large market share – about 35 per cent – and the associated scale that delivers material cost advantages," he says.

Within its medical centres business, the majority are large-scale, bringing cost advantages over smaller centres through increased cost efficiency.

Investors under-estimate strategy

Narrow-moat drug distributor Australian Pharmaceutical Industries is currently trading at an almost 20 per cent discount to Morningstar's fair value estimate of $1.80 a share – having closed at $1.34 on Tuesday 9 July.

Though Morningstar senior equity analyst Brian Han has trimmed his earnings before interest and tax forecast over the next 6 years – in response to reforms of Australia's Pharmaceutical Benefits Scheme – his long-term outlook remains positive.

He believes the market is underestimating management's strategic initiatives to offset pressure from PBS reform – most notably through its attempted merger with competitor Sigma.

While this proposal was rejected in March, Han says the logic of the combination is too compelling to ignore, "as it would strengthen both groups and eliminate duplications in the industry."

"This may well explain why API is keeping its options open with respect to the 13 per cent shareholding in Sigma, a strategic stake that was built ahead of its tilt at the peer pharmaceutical distributor," he says.

'No point crying over spilt milk'

Also holding a narrow moat, Sigma is a Morningstar four-star stock that is currently trading at a discount– its last closing price of 58 cents around 17 per cent below Han's 68 cent fair value estimate.

One of three main Australian-listed pharmaceutical players – alongside Ebos and API – Morningstar regards Sigma as having the most distinct set of brands and strategies.

Though Sigma's fiscal 2019 underlying EBIT of $76 million was down 16 per cent year-on-year, a major investment program is almost complete, including a $100 million upgrade of distribution centres.

Han attributes much of the current share price weakness to perceived challenges linked to this upgrade project, along with its rejection of API's approach.

"However, there is no point crying over spilt milk…and there is value in Sigma shares on a long-term fundamental, stand-alone basis," Han says.

'Best-in-class operating costs'

Among US stocks, Morningstar's Conover sees only a few buys, with only 5 per cent of its long healthcare coverage list rated five stars: "And most 4- and 5-star healthcare stocks are in drug manufacturers and healthcare providers."

His top pick in the US sector is NYSX-listed CVS, the largest national pharmacy benefit manager.

With a fair value estimate of US$92, its last closing price on 9 July was US$55.30 – a 40 per cent discount.

"CVS' scale provides substantial negotiating leverage and cost advantages in claims processing, allowing for best-in-class operating costs per claim.

"Further, the firm's combination with Aetna should put the company in a much more attractive competitive position as the industry moves toward preferring a more integrated service offering," Conover says.

He also believes investors should benefit from meaningful cost and selling synergies associated with the combination of a leading medical benefits business with the largest PBM and retail pharmacy network in the country.

Kidney treatment leader

DaVita, the US market leader in dialysis services, has a narrow moat which also stems from its size – allowing it to negotiate better prices from suppliers along with other efficiency benefits.

The company's last closing price of US$55.51 is a 30 per cent discount to Morningstar's US$79 fair value estimate.

"Dialysis operators benefit from structural 3 per cent to 4 per cent volume growth year in and year out, a rarity among healthcare providers.

"While industry pricing is always the wild card, we expect 1 per cent blended rate growth in the coming years, helped by Medicare's proposed rate increase for 2019," says Conover.

He attributes recent underperformance to "unwarranted fears that the dialysis industry will ultimately face the ire of regulators."

Genetic disease treatment

Biomarin Pharmaceutical also holds four-stars, with a strong pipeline of late-stage drug development that supports Morningstar's narrow moat rating.

"We think the market underappreciates the firm’s entrenchment in current markets, as well as its potential in new markets, particularly with its emerging gene therapy pipeline," says Morningstar US equity analyst, Karen Andersen.

BioMarin has several products on the market to treat rare genetic diseases – products which generally have strong pricing and limited competition.

Andersen points to patent protection, complex manufacturing techniques and BioMarin’s close relationships with patients, who rely on its therapies for chronic treatment, as key drivers of these advantages.

"We think BioMarin is poised to generate more gene therapy targets and has strong intangible assets due to its innovative products, manufacturing expertise, and global reach among patients with very rare diseases."