The “Halo Effect” on Healthcare

In brief, financial markets continue to normalize after an uncertain and volatile 2020. In March, U.S. consumer confidence rebounded acutely over the past two months to a “pandemic high” supported by optimistic income prospects as the job market improves and stimulus checks hit bank accounts. Leading economic indicators also illustrate an accelerating economy. In March, the leading economic indicators (LEI) grew by 1.3% month-over-month (with all ten components improving), with the end of year GDP expectations rising to the mid-single digits.

Despite normalcy settling in with almost 30% of Americans fully vaccinated and social restrictions gradually easing, investors should not forget the innovative power of specific sectors that became magnified throughout the pandemic. The industry and segments under the spotlight in 2020 and so far in 2021 remain the healthcare (including biotechnology) sector but more generally the life science segments.

Though some skeptics may question the speed of clinically testing, developing, and mobilizing a COVID-19 vaccine, it is probable that 20 years from today, we will look back on the speed/accuracy of this medical breakthrough and coin it as one of the best medical achievements in history. Opinions aside, the origination of a novel vaccine in less than one year is a testament to the compounded effects of scientific research, the capital inflow to life sciences, and the record-breaking enrollment for final stage clinical trials. The perfect storm to find a breakthrough led to the swift mobilization and inoculations of a COVID-19 vaccine.

With the search for a vaccine at the top of the public agenda, investors explicitly or implicitly viewed healthcare as a growth investment. This is likely a result of the COVID-19 “halo effect” on the healthcare industry. A “halo effect” is “the name given to the phenomenon whereby evaluators tend to be influenced by their previous judgments of performance.” In our case, the “halo effect” for the search to develop a vaccine is a derivative of “arbitrary coherence” or “the phenomenon of anchoring a value metric (creating a determinism effect) in attributing a comparable value or rank to something similar.” In short, this is the origination of creating social norms or, in our case, investing norms. These investing norms that spawned from COVID-19 and the pursuit of a vaccine remains the increased value and importance on healthcare, biotechnology, and life science innovations. As experienced throughout 2020, an individual’s health is the greatest luxury good. Without one’s health, social and economic foundations become distressed, as seen in 2020 with the COVID-19 pandemic. Therefore, though intentionally or unintentionally, the deviation of normalcy post-COVID-19 will likely stamp a higher economic value on life science innovations in pursuit of clinical, therapeutic, or technological breakthroughs. Thus, this new mindset may positively impact the growth of healthcare and life science companies, specifically genomics, oncology, DNA sequencing (various applications), and biopharma. For instance, as illustrated in the two-part series, The Next Stage of the Disruptors: Part 1 & The Next Stage of Disruptors: Part 2, many subsectors to healthcare, specifically, segments of biotechnology, remain poised to grow double digits through 2025 as the entire biotechnology sector is estimated to have an approximately 16% compounded annual growth rate (CAGR) through 2028. Therefore, the biotechnology market is estimated to eclipse $730 billion by 2025 as venture capital investment increases amid health-conscious agendas spurring demand for innovations and personalization of biological engineering, drug development, etc. More generally, the healthcare industry is on pace to reach a market value of over $10 trillion by the end of 2022 amid the U.S.’s increase in healthcare spending (also most in the world), internet integration lowering operational costs, and industry output and speed to market improving. Applied technological innovations and advancements such a 3D printing, artificial intelligence, and blockchain systems will add efficiency value and increase medical breakthroughs, further growing this sector’s market value.

More generally, after the success of the COVID-19 vaccine mobilizations, government capital investments and initiatives will continue to improve the drug regulatory pathway, standardize clinical studies, revamp reimbursement policies, and streamline product approval processes.

However, many questions arise about the stability and near-term volatility of these segments. Others question if this sector could sustain its’ estimated growth prospects while creating disruptive innovation arbitrage opportunities. In essence, all of these concerns ultimately ask the same question:

Can this market become oversaturated?

Some investors fear that the healthcare/biotech market may become overcrowded, diluting investing alpha. However, the healthcare sector and its various subsectors are unique compared to the better-known consumer staples or technology sectors. There can be many winners (and losers) in healthcare, and very seldomly is there one best procedure, therapy, or drug applied. The primary catalyst to this dynamic is the growing need for personalized medicine and customized procedures overlayed with the physician’s pledge to the Hippocratic Oath. In essence, on a macro level (not accounting for self-interest anomalies), for physicians to meet their patient’s personalized needs, self-interest biases are discarded, and options for treatment are applied to meet the patients’ best interests. If the treatment is not successful, then that treatment is replaced with another alternative procedure or even physician. This dynamic can be viewed as a form of “reciprocal cognitive deterrence” or the psychological discouragement of opportunism through reciprocal installments of doubt or fear of operating inefficiency (losing a patient, unsuccessful treatment, etc.), thus, breaking through the prisoner’s dilemma (as explained in The Social Experiment: The Game Theory of COVID-19 and Markets) or an outcome not meeting utility maximization. In addition to this dynamic breaching opportunism and self-interest biases, it also creates endless pockets of arbitrage for investors from illegitimacy discounts resulting from the lack of technical knowledge or market interpretation of the synergies and interpersonal dynamics illustrated above.

On a micro-level, innovation does not stop at one breakthrough. Many healthcare and biotechnology firms that have successfully developed an innovative medical breakthrough must continue to invest in research and development to continue to innovate their products to meet market demand and maintain their economies of scale. Maintenance of economies of scale limits the market share depletion that new entrants and competitor breakthroughs can have and potentially limits that cannibalization of economic profits. It also limits the original innovators’ potential displacement in the market (as basic competitive market economics illustrates, barriers to entry remain low amid high growth prospects as outsized economic profits remain available in the market).

Conclusion

In short, life science, healthcare, and, more specifically, biotechnology segments are unique in financial markets. The countless pockets of arbitrage opportunities, need for innovations, and implicit checks and balances on the market’s interfirm relationships and social micro-foundations plaguing capitalistic industries make this area of the market not only unique but also a fantastic way for investors to capture long-term returns. Managers with a seasoned investment strategy accompanied by the tools necessary to conceptually value investments in this segment (plagued with illegitimacy discounts and mispriced) can see outperformance using value investing techniques in a high growth segment. Thus, managers with a core life science foundation appreciate the inertia of innovation and conceptualize the contexts of the compounded value of all previous discoveries back to the ancient Roman physician and the founder of many disciplines, Galen. For investors, it is not easy to comprehend the value of compounded historical discoveries with the rolling innovations and integration of technology. However, that does not mean that investing in this space does not generate consistent returns. Instead, it is quite the opposite as relative returns compound over time, generating long-term outperformance.