Healthcare is supposed to keep you… well. At least as a patient. As an investor many healthcare companies were also considered to have protective properties – they were so-called defensives and provided some inoculation against cyclical downturns. The aftermath of Covid-19 put paid to that.
Healthcare stocks have traditionally been viewed as a safe investment, providing consistent returns even during economic turbulence. The rationale behind this is simple: healthcare is a necessity, and demand for medical services and products remains relatively stable regardless of economic conditions.
However, the Covid-19 pandemic turned this assumption on its head. Between 2022 and 2023, many European healthcare companies, previously considered defensive, found themselves caught in a cyclical downturn.
The pandemic's impact on healthcare stocks
The Covid-19 pandemic brought unprecedented challenges to the healthcare sector. Initially, there was a surge in demand for healthcare products and services as governments and individuals scrambled to respond to the crisis. This led to over-investment in healthcare stocks, with investors expecting sustained high demand. However, as the pandemic progressed, several factors converged to undermine the defensive nature of these stocks.
One of the primary reasons for the decline in defensive properties was over-investment during the early stages of the pandemic. End-customers and intermediaries, anticipating prolonged high demand, heavily invested in healthcare products which led to high inventory levels. Those high levels only returned to normal levels after three years. This over-investment created a bubble that eventually burst.
Additionally, the rising interest rate environment further exacerbated the situation. Higher interest rates increased the cost of borrowing, putting pressure on companies with significant debt and reducing their financial flexibility.
The case of Addlife
Swedish-based Addlife, one of Europe's leading distributors of labtech and medtech consumables, instruments, and services, provides a compelling example of how healthcare stocks were affected.
Before the pandemic, Addlife enjoyed robust growth, driven by both organic expansion and strategic acquisitions. However, in 2022, the company experienced a slowdown in sales growth and a buildup of inventory. This was primarily due to the correction in the global healthcare, lab, and medtech markets following the over-investment during Covid-19.
Despite these challenges, Addlife has since shown signs of recovery. The funding environment for the healthcare and laboratory sector has improved, and Addlife's sales growth has reaccelerated to over 10% in the past three quarters.
The company's strong management team, led by Fredrik Dalborg, the former long-term Chairman of Addtech, has played a crucial role in navigating these turbulent times. Addlife's high proportion of consumables sales, which account for approximately 80% of its total sales, is expected to restore its defensive profile going forward.
The case of Revenio
Revenio, a Finnish health technology company specialising in eye screening devices for early disease detection, also faced significant challenges during the pandemic. Revenio operates in niche markets characterised by a lack of innovation in traditional detection methods. The company's solutions offer substantial advantages over existing options, effectively replacing outdated methods with innovative technologies.
In 2023, Revenio's end markets, particularly US-based private equity-backed optometric chains, held back investments in new equipment due to the rapidly rising interest rate environment. This led to a stagnation in market growth, which had previously been expanding at a rate of approximately 15% per year.
However, these trends have recently eased, and the market has returned to growth. Revenio's strong financials, including a net cash position, a five-year average free cash flow conversion rate of 91%, and a 31% EBITDA margin, position the company well for recovery.
Conclusion
The Covid-19 pandemic disrupted the defensive nature of European healthcare stocks, causing many companies to experience cyclical downturns. Over-investment during the early stages of the pandemic and the subsequent rise in interest rates were key factors contributing to this shift.
However, companies such as Addlife and Revenio are now showing signs of recovery. Improved funding environments, strong management teams and innovative solutions are helping these companies regain their defensive properties.
As the healthcare sector continues to evolve, investors should remain vigilant and consider the lessons learned from the pandemic. While healthcare stocks may have temporarily lost their defensive characteristics, the underlying demand for healthcare services and products remains strong.
Companies that can adapt to changing market dynamics and maintain financial resilience are likely to emerge stronger and more defensive in the long run.
Peter Kraus is head of small caps at Berenberg Wealth and Asset Management. The views expressed above should not be taken as investment advice.