In conversation with Aditya Khemka, Fund Manager, InCred Healthcare Fund, InCred Asset Management

Key threat to the healthcare sector is essentially more regulations & delays in the execution of government initiatives like Ayushman Bharat and National Digital Health Mission, expresses, Aditya Khemka, Fund Manager, InCred Healthcare Fund, InCred Asset Management

Will the healthcare sector lose steam as the pandemic threat has subsided? What are the key growth triggers for the sector in 2022?   
We believe that the healthcare sector by and large lost business due to COVID as against the popular perception that it benefitted from the pandemic. Approximately, 65 per cent of drugs prescribed in India are for acute conditions. Acute diseases mostly occur when humans move out of their houses and interact with foreign elements like polluted air, street food, etc. Since during COVID, most of us stayed at home for prolonged periods of time, the acute sales of pharma companies took a beating. Further, COVID has resulted in multiple supply shocks of raw materials and cost inflation, which has impacted margins too.

Hence, in our belief, healthcare is also a COVID recovery story and unlikely to lose steam as the pandemic subsides. The key growth trigger for pharma companies that are focussed on the India business would be the growth in price (driven by high WPI) and volume (driven by a low acute sales base). Higher price & volume growth could begin to reflect in financials starting 1QFY23, and 2QFY23 would have the complete impact. This may help the companies reset the margin pressures that have been witnessed in 2QFY22-4QFY22. 

The healthcare sector is a diversified lot. Which sub-segments furnish the most-promising growth prospects? 
We divide the healthcare sector into largely six buckets. Companies that are focussed on unbranded generics (e.g. Aurobindo Pharma), branded generics (e.g. FDC Limited), API/CRAMS/chemicals companies (e.g. Divi’s Labs), hospitals (e.g. Aster DM), diagnostics (e.g. Thyrocare) and allied (insurance, equipment, etc). Given that India’s healthcare sector has exhibited growth of 1.4x-1.5x of India’s GDP over the past decade and yet India spends only 3.5 per cent of GDP on healthcare versus 5 per cent-10 per cent for other emerging markets, we believe that the healthcare sector in India will continue to grow faster than GDP.

Hence, we at InCred Healthcare PMS, focus on those companies that stand to benefit from increasing healthcare spending in India. This would include all the buckets mentioned above, other than unbranded generics. We believe that unbranded generics have high capital intensity, regulatory risks (USFDA, etc), commoditised products, concentrated buyers (low bargaining power for suppliers), and high competition. This is a segment that we would like to avoid in the foreseeable future unless a structural change occurs. 

What are the key opportunities and threats to the sector in the next 2-3 years? 
We believe that the Indian branded generic market is unique in its sustainability of cash flows and profitability. The fact that this market has grown 1.4x-1.5x of GDP in the past decade and is likely to continue growing at that rate is a large opportunity for investors. The active pharmaceutical ingredient (API) business had also shifted from India to China post-1990. Today, estimates suggest that China exports API worth USD 30-40 billion vs India at USD 4 billion. This shift from Indian API to China was largely driven by the low cost of production in China, which was driven by multiple factors such as negligible pollution control, subsidised thermal power, low cost of capital & labour, etc.

However, over the past 2-3 years, we have seen all these factors fading and hence, China’s low-cost advantage is fading versus Indian API. Hence, we see that most of the API companies in India have announced substantial Capex budgets, which in our opinion is driven by substantial growth in the order book. We believe that the Indian API industry can achieve in the next five years, what the Indian chemical industry has achieved over the last five years, i.e., import & export substitution, leading to high top-line growth as well as margin expansion. The key threat to the healthcare sector is essentially more regulations & delays in the execution of government initiatives like Ayushman Bharat and National Digital Health Mission.   

Can you shed some light on how InCred Healthcare’s portfolio is positioned to make the most of the current market scenario?  
As discussed above, we remain highly optimistic about the growth of healthcare spending in India. Hence, we allocate broadly 40 per cent-45 per cent of our portfolio to pharma companies that are focussed on Indian business i.e. approximately 20 per cent to hospitals, 20 per cent-25 per cent to API/CRAMS/chemicals, (contract research & manufacturing services), and around 5 per cent to diagnostics. All these positions are built around the thesis of Indian healthcare spending, outpacing Indian GDP growth. We would like to point out that the largest weight in our benchmark is that of unbranded generic companies that account for almost 40 per cent of the index.

Hence, our portfolio has a high active share vs index and is a benchmark agnostic portfolio. However, we are comfortable with it as we believe in creating a portfolio that may exhibit the highest quality of cash flows, return on equity, comfortable valuations, and less-levered balance sheets. It is unique to the healthcare sector in India than the larger companies because they have larger exposure to unbranded generics, have lower RoE, higher volatility in cash flows, more leverage, and higher valuation multiples. We see this as an opportunity to create higher returns with a higher margin of safety.