Highest risk, maximum reward in healthcare lies in diagnostics, says Incred PMS' Aditya Khemka

Aditya Khemka

Aditya Khemka, Fund Manager at Incred PMS, highlighted the varying growth trajectories anticipated in the non-homogenous healthcare universe in the coming quarters, in an interview with Moneycontrol. Different companies within the healthcare segment operate in varying niche segments, with each company facing its own set of headwinds. Some of these include price erosion in the US market, regulatory scrutiny, subdued margins, aggressive expansion, and disruption from new-age players, to name a few.

With over 16 years of experience in healthcare businesses and investments, Khemka says that his investing style focuses more on understanding the sources of cash flows and their sustainability.

He also talks about the various trends emerging in the healthcare services space. Edited excerpts from the interview:

The healthcare universe is a non-homogenous space where players focus on different niche segments ― hospitals, diagnostics, CDMOs (contract development and manufacturing organisations), APIs (Active iharmaceutical ingredients), etc. Among these niche segments, where do you see maximum returns coming from?

While looking at returns one should also think of the risks that are involved, as the two go hand in hand. So, as we stand today, I see the highest-risk, highest-reward situation emerging in diagnostics. The rationale is backed by data which shows that despite concerns of disruptions from new-age players, incumbent diagnostic companies are showing decent growth, with improvement in pricing. However, there is also a higher risk involved with diagnostic companies if the concerns over disruptions actually turn out to be true. In such a scenario, there is a lot of downside in diagnostic stocks.

However, if one has look at a lower-risk, lower-reward situation, then that exists in the branded generic space. These companies will take price hikes this year after the National Pharmaceutical Pricing Authority (NPPA) raised by 11 percent the prices of 800 drugs under price control. On top of that, the major issue weighing on the segment, which was raw material inflation, has started easing and will now cushion their margins. Even though these companies cannot give 100 percent returns in a year, they definitely make a good stable investment story.

Companies focused on the API segment had been struggling from a higher base effect in FY23. Weak volume growth and high inflation added to their woes. Do you see recovery making its way in the coming quarters?

There are expectations that the normal base of FY23, along with a declining trend in raw material prices, will reflect positively on their growth and margins in FY24. Added to that will be the China+1 theme. However, the numbers are yet to reflect that and until we get a clarity on that front, there is a downside risk in API companies. These factors make API companies moderate-risk, moderate-reward bets.

At a time when the US market is not just facing challenges from price erosion and increased competition, but also from intense regulatory scrutiny, do you think investors should shift focus to companies with more exposure to the domestic market?

For the non-branded generic segment, prices and margins have fallen, while raw material costs have gone up. It is true that price erosion in the US market is easing, but that doesn't mean prices have stopping falling. All it means is that prices are falling at a slower pace. Nonetheless, the net impact of price erosion will continue to reflect on margins of companies with greater exposure to the US market even if raw material costs are showing signs of easing. APIs and branded generics players, who largely operate in the domestic market and do not suffer from price erosion, their prices will rise and so will their financials. On the other hand, since much of the non-branded generic segment is based out of the US, it is only true to say that investors should now prefer players focused on the domestic market, as that is where the growth potential lies now.

In your Incred Healthcare Fund, 62 percent of investments are in small-cap companies. What is the rationale for this selection of companies?

We don't favour any market cap over another. All that we look for is the right kind of cash flow. In pharma, it just happens to be so that all the large-cap companies have very large exposure to unbranded generics, and the majority of companies which are purely branded generics or largely branded generics are small-caps. This is just happenstance and not a choice. We filter companies by the quality of the cash they generate and the sustainability and growth of that cash flow ― that is our criteria. If that happens to be with a small-cap company, we buy it.

An emerging trend across hospitals is their aggressive expansion plans, be it in terms of bed additions, foraying into digital or capturing a higher market share. What are your views on choosing the right bets in the segment when the entire industry has been moving largely in the same direction?

Historically, we have seen that whenever hospitals do huge amounts of capital expenditure (capex), their margins go down, and balance sheets get stretched, which adversely impacts their stock prices compared to those hospitals where capex is already done, because much of the losses in their financials had already occurred while they were expanding. So, the right time for entry in any hospital stock is after the company has completed its capex, because the downside potential from that level is much less, while the upside is good. One should enter at the right time post-completion of capex to reap the benefits of a better turnaround, improved margins and RoCE (Return on Capital Employed), and reduction in debt levels.

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