NEWSLETTER OCTOBER 2016

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TABLE OF CONTENTS

HEALTHCARE MARKET REVIEW AND OUTLOOK .... 1

INNOVATION: STILL STRONG ........................ 5

ABOUT SECTORAL ASSET MANAGEMENT ......... 12

HEALTHCARE MARKET REVIEW AND OUTLOOK

The post-Brexit sell off at the end of the second

quarter proved to be the best stock-buying

opportunity this past quarter. Macro issues faded

temporarily from the limelight, allowing equities to

run a bit, only to reappear late in the quarter in the

guise of interest-rate worries, re-emerging OPEC oil

price collusion (driven by Saudi Arabia’s new

“austerity”), and Hillary’s health scare, which

prompted a Trump election scare.

Over the quarter, the broad markets were up 5.3% (as

measured by the MSCI World AC Index), with

healthcare underperforming at +0.1%. Our

recommended positioning played out nicely this

quarter: both emerging-market and biotech equities

outperformed healthcare and the broad markets

generally. This quarter featured the beginning of the

long-awaited M&A resurgence, as well as some quite

unexpected clinical and regulatory events.

For much of the year, many market participants have

highlighted M&A as an important driver in healthcare,

given accumulating cash piles at many large

healthcare companies and depressed valuations for

many small ones. In Q3, deal making seemed to take

off in earnest, as we saw a significant number of

transactions. Having sold its Actavis generic business

to Teva at a pre-sell off valuation, cash-rich Allergan

went on a shopping spree, buying Vitae (for a 160%

premium) and Tobira (for an almost 500% premium

upfront plus milestones). Pfizer purchased Medivation

after a drawn out and competitive sale process.

Galenica acquired Relypsa for USD1.5bn, and Horizon

bought Raptor for USD0.8bn. In generics, Japan’s

ANNUALIZED VOLATILITY

1 MONTH 3 MONTH 6 MONTH 9 MONTH 12 MONTH 30 DAY 90 DAY

MSCI World Index (all country) 196.2 0.6% 5.3% 6.3% 6.6% 12.0% 11% 14%

MSCI World Index 4755.4 0.5% 4.9% 5.9% 5.6% 11.4% 11% 14%

MSCI World Healthcare Index 266.0 -0.1% 0.1% 5.7% -1.5% 5.3% 12% 13%

MSCI World Pharma 198.9 -1.0% -3.4% 3.1% -4.7% -0.1% 10% 12%

MSCI World Biotech 1261.2 0.2% 6.6% 6.8% -7.6% 3.2% 17% 19%

MSCI World Equip and Supplies 387.6 0.9% 3.2% 13.2% 13.7% 26.3% 13% 13%

MSCI World Healthcare Providers 457.7 0.2% -2.0% 3.1% 0.9% 5.3% 14% 13%

MSCI Emerging Market Healthcare 538.1 -1.1% 2.3% 2.7% 2.2% 4.5% 15% 14%

MSCI Emerging Markets 396.3 1.3% 9.0% 9.7% 16.0% 16.8% 15% 16%

CLOSE

9/30/2016INDEX

RETURN

NEWSLETTER THIRD QUARTER 2016

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Nichi-Iko picked up generic-injectable player Sagent.

Among medtechs, Zimmer, Globus, and Boston

Scientific each acquired smaller companies, while

Danaher bought Cepheid for a 50%+ premium. We

expect this M&A trend will continue.

The quarter offered a number of surprises. The most

significant clinical surprise completely changed the

near-to-mid-term fortunes of Merck (for the better)

and Bristol-Myers Squibb [(BMS), for the worse]. Both

companies reported Phase III findings of their

respective immune-oncology anti-PD-1 antibodies in

treatment-naive lung cancer. Merck reported positive

results, while BMS, to everyone’s surprise, announced

that its study had failed. Although the actual data will

not become available until a Q4 medical meeting,

many believe the different results stemmed from the

way the two companies defined the population

eligible for treatment (based on the degree of

expression of the PD-1 ligand, PD-L1). Merck, the top-

performing pharma this quarter, was up 9%, and BMS

was down 27% on the quarter.

Other clinical surprises included Seres Phase II failure

in C. difficile infection, Novavax’s Phase III failure of

its RSV vaccine in older adults, and the failure of

Intra-cellular Therapies’s second Phase III study in

schizophrenia. Topping off our Q2 surprise list was the

FDA’s unexpected approval of Exondys, Sarepta’s drug

for Duchenne Muscular Dystrophy, after a long and

public fight internally at the FDA.

Small and mid-cap stocks (biotech, medtech, pharma,

and services) were strong this quarter, and the Russell

2000 HC was up 13.5%. Aside from the previously

mentioned M&A dynamic in this space, which

certainly drove performance, many positive events

also contributed to the strong smid-cap rally. Most

notably, Clovis was up 162% on positive data with

rucaparib in ovarian cancer, and Aerie was up 114% on

positive Phase III data with Roclatan in glaucoma. In

medtech, ophthalmology company STAAR Surgical

(+70%) and vascular surgery company LeMaitre (+40%)

led the pack following solid beats. Among services,

Healthways (+129%) headed the group after

announcing strong quarterly results and a

restructuring that saw the sale of two

underperforming segments. Among smid-caps, we

continue to be most attracted to biotech names,

which trade at about 5.4x forward 12m price/sales

(range 4-10x).

The emerging markets (+9.0%) also had a stellar

quarter, outpacing the broad markets, while

healthcare in emerging markets (+2.3%) topped

developed-market healthcare. Chinese, South Korean,

and Indian names led the performance, while

Taiwanese, Hong Kong, and Thailand stocks were

weak. In China, Fosun Pharma, the top performer at

+28%, acquired Indian Gland Pharma and signed an

innovative deal with medtech Intuitive Surgical for

the development of products targeting the early

diagnosis and cost-effective treatment of lung cancer

via robotic-assisted catheter-based medical devices.

The CFDA also laid out a number of policy changes;

these included prioritized review of first-to-market

generics, specific requirements for bioequivalence

filings, and the establishment of US-style advisory

committees to support application reviews. Indian

names exhibiting strength this quarter included

Piramal Enterprises (+29%), Cadilla (+20%, on progress

with remediation), and Cipla (+18%, on a CEO

transition and a strategy change in Europe). In Korea,

Celltrion (+16%) was strong due to legal progress in

bringing J&J’s Remicade to the US market, while

Hanmi (-25%) fell on the last day of the quarter

following Boehringer Ingelheim’s termination of a co-

development program. In Thailand, hospital stocks

were weak following multiple terror-related bomb

blasts that threaten to dampen medical tourism

volumes.

On an industry basis, biotech had the strongest

performance (+6.6%), thanks to its attractive

valuation (as we have highlighted), good clinical-

development news, and M&A. Pharma was the

weakest performer, at -3.4% for the quarter, pulled

down by a number of key players. As noted, BMS (-

28%) was a big drag on the sector, falling dramatically

on its self-imposed misfortunes in immune-oncology.

Novo-Nordisk (-21%) followed closely, after a reset of

growth expectations for its long-acting insulin

NEWSLETTER THIRD QUARTER 2016

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franchise after the approval of Eli Lilly’s biosimilar

Basaglar. The new product gives the Indiana player

increased bargaining power with PBMs and managed

care. Finally, Pfizer (-3%) was weak after its second

quarter earnings when management hinted (and later

in the quarter confirmed) that it was not going to split

its business into two as had been speculated for many

years.

Following a number of solid quarters, healthcare

services (-2.0%) reversed course and were negative

this time around. McKesson (-10.5%) led the pack

downhill following commentary on generic deflation.

United Health (-0.4%), one of the year’s best

performing managed-care stocks given its lack of M&A

involvement and Optum segment growth, finally

paused and retreated a bit. Acute-care provider

results were disappointing, as 2016 had fewer

catalysts and incremental ACA benefits. Finally,

medtech continued its ascent, up +3.2% for the

quarter. Most companies reported above

expectations, including Intuitive Surgical, Edwards,

Boston Scientific, Dexcom, and Abiomed. However,

not all were strong; notable exceptions included

Medtronic (which had a slight revenue miss and is

facing headwinds in TAVR and ICDs) and orthos. Key

approvals for the quarter included Boston’s Lotus

Edge (in Europe), Edwards Sapien 3 in intermediate-

risk patients, and Abiomed’s Impella 2.5 and 5.0 heart

pumps for the treatment of drug resistant acute

hypertension in Japan. Dexcom won a significant

victory at the FDA as an Advisory Committee voted in

favor of non-inferiority of their continuous blood-

glucose monitor versus finger-prick glucose

measurement. However, the approval of Medtronic’s

“artificial pancreas” closed loop cBGM and insulin-

pump system later in the quarter, will likely cause

Dexcom to experience an earlier-than-expected

headwind.

It is probable the next three months will not be as

calm as the previous three. The macro side may prove

more challenging. Contributing factors include a US

presidential election hosting the most controversial

cast of characters in some time, a likely rate hike

from the US Federal Reserve, an Italian referendum,

and the continued rise of German populist parties

ahead of next year’s election.

Healthcare industry news flow, though, should be

robust this quarter. In pharma, we will get a glimpse

at Merck’s and BMS’ first-line lung cancer anti-PD1

studies, which should shed some light on BMS’

disastrous outcome. We will also get data from Eli

Lilly’s solanezumab in the long-awaited Phase III study

in mild Alzheimer’s patients. Roche will report data

from the APHINITY study, which may go a long way in

helping to protect its HER-2 franchise. Pharma-

industry valuation contracted almost one full point (to

15.1x ntm P/E) this last quarter, with BMS’ collapse

the major driver of the contraction.

In biotech news, we will see a number of gene-

therapy companies report clinical data (Avexis,

Biomarin, Bluebird and Spark Therapeutics).

Ophthotech’s Phase III results in wet age related

macular degeneration will settle whether Regeneron’s

late Q3 setback was a drug or class effect (and good

or bad for the former company). Biogen and Eisai will

release additional Alzheimer’s data, and, finally,

more data on migraine prevention from CRGP

antibodies will be announced.

Despite the modest run-up this quarter, valuations in

healthcare remain attractive (P/E 13.8x ntm

earnings), and the outlook is solid (see our feature

piece, “Innovation: Still Strong”). This being said, the

M&A premiums now baked into the valuation of

several smid-cap biotech names should be expected

to fade away over time.

In the medtech industry, the momentum from the

solid roll out of new launches should continue. The

issue that we have with the industry is its valuation –

at 20.6x ntm P/E, it is the healthcare’s most

expensive major industry. Thus, we are much more

SALES EPS PE17E EV/SALES17E COGS

MSCI World Pharma 4% 8% 15x 3.7x 27%

MSCI World Biotech 8% 11% 13x 5.4x 16%

MSCI World Equip and Supplies 6% 11% 19x 3.8x 37%

MSCI World Healthcare Providers 6% 12% 14x 0.5x 83%

GROWTH P.A. 2016-2018E

NEWSLETTER THIRD QUARTER 2016

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selective. In managed care, little progress in the

ANTM/CI and AET/HUM deals should occur before the US election. Hospital volumes show no sign of turning

around and are likely to remain soft. In services, we

prefer to focus on smaller, more innovative, players

in the space. Valuations stand at 14.5x ntm PE.

Overall, the areas we continue to be most excited

about are biotech and emerging-market healthcare.

These industries have solid fundamentals and quite

attractive valuations despite their strong recent

performance. Indeed, with biotech at 13.8x ntm

earnings and 5.4x ntm sales, and emerging-market

healthcare equities at 23x ntm earnings, both have

further upside potential, given expected bottom-line

growth rates of 15-20% and 15%, respectively.

Stephan Patten, CFA

Managing Director & Deputy Chief Investment Officer

NEWSLETTER THIRD QUARTER 2016

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INNOVATION: STILL STRONG

INTRODUCTION

During the 2009-15 biotech rally, numerous

commentators speculated on its cause and concluded

that, at least in part, an improvement in R&D

productivity was responsible. With the correction over

the last twelve months, the question is now: has R&D

productivity subsided and the stream of innovative

products ground to a halt? Over time, additional

analyses of R&D trends have been possible and many

have pointed in an encouraging direction.

In this report, we explore some of the evidence, using

four vignettes of recent R&D success as practical

illustrations of transformative innovation. We also

highlight that innovation is not limited to biotech and

pharma players; indeed, as shown in two of our

vignettes, medtech and healthcare service companies

are capable of creating exciting new products. In light

of ongoing concerns about unsustainable healthcare

spending and growing scrutiny of drug pricing in the

US, the importance of strong innovation over the long

term cannot be overstated as breakthrough products

are well appreciated by both public and private

payers.

Figure 1: US FDA approvals of new molecular entities.

Source: Fda.gov. As at December 2015.

Figure 2: Cumulate success from Phase I to launch;

percentage likelihood of moving from Phase I to launch.

Source: Pharmaprojects 2015, McKinsey analysis.

Empirical evidence of R&D’s improvement generally

begins with FDA drug-approval rates and gradually

moves in more esoteric directions. The recent trends

in FDA approvals of “new molecular entities” show no

evidence that the pace of new drugs approvals is

slowing. The previous two years have been among the

highest on record (see figure 1), and this year, 17

approvals have already been announced. A greater

understanding of the underlying mechanisms of

disease and an improved ability to produce

informative early “test” models have been offered as

qualitative reasons for this improvement in R&D

success. Are they correct? Hard measures of these

factors are difficult to assess. A recent McKinsey

analysis concluded that the cumulative rates of

success in drug development have improved in recent

years, after hitting a nadir a number of years ago (see

figure 2). Also, a recently published review from

Boston Consulting Group tried to disentangle R&D

success factors by analyzing 18 different attributes of

842 molecules created by 419 companies over the

past 10 years. The analysis concluded that company

size, location of the company headquarters, market

size, or the drug target’s family contributed little,

while attributes associated with scientific creativity

NEWSLETTER THIRD QUARTER 2016

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and good judgment generally contributed to success1.

At present, more than 7000 unique new medicines are

in development, with cancer drugs (1919),

neurological drugs (1308) and infectious-disease drugs

(1261) leading the pack. Remarkably, it is estimated

that 70% of the projects in development are

potentially “first-in-class,” meaning that, if

successful, these products would be novel approaches

to disease treatment.

Innovative medical products – be they drugs or

devices – will be able to continue to command price

premiums, even in our current environment. Truly

innovative companies have generally been spared -

and should continue to be spared - consumer and

political wrath. Remember that last year’s political

uproar over Turing Pharma’s Daraprim, Valeant’s

Nitropress, Isuprel and other products, and, more

recently, Mylan’s EpiPen, was about very old drugs,

and not breakthroughs. This distinction is consistent

with our view and reflects current political thinking.

For instance, Hillary Clinton’s Drug Plan differentiates

between old and new therapies:

“Our pharmaceutical and biotech industries are an

incredible source of American innovation and

revolutionary treatments for debilitating diseases. But

it’s wrong when drug companies put profits ahead of

patients, with unjustified price increases not for new

innovations, but for long available and generic

treatments……” (Emphasis added)

The resistance to price pressure generally comes from

two sources: the tremendous medical benefit of

innovative drugs and pharmaco-economics.

Revolutionary treatments usually have far reaching

effects. For example, the advent of Highly Active

Antiretroviral Therapy (HAART) in the late 1990s

1 Scientific creativity was measured crudely by the number of publications and patents per dollar of R&D spend and citation frequency. Good judgment was measured by attributes such as the company’s having a long-tenured R&D leader and having a high kill-rate in pre-clinical and Phase I products.

Figure 3: Actual vs projected death rates for HIV/AIDS in

the US. Source: Truven Health Analytics, 2014.

dramatically changed the projected course of HIV

outcomes. Companies such as GlaxoSmithKline,

Gilead, and Merck contributed to changing the course

of the disease from a death sentence into a largely

chronic condition, avoiding an estimated 862,000

premature deaths. More recently, Gilead’s

introduction of the costly hepatitis C therapy

sofosbuvir (USD 1000/pill) was accompanied by much

anger. These direct antiviral drugs radically altered

the outcome for patients, reducing the treatment

course from 12 to 3 months and boasting a cure rate

of nearly 100% (vs 40% for older therapies), with a

marked improvement in side effect profile. When

Congress requested justification for Gilead’s price

point, the company readily complied and provided

thousands of pages of pharmaco-economic studies.

New products – such as those that will be discussed

later – are generally launched at a price that has been

firmly vetted with extensive pharmaco-economic

research. These studies, conducted in parallel to

Phase I, II, and III safety and efficacy studies, aim to

answer questions regarding the broad financial

benefit (ie, quality of life, reduction in

hospitalization, and other indirect costs) the product

will bring to society.

What follows are four illustrations of the remarkable

state of healthcare innovation today across various

industries. We will first look at gene therapy, a

technology that suffered serious setbacks in the past

NEWSLETTER THIRD QUARTER 2016

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but is emerging as an exciting area of clinical

research with the potential to truly revolutionize

multiple therapeutic areas. Then, we will revisit

immune-oncology, popular among biotechs and

pharmas, for this year’s developments. Third, we

shall leave the drug-development sector to

investigate Edwards Lifesciences, which has pioneered

the catheter-based delivery of replacement aortic

heart valves. We will conclude with a healthcare

service company that is successfully offering new

modalities of healthcare delivery.

BIOTECHS: GENE THERAPY – COMING OF AGE

The concept of gene therapy is relatively

straightforward: diseases caused by defective genes,

such as cystic fibrosis, hemophilia and many others,

could be treated or even cured by introducing

functional genes into the patient’s cells. However, in

practice, a large number of challenges arose, and

these had to be addressed before the promise of gene

therapy could be realized.

Viruses were the first mechanism used to deliver

genes to cells, capitalizing on their ability to target

specific cell types and generate the expression of new

genetic material. However, the types of viruses used

in early trials caused complications, including

mortality, and led to significant caution in the field.

In a highly public case in 1999, four days after

receiving an experimental gene therapy for a rare

metabolic disorder, Jesse Gelsinger died as a result of

Figure 4: Basic mechanism of gene therapy. Source:

http://biol1020-20121.blogspot.ca/2012/09/gene-

therapy-for-duchenne-muscular.html.

Accessed September 2016.

a severe immune reaction to the modified cold virus.

Further, some trials used retroviruses, which

integrated or became inserted in the patient’s

genome; viral integration can lead to mutations or the

activation of genes that promote the development of

cancer, and several cases of leukemia were observed.

Recent and ongoing innovation has led to the

development of novel viral vectors that have

overcome these problems. The new vectors are less

immunogenic and do not insert into the patient’s

genome or are not associated with harmful mutations

at sites of integration.

More than 25 years after the first human received

gene therapy, the field is finally coming of age. Two

gene therapies have been approved in the EU,

Strimvelis (GSK) for the treatment of a severe

combined immunodeficiency (ADA-SCID or 'bubble-boy'

disease), and Glybera (Uniqure) for a rare metabolic

disorder called lipoprotein lipase deficiency (LPLD).

Hundreds of other gene-therapy trials are ongoing or

planned in a wide range of diseases, and early data

have shown remarkable clinical benefit. One of the

more dramatic examples is a treatment being

developed by Avexis for spinal muscular atrophy

(SMA). SMA is caused by a mutation in a single gene,

the survival motor neuron gene 1 (SMN1), which

affects motor nerve cells in the spinal cord. SMA

affects about 1 in 10,000 babies and is the leading

genetic cause of death for infants. In its most severe

form, babies cannot sit unsupported or walk, and the

median age of survival without permanent ventilation

is less than one year. Ninety percent of patients do

not reach their second birthday. Interim results from

Avexis’ Phase I/II trial showed marked improvement

in functional scores, with 11 out of 12 (92%) patients

treated with a therapeutic dose achieving levels of

function almost unheard of in SMA type-1 patients,

and 25% achieving scores in the normal range. No

deaths have been observed to date. The magnitude of

the benefit of this treatment for SMA patients will

become clearer over the coming months, as data to

be presented at upcoming medical meetings will show

patients’ achievement of major motor milestones,

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Figure 5: Hypothetical overall survival Kaplan Meier

curves. Source: Roche Q3 2014 presentation.

including walking, and will reflect a longer duration of

follow-up.

While the promise is clear, some challenges still

remain. Unanswered questions relate to optimising

gene therapies across different organs and

indications, as well as to the potential duration of

clinical benefit and the possibility of re-dosing.

However, a key question concerns the business model.

Many gene therapies may result in a long-term benefit

after a single administration, possibly even in a cure.

In order to recoup the R&D investment in very rare

diseases, the cost per patient is likely to be extremely

high: Glybera is priced at USD1.4 million in the EU2.

The payment model for potentially curative

treatments may evolve alongside the development of

such therapies. Single-payer systems in Europe and

elsewhere may favour annuity models, whereby the

cost is amortized over the expected duration of

clinical benefit. Due to customer mobility, the

willingness of US commercial payers to reimburse

such costly treatments remains to be seen, and

reimbursement upfront or via annuities may vary,

2 Glybera has not garnered significant use, even considering the rarity of the condition. While the hefty price tag may play a role, most of the reason for the commercial failure lies with the setting and the available data. Glybera was never shown to produce a durable clinical benefit; rather, some evidence was generated showing reduction in episodes of pancreatitis, the painful complication of the disease. In contrast, many of the promising ongoing gene therapy programs are showing dramatic clinical benefits that could better justify a 7-figure price tag.

depending on whether the gene therapy has a

pronounced impact on existing treatment costs. While

various aspects of the commercial model need to be

worked out, we are convinced that life-saving or life-

altering gene therapies will drive economic as well as

medical value.

PHARMA: IMMUNE-ONCOLOGY

Immune-oncology (IO) has changed the landscape of

cancer therapy. While standard chemotherapeutic

and targeted therapy regimens can shrink tumours

and improve short-term survival, IO offers the

possibility of a durable response. With the advent of

immunotherapies, researchers have observed a novel

phenomenon - “long-term remissions” in a meaningful

proportion of patients (see figure 5).

Although researchers have long believed that the

immune system (fighter of ‘non-self’ in our bodies)

should be well suited to fight cancer (‘non-self’),

scientists have found it difficult to realize the

potential of leukocytes, macrophages, and other

immune cells to destroy tumours. Years ago, small

biotech companies tried to prime the immune system

to recognize and fight cancers through initial

attempts at cancer vaccines. Curiously, these

techniques failed to extend survival, despite the fact

that some immunologic effects were reported.

However, the recent discovery of a class of

molecules, known as ‘immune checkpoints,’ which

are expressed on tumour cells and block the action of

certain immune cells offered drug developers a way

to bring those cells back into play. Releasing the

brakes using novel immune-checkpoint inhibitors

enabled a huge leap forward in the field of immune-

oncology.

This year has seen an expansion of the tumour types

in which immune-oncology drugs are licensed for use,

including head and neck cancer, squamous cell lung

cancer, and renal cell carcinoma. The most significant

development came in lung cancer, when Merck

announced that first-line Keytruda showed a

statistically significant improvement in progression-

free and overall survival, while Bristol-Myers Squibb

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reported that their comparable drug Opdivo failed in

a different frontline-therapy trial. (Both drugs are

approved as second-line therapies in non-small-cell

lung cancer.) Although the full data are not yet

available the speculation is that the choice of

biomarker cutoffs (ie, what proportion of tumour cells

express the checkpoint inhibitors’ ligand), with Merck

at 50% and Bristol-Myers at 5%, led to the different

outcomes. Another strategy, chemo-sensitization of

tumours that seem to be non-responsive to

immunological attack, is showing signs of success. A

second group at Merck has reported evidence that

chemotherapy can augment the effects of immune-

checkpoint inhibitors in lung cancer.

Much more can be expected from this fertile field, as

new drug targets are discovered, new IO combinations

are paired, and new immunotherapies are combined

with standard chemotherapies and targeted

therapies. In the years to come, expect to see long-

term remission rates continue to climb in many

cancer types, with the goal of increasing rates far

north of the currently observed 18% in melanoma.

MEDTECH: EDWARDS LIFE SCIENCES

Moving to other areas of healthcare, one of this year’s

best performers (+53%) has been Edward’s

Lifesciences, thanks to the very meaningful market-

opportunity expansion of their novel transcatheter

heart valve. The rise of minimally invasive solutions

has largely replaced legacy surgical counterparts.

These new options have allowed thousands of patients

to forgo treatments of highly variable efficacy with

significant toxicity. Many others, who heretofore

would have been untreatable, have now been able to

receive a functional valve. In coronary artery

diseases, stents delivered over a catheter in a

minimally invasive fashion to occluded vessel sites

have for the most part cannibalized coronary artery

bypasses. In a similar fashion, transcatheter aortic

valve replacement (TAVR), first approved in Europe in

2007 and in the United States in 2011, has rapidly

established itself as the treatment of choice for

stenotic aortic valves. Keep in mind that patients with

severe aortic stenosis have a limited life expectancy,

with survival rates as low as 50% at 2 years without

the replacement of their natural aortic valve.

Although heart valves have been surgically implanted

in patients for years, the development of valves that

could be implanted in a minimally invasive manner via

a catheter required substantial engineering ingenuity.

First, the replacement aortic valve must be flexible

enough to fit into a catheter that is narrow enough to

pass through major blood vessels. As correct

placement of the replacement valve is important,

deployment needs to be exact. Finally, this heart

valve needs to have long-term durability, 10 years or

more. The genius that allowed the optimizing of these

divergent variables (flexibility and durability) led to

the successful development of transcatheter heart

valves.

Figure 6: Edwards Lifesciences SAPIEN 3. Source:

Edwards.com. Accessed September 2016.

Through a phased process, the rapid development of

new generations of transcatheter valve initially

opened up the market to surgically inoperable

patients. Later, patients traditionally deemed as high

surgical risk were treated. Today, these two

indications represent a worldwide market exceeding

USD3bn annually (source: Sectoral). Two leaders,

Edwards Lifesciences and Medtronic, share the bulk of

it. The balance of the market is held by a handful of

other competitors.

NEWSLETTER THIRD QUARTER 2016

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Figure 7: Penetration of valve replacement in the US.

Source: Edwards.com, 2015 Analyst presentation.

Although some are making inroads, their success has

been limited to approximately 20% of the market

outside the US. (Source: Sectoral estimates). Most

important, the field of aortic stenosis remains large

and underpenetrated. As a result, valve developers

must steadily innovate to stay at the forefront of the

field.

The latest advance came in August 2016, when

Edwards Lifesciences received US approval to treat

patients characterized as intermediate risk to

surgery. (Prior to this announcement, Medtronic had

been granted a similar approval in Europe.) This

indication is estimated to represent an opportunity

exceeding USD3bn, more than doubling the current

market (source: Sectoral estimates). Furthermore, as

awareness rises on the back of positive clinical

results, more patients are likely to become

incrementally disposed to seek TAVR therapy. The

better outcomes should help overcome their fears of

undergoing a risky and invasive surgical procedure.

Finally, Edwards’ low-risk trial (targeting a USD5bn

market) in the US is under way, but approval for this

indication is not anticipated for several more years.

SERVICES: INNOVATION IN HC PROVISION

In years past, the sound of cold-and-flu season was

the sniffling and coughing of patients waiting in

overcrowded clinics, physician offices, and emergency

departments. For many, the wait could last several

hours. More recently, some patients have benefitted

from a cost-effective and convenient alternative:

telemedicine.

In Lewisville, TX, the operation hub of Teladoc

(Bloomberg ticker: TDOC), the cold-and-flu season

plays a very different tune. Similar to a control room,

Teladoc can track in real-time an uptick in cold-and-

flu-related physician consultations or visits. With their

first-mover advantage, Teladoc has built a highly

scalable technology platform; via a mobile app, online

portal, or simply over the phone, patient requests are

answered in a matter of seconds and connected to a

physician in minutes. If needed, a physician can e-

prescribe a treatment and have it ready for pick up at

the patient’s preferred pharmacy.

The cold-and-flu season is just one timely example of

telehealth’s ability to bridge the patient-physician

gap in a cost- and time-effective manner. Today,

more than fifteen million Americans have access to

Teladoc services in general medicine, pediatrics,

behavioural and mental health, dermatology, smoking

cessation, and sexual health. Members can rely on

Teladoc twenty-four hours a day, seven days a week.

Indeed, access to care is becoming a growing concern

in healthcare delivery. Changing demographics,

coupled with a growing number of American’s with

health insurance coverage have created bottlenecks

in traditional brick-and-mortar facilities. Based on

CDC data, Teladoc believes that 9 of its top 10 most

common diagnoses are responsible for roughly 100

million annual office visits.

A number of forces have come together to make

telemedicine an attractive service for patients. First,

the rise of high-deductible health plans shifts a

meaningful share of the medical liability onto

NEWSLETTER THIRD QUARTER 2016

11

employees. Consequently, healthcare consumers have

become more sensitive to price. In feedback surveys,

25-30% of Teladoc users would have visited an

emergency department, while roughly 50% would have

gone to an urgent care center or physician office.

Compared with a USD1,500 emergency department

visit or a USD200-300 physician office visit, Teladoc’s

USD45 charge offers significant value to both patients

and their employers/health plans.

Second, as payment models move away from fee-for-

service to quality outcomes, the efficiency gains from

telehealth in patient time, productivity, satisfaction,

and overall medical cost will become increasingly

important. Current technologies enable Teladoc to

offer a sophisticated call-in center for efficient co-

ordination of patients and physicians; as a

consequence, highly regarded provider groups,

including Mount Sinai and HealthPartners, now use

the Teladoc platform. Finally, Teladoc’s special

business model, in which clients are charged modest

subscription fees (in addition to usage fees), has also

helped ensure the company’s success: promoting

patient/consumer engagement through the delivery of

prompt (and profitable) telemedicine services.

Figure 8: Teladoc’s differentiation. Source: teladoc.com.

Accessed September 2016.

The value proposition of telehealth seems well

accepted by Teladoc’s long list of marquee health

plans, employers, and provider-group clients. The

company also has a notable partnership with CVS.

From a government standpoint, most states now

require insurers to reimburse telehealth visits.

However, the Texas Medical Board (TMB) passed anti-

telemedicine legislation that it wishes to enforce. In a

friend-of-the-court brief, the Federal Trade

Commission commented on the ongoing litigation

between the TMB and Teladoc, and its remarks may

serve as the best endorsement for telehealth yet:

"There is no evidence that any disinterested state

official reviewed the TMB rules at issue to determine

whether they promote state regulatory policy rather

than TMB doctors’ private interests in excluding

telehealth—and its lower prices—from the Texas

market."

CONCLUSIONS

During the past year, biotech equities – especially

small and mid-caps – have corrected dramatically.

Given the overall robust quality of R&D trends, we are

confident that strong innovation should continue.

Thus, we see this pullback in biotech as a buying

opportunity. As we have seen, innovation is also

present in other healthcare industries and, among

service names, we are quite interested in innovative

business models. Immune-oncology should continue to

provide many investment opportunities, as novel

mechanisms are fully investigated in the near-term

and established therapies expand their range of

indications. Finally, our sweet spot among medtech

stocks includes those companies, such as Edwards,

that have come to market with very innovative

technologies that address a significant market in a

revolutionary way.

The Sectoral Investment Team

NEWSLETTER THIRD QUARTER 2016

12

ABOUT SECTORAL ASSET MANAGEMENT

Sectoral Asset Management is an investment advisor whose focus is managing global healthcare equity portfolios. Sectoral has one of the world’s longest track records in managing biotech equities and is a

sub-advisor of numerous healthcare and biotech funds offered by partners in Europe, North America, and Asia.

Investment Professionals

Jérôme Pfund, CFA - Chief Executive Officer Marco Cianflone – Financial Analyst

Michael Sjöström, CFA - Chief Investment Officer Anna Fan, Ph.D., CFA - Financial Analyst

Stephan Patten, CFA – Deputy Chief Investment Officer Adrian Lam – Financial Analyst

Marc-André Marcotte, CFA – Head of Research François Beaubien, Ph.D. - Associate

Mina Marmor, Ph.D., CFA – Portfolio Manager Olivier Brosseau, MBA - Associate

Maha Katabi, Ph.D., CFA – Partner, Private Equity Vasilios Tsimiklis, CFA – Economist

Howard Riback, CPA, CA - Director, Private Equity Pierre Gauthier, CFA - Senior Trader

Christopher Lui - Senior Financial Analyst

Sectoral Advisory Network

Under the supervision of Marc-André Marcotte,

Sectoral has established a proprietary network of

talented professionals, researchers and clinicians in

complementary disciplines worldwide.

The Sectoral Advisory Network (SAN) is designed to

support Sectoral with scientific due diligence in its

investment process. SAN’s members include:

Amanda Adler, MD, Ph.D. Epidemiology / Diabetes Addenbrooke's Hospital, Cambridge, UK

Michel Aguet, MD Oncology Swiss Federal Institute of Technology, Switzerland

Henry I. Miller, MS, MD Health Policy / Regulation Hoover Institution, Stanford, CA, USA

Jeffrey P. Somers, JD Law Morse, Barnes-Brown & Pendleton, Waltham, MA, USA

Angus C. Russell Pharmaceuticals Industry Retired CEO of Shire plc

William N. Starling Medical Technologies Synergy Life Science Partners

Magdalena Leszczyniecka, Ph.D. Biosimilars STC Biologics, Cambridge, MA, USA

Frank Ma, Ph.D. Pharmaceuticals Industry i-MD, Shanghai, China

Vishar Vasudevan Emerging Markets Former CFO of Dr. Reddy’s

Contact Information Phone: +1 514 849 8777 ext. 223 Fax: +1 514 849 6777 1010 Sherbrooke St. West, Suite 1610, Montreal QC H3A 2R7, Canada

www.sectoral.com

The Sectoral Asset Management newsletter is published quarterly by Sectoral Asset Management (“Sectoral”). It is provided solely for purposes of evaluating Sectoral's advisory services. This newsletter is not an offer, recommendation or solicitation to buy or sell securities or units of any Fund. Any commentary within the report is for informational purposes only and is general in nature. This document contains certain statements that may be deemed forward-looking statements. They are based on certain assumptions, analyses of historical trends, current conditions, expected future developments and other factors. Certain information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Past performance is no guarantee of future results. Investing in healthcare companies involves a high degree of risk, and prices of these companies' stocks may be very volatile. Sectoral may hold securities of issuers referred to in this report in portfolios under management. You may request performance updates by emailing Jérôme Pfund at jerome@sectoral.com. SECTORAL372