Exploring Health Care's Frontier: Biotech, GLP-1s and Global Pricing Dynamics

Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Jessica Schmitt, Director of Investment Communications. Today on the podcast, we have guest host Matt McLaughlin, who is the product specialist for our international strategy, and Chendhore Veerappan, one of our dedicated international research analysts. In today's discussion, Matt and Chendhore will discuss the ever-evolving health care industry, diving into topics such as the biotech space, GLP-1s and more.

Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So, sit back, grab a cup of coffee or tea, and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Matt and Chendhore.

Chendhore, welcome to the podcast.

Hi, Matt. How are you?

Doing good. Doing good. Thanks for coming on today.

Well, thank you.

Sure. Well, hey, maybe to start, I know you've been on the podcast before, so you've probably had a little bit of introduction, but for people who aren't listening who may be a little unfamiliar with you and your background and your role at Diamond Hill, maybe go ahead and just kind of go through quickly, your background and your role currently at Diamond Hill.

Sure. The first dozen years after high school, I focused on academia. I have an undergrad in computer science, a master's in bioinformatics, and then I got a doctoral degree in molecular biology and genetics and a postdoc in neuroscience. So that's my academic background. Then I transitioned for a year-long program, which is business school for postdocs. It's a very specialized program in southern California. And then, I made the transition to Diamond Hill, and I've been here for the last 10 years.

In full disclosure, Chendhore and I work on the international team here at Diamond Hill. And on the international team, we like to say we don't have sector specialists, but we have generalists with areas of expertise. And as you can hear from Chendhore’s background, he has a ton of expertise in health care. And that's what we've brought him on the podcast today to talk about.

So maybe just jumping right in. Health care has been, I feel like, a tough area over the last couple of years. There was a spotlight on it during the pandemic for obvious reasons, but especially in health care and biotech. Biotech didn't really do well in 2022 and 2023, but there seems to be some optimism right now. Chendhore, I'd love for you to just dig in and go through why it didn't do well in 2022 and 2023. What is the source of optimism for investors right now in biotech specifically?

Biotech itself went through a cycle before, which ended around 2015-2016. And then there was a period of optimism leading up to COVID, but particularly during COVID, the development of vaccines and therapeutics raised a lot of awareness. But at the same time, you had other technologies maturing — things like gene therapy, cell therapy, the review modalities that were coming through from the clinical trials and into the commercial space.

So, you combine that with 0% borrowing costs, and all of a sudden, your hurdle rate is super low to get into biotech. There was a lot of excitement. There was a lot of money going into various areas within biotech. The XBI (SPDR S&P Biotech ETF), which was trading below 100. XBI is the equal-weighted biotech index, and it roughly went up 50% during the height of COVID, and then after the excitement of mRNA and the vaccines and the therapeutics, essentially, there was a period of sobriety, I would say. But it also coincided with high inflation, high interest rates. Then you had geopolitics. Then, every four years, you have the election noise, which generally is negative for biotech.

We've gone through a period of weakness, I would say. Yeah, 2022-2023 and 2023, I would say, was super cautious optimism, and then it started getting better toward the end of 2023. But I would say that there is still a certain amount of cautiousness; there are pockets of biotech that are still struggling. Just going back to the interest rates. So, biotech, people don't quite realize that mRNA has been under development for decades. These technologies are not overnight sensations. It takes a lot of time and investment, and your cash flows are generally a decade away. So essentially, biotech is a long-duration asset, so it's highly sensitive to interest rates. As much as the discussion around interest rates goes with the Fed and everything else, you have the XBI gyrating.

One of the ways I assess risk is how much cash biotechs have to burn until they get the products into the marketplace or if they have to raise more capital. So basically, right now, 17% of biotech only have cash for the next two years, 45% of them or two to three years – they have enough cash, and then 38% is three plus years. So, what I want to see is that curve to move towards the three-year plus timeframe because that's usually how long it takes for either proof of concept or clinical evidence for safety and efficacy. So, we are set up in a spot where I think low-value assets are exiting the market.

There was a lot of crowding and different modalities. So, for example, gene therapy was super-hot. Many companies raised money in gene therapy, and it so happened that it's a super risky area of research. It's the same with cell therapy. Other things like bispecifics, for example, stem cell research was funded a lot, but it takes a long time for these things to come online.

So, I would say that that's where we have with biotech. The way we look at it is to become super selective of what we pursue. We are looking for transitionary technology that's moving from proof of concept to clinical validation. These are usually companies trading in the high hundreds of millions to a couple of billion in market cap. So that's how we look at biotech right now.

Great. Thanks for that. That's super interesting. Other than biotech within the health care space, GLP-1s have been the talk of the town, if you will, for maybe at least a year or so. And everyone, if you haven't heard about the companies that have the GLP-1 drugs, you probably heard about it around the dinner table or a family or friends gathering and people talking about it. It's such a hot topic right now. Maybe just given your expertise, talk to us about what's the history of the drug, why have the companies with approved treatments done so well recently? What's your outlook from here?

Again, just like mRNA that I just mentioned that's been developed over decades. I think GLP-1s were first described in the 1980s. I don't think people are aware that the first GLP-1 was approved in 2005. So, what is that 20 years almost? So GLPs have been around for a long time, and it's part of a pathway called the incretin pathway, which is well characterized. There are several targets that you could use within that pathway to increase insulin production, to increase glucose uptake, to delay gastric emptying. So, these are some of the characteristics that you can see if you interfere with the incretin pathway. So, GLP-1 essentially is one of those drugs that act on that pathway.

Since insulin was discovered and used in the 1920s, we've had a series of discoveries that were designed to reduce blood glucose. So, if you want to bring your A1C level to seven, that's your goal. At each juncture, in every decade or two, you have a new drug coming in. And then it's the last 10 years, I would say that it's gotten pretty hot. So, you had two generations of GLP-1s in the same pathway that I just described. There was another promising drug called DPP-4, which came in before GLP, and then there's a separate pathway called SGLT2. So, what I'm trying to say is you had insulin, you had metformin, and then there was a period of research, and then all of a sudden, on the clinical side, you have these drugs coming through very quickly.

Now, the thing is, at each juncture, each of these drugs are tested against standard of care. So, it could be metformin and diet, exercise, it could be insulin. At each juncture, there was a risk adjustment event, which is you don't quite know if the new drug is going to be sufficiently better than the previous generation. So, we went through that series. When DPP-4 came, there was a lot of excitement. I think DPP-4s are still in the market, and then your SGLT2s come in, which were maybe arguably better than DPP-4. So those drugs had the time in the sun, and then all of a sudden you had GLP-1, the first generation ones, which were okay; they acted fine. And then you had the second-generation GLP-2s, which were very effective in bringing down A1C levels. So, at each juncture, if you're looking at these companies like Novo or Lilly or anybody else working on these targets or on these drugs, you have just that risk of the probability of success. So, you couldn't tell is a 30% success rate, 60% success rate. Each time, the market gets excited, but you don't know if it's going to work or not.

I think that is the sequence of events that gets us to where we are today. I think the recent excitement is it's okay to reduce A1C levels, but doctors are always going to ask the question, “Hey, what is the clinical benefit?” Right? If you're going to reduce glucose, can you reduce inflammation? Can you reduce cardiovascular events? Right. So those are the things that doctors are worried about when you have high levels of glucose or even nerve damage, for example.

I think one of the things that really broke open this market is when they were first able to show significant risk reduction in cardiovascular disease. I think that was shown first in type 1, type 2 diabetes patients.

And just to give you context, I think the street consensus is somewhere around $50 billion to $70 billion market opportunity, but the payers are not going to pay for this drug unless they see real cardiovascular benefit. So that is the first thing that we saw that really broke open, and the market opened up, and the valuation of Lilly blew up and blew up positively. And then also, Novo Nordisk.

One thing that was described when type 2 diabetes data came out was, hey, we are beginning to see weight loss with SGLT2. We saw some weight loss with GLP-1 first generation, we saw some weight loss, but then by the time we got to GLP-2 studies, the weight loss is significant. You're talking about, if you take an average patient population, the trial, which was 232 pounds, they were able to lose 35 pounds. A third of the patients lost 46 pounds. I mean, that's significant weight loss.

So again, the question was, can you show outcomes? Can you show survival? So again, I remember sitting at a Goldman Sachs conference, and Novo Nordisk was presenting, and it was a Q&A session, and there was one side that thought, oh, we just think the risk reduction of cardiovascular events are going to be 15% to 17%. Meanwhile, the bulls are saying, it's going to be 20% risk reduction. So, if you're sitting at that juncture, you didn't know which direction things are going to go, and turns out they hit it out of the park, you had significant reduction in cardiovascular events.

So that's where we are today. And then now people are talking about combination therapy, but people are also talking about, okay, now we know type 2 diabetes it works, people with BMI over 25 it works. What can we do next? So recently, we saw super positive data on sleep apnea. Again, anyone who has sleep apnea, the first thing the doctor tells you is to lose some weight, right? So, it's going to help your sleep apnea, it's going to help you with kidney disease, it may help you with kidney disease. People are trying it in peripheral arterial disease. People are experimenting with heart failure. Osteoporosis is a good example because the heavier you are, the higher the risk of osteoporosis. There is even an effect on the brain, for example. So, people are thinking perhaps it could be used in Alzheimer's, in Parkinson's.

The list goes on and on. A few months ago, maybe last year, I think I went through an exercise of trying to understand what are the different trials out there? And there were like 200 and something that I tabulated. There are plenty of trials out there trying to figure out how to use these things. And, of course, the other thing is oral drugs; oral GLPs are being developed. Now, that's more on the risky side because orals at that dose, you might have some liver complications and stuff like that, and that's a big no-no in a Medicare setting.

The next thing is, where else are we going to see benefits? But again, I think people know this, but it's important to emphasize that the side effect of this drug could be the weight loss. So, for example, it's known to cause nausea, diarrhea, vomiting, constipation, pancreatitis. The incidence of this is low, but as you go with larger populations, I think payers and doctors are going to be extremely sensitive about safety. I think this is just a quick overview of the GLP space, diabetes, and also obesity. I hope that helps, but I can answer any more questions in this arena if you'd like.

Sure. No, that's super fascinating. I know it's something that I've heard a lot about, and I think a lot of people have heard about. So that was great. Just the quick summation of the history and where we're looking from here.

Just jumping around, I feel like there's so many interesting topics in health care, especially right now. The US is the largest health care market in the world. And think almost any, and correct me if I'm wrong here, company, even in our portfolio, probably is either looking at the US or sees the US as a big health care market. So, what happens in the US is pretty important to health care companies around the globe. We've heard a lot of talk about the Inflation Reduction Act (IRA) here in the US that was instituted into law a couple of years ago, and it has created some uncertainty about drug pricing, I believe, here in the United States. What was that piece of legislation as it pertains to health care, and why has that created some uncertainty with pricing?

As you mentioned, IRA was passed, I believe, in 2022. Again, this was a reflection of the constant outcry you see with health care costs in the US. The US is by far the number one innovator in the world, but it's also one of the most expensive in terms of providing health care.

So, to give you context, per capita spending for health care in the US is $12,000 per patient. That's about, I think, roughly 16% of GDP. Everyone else in the world spends somewhere between 5% and 12%, and only Germany or Switzerland is in the 12% range. But pretty much most western European countries, Australia, Japan, are in the high single-digit thousands of dollars per capita. And then you have countries like China or the BRIC countries spending less than $2,000 per capita. I think China is somewhere around $1,000, and India is around $250.

So clearly, the US is spending a lot of money on health care, and there's always been an outcry. The Inflation Reduction Act is designed to provide some benefits for the average health care seeker, but it's mostly tuned towards people who are in Medicare, Medicaid, and the veteran’s plans. So, Medicare, Medicaid, and the veterans, I think it's about 40% of spending, and it's paid for by the government. It's not necessarily private. It indirectly goes to private, but then it's paid for by the US government. We do have a public health care system, and the government can leverage its buying power.

One of the things that IRA has brought about is reducing the cap on insulin costs. We just talked about diabetes. It provides more assistance for health care plan purchases and premium costs. So, that's an important piece. But the most important thing I think that's causing the most noise, I would say politically, is negotiating drug prices.

The way this works is the program is designed to negotiate prices for the most expensive prescription drugs in (Medicare) Part D. So, these are things you buy from the pharmacy. So, the way this works is I think the first negotiation is for the year 2026. There are 10 drugs in the pipeline that will be negotiated on, and then every year they're going to add more and more drugs, and I believe in 2028 or so, Part B, which is hospital, if you have cancer drugs and so forth, those will also be on the negotiating table. Now, the thing about the IRA is it's kind of nebulous. So, you don't necessarily know how draconian the government can get. I mean, the government cannot…it has to act within legal boundaries. And I mean, it is in the law books, but again, the government has so much power that they could get draconian. There's always been the risk, and there's been massive pushback on the pharma industry.

But the thing is that the government is also trying to promote things like the entrance of more generics in the system, more biosimilars, which is a generic copy of injectable protein drugs. So, there are things in place to give you a more free trade kind of environment for competition. But when the government does not see that, and it's an expensive drug, then it's going to start negotiating. So, the way pharma companies have reacted is, first of all, they reacted angrily. There was a lot of lobbying going on in Congress. Pharma threatened initially that, oh, this is going kill innovation in the US. And to some extent, they're actually coming through with that threat. Because what I'm seeing every quarter is some of the large pharma companies are cutting some of the R&D programs that are considered high risk, or not first in class, not best in class, and they're trying to focus on areas where the probability of negotiation is going to be lower. So, this could be rare diseases. They can focus on biologics, for example, the injectable proteins, which have a longer exclusivity agreement with the FDA compared to oral drugs.

So, there is some shift going on in the industry. I'm not quite sure how it's going to affect innovation in general in the US. I'm not quite sure how it's going to impact biotech funding. I'm not quite sure how it's going to impact future deals in M&A, so those things are still in flux, I would say, but it's worth following.

So, what we are trying to do is essentially look at pharma companies that are trying to become specialized entities, companies that are shedding unwanted business segments, for example, like consumer health care. And we are looking for companies that are super focused on high-value therapeutic areas and where we think that they can add value in the health care system. So that's how we are looking at the IRA. But again, this is evolving. It could get better for pharma companies, it could get worse, but the point is it's in the books right now, so it's going to happen. I don't think the courts are going to block the IRA. It seems like it's going to go through, but I'm not a lawyer. I'm just speculating here.

Sure, given the fact that you look at the whole globe and the health care market around the world, China's an area too where there's maybe some uncertainty, some regulatory overhang if you will, but it's a much different market than the US. So, for anyone who's been paying attention, there's something called VBP (volume-based procurement), but I know I'm not as familiar, and maybe some out there might not be as familiar either. What is volume-based procurement, which is occurring in China right now, and how's that affecting the health care market there?

China spends about, I think it's around 5% to 6% of GDP on health care. Again, I mean, there's a difference from a PPP perspective versus a nominal number, but their whole goal is to not become the US or Western Europe. They don't want to be spending too much of the GDP on health care.

Starting in the 1980s, the Chinese government had a slew of reforms designed to provide some sort of universal coverage. This coverage is a mix between private pay companies paying into the system and the government paying into the system. It was formalized within provinces, and there's also a national umbrella on top of that. So, what the Chinese government is trying to do is cut the cost of procuring more commoditized, lower-value products through something called VBP or volume-based procurement. Meanwhile, they want to invest in the domestic biotech and pharma industry and also medical devices to essentially become more self-reliant and not be dependent upon expensive Western imports.

So, the way they can free up resources to actually do this is if you have an alternative. So, if you have multiple vendors of the same product, what they're trying to do is they're just going to pick one or two of these vendors and buy these things at a massive discount but give them all the volumes. So, in that regard, they're able to procure at a much lower price, but at the same time, they're able to distribute these drugs to a larger population. So, that is essentially the idea of VBP. Now, it was a benign start. It was going after older aging drugs, but then eventually, it has moved into higher-value drugs, and it has also moved into medical devices.

So, some of the companies that we've invested in are exposed to Chinese VBP. We don't have any one company that has massive exposure to China, but we have to keep monitoring this as they expand the reach of VBP to various industries or sub-sectors of health care. So, it started off with medicine or drugs. Now, it's moved into medical devices. It may move into capital goods. We don't know. It may move into services. I don't know where China's going to go with the VBP.

And at the same time, they enacted something called the Anti-Corruption Drive. So, these are middle players who may take a bribe to favor one vendor or the other. So, China's getting at this from different directions. One is made in China, so they want to make sure that the domestic industry is doing well, and then they're doing VBP, and then they're going after corruption. It's an interesting time in China. Generally, for us, we want to keep our exposure low and the way we would invest in, or rather, we would have exposure in China if it is a product or a drug that's not easily replicable, meaning a super high-value product.

So, for example, if you're selling a highly customized MRI machine in the Chinese market, it's a very low probability that you're going to find an alternate vendor at scale. So those are some of the companies we look at. So, if you have some exposure to China, and what we don't want is a surprise binary event that happens, and all of a sudden, one product line just disappears. So, we have to keep monitoring these events as well. China, if you asked me five ago, I would say, oh, wow, this is a fantastically big market — 1.3 billion people. They have a high teens trillion GDP. It could be a market instead of growing 5% or 6% today, could be growing double digits. But those things, I would say, have been reset moving forward.

Another super interesting topic. We could probably have an individual podcast about every single one of these topics, but just kind of rounding out this one, you mentioned a couple of areas that with the IRA and with China that we either gravitated towards or maybe you're looking to avoid. Where, generally speaking, are you finding the best opportunities in health care outside of the US right now?

So, this actually is tied to IRA in a sense because I've mentioned the promotion of generic drugs by the IRA. One of the things we're interested in, and we've been looking at generic and biosimilar players across the world. So, I did a trip to India, and I met with a whole bunch of generics companies and potential biosimilar entrants. We also looked at a couple of companies, Swiss and German companies in Europe. So that's one area we are looking at. I would say that is one. And then, actually, just to go back to GLPs, for example, one of the areas we're trying to see is, what are the companies that make it disintermediated by GLPs? So, what should we not do? For example, if you think sleep apnea could be cured by a medicine, would you buy Philips, for example, that sells sleep apnea machines or specialist sleep apnea players?

So, there are areas where we want to know where we should be careful not invest in, and also with the IRA, given the squeeze that pharma might go through in terms of margins because of drug price negotiation and the fact that they want to get more efficient with R&D. So, we believe that the rate of outsourcing from pharma companies to contract research organizations or contract manufacturing organizations or contract drug development organizations could pick up over the next 5 or 10 years as these things unfold with the IRA.

So, contract services is another area that we've been looking at. I think there's a lot of growth available in hospitals, in a country like India, where the per capita number of beds and the per capita number of doctors is terribly low. So, there is a long runway of growth in those areas. Diagnostic companies, for example, have gone through a sobering period because they had so much volumes and placements for PCR testing or molecular testing for COVID, and now they're coming out of this, and there's a question, excess capacity in the system. Who's going to be the winners moving forward? So, diagnostics is another interesting area, and as I mentioned before, capital goods is something that hit my radar when, at the peak of COVID, we saw the labor crisis. Sometimes, running this equipment could be labor intensive. Labor shortages are still an issue in hospitals.

predictive medicine. For example, AI-assisted diagnostics, for example. So, we are seeing some green shoots in terms of the speeding up of the application of next-generation automation in AI (artificial intelligence), for example. Those are the areas that excite me. And again, our coverage universe is essentially ex-US. So, we have tons of areas that could eventually become interesting, or it'll unveil itself as things go along.

Great. Well, that's all the time I think we have for today. Chendhore, really appreciate you coming on the podcast — all super interesting topics and look forward to talking to you again in the future.

Thank you, Matt. I appreciate it.