KURE: Get Ready For the Boom in China’s Healthcare!

Demand for healthcare in China is growing exponentially, backed by a rapidly aging and increasingly ill Chinese population.

Flagged as a major concern, the Chinese government has pledged to fully support its pharmaceutical industry in its transformation into a world-class innovation leader.

We believe the larger Chinese drug-makers will reap major benefits in the process, outgrowing the broad market.

KURE, which provides the best exposure to this sector, now offers you an upside potential of more than 20%, based on our valuation of USD 26.00.

Broad Market Selloff Exposes Investing Opportunity

In the last few months, China pharmaceutical stocks were among the Chinese equities indiscriminately sold off in the stock market, sparked by an escalating US-China trade war. The selloff was further exacerbated when the Chinese government forced drug-makers to cut drug prices amidst intense pressure on its healthcare budget.

However, we believe that the China healthcare sector is an attractive investment opportunity, considering its immense growth prospects – backed by the massive demand from a rapidly aging and increasingly ill China population and now, cheaper valuations.

We have selected a fantastic US-listed ETF: Kraneshares MSCI All China Health Care Index ETF (NYSE:KURE), which we believe provides the best representation of the sector, enabling investors to capture the huge upside potential arising from the boom in the industry.

1. Healthcare Is A Leading Demand in China

The largest population in the world is also a rapidly aging one: 200 million Mainland Chinese will reach the age of 60 by 2020 – equivalent to the entire population of Brazil. China’s fast-greying society means that there is an ever-growing need for healthcare and medication. This spike in demand is further compounded by a rising prevalence of chronic diseases in China, especially cancer and diabetes. China, in particular, have an unusually high cancer rate: it accounts for one in four global cancer cases. Likewise, diabetes plagued one in 10 adults in China, making it the largest community of diabetic patients in the world.

Highly effective in treating these chronic diseases, biopharmaceuticals have, in recent years, become one of the fastest growing and most profitable segment of the global healthcare industry. Eight out of 10 top-selling drugs sold in 2017 are biologics (biological drugs made from living organisms). From 2012 to 2016, China’s biologic drugs market expanded at an annual growth rate of 25% from RMB 62.7 billion to RMB 153 billion. Yet biologics only make up 12% of China’s total drug market, compared to a global average of 25%. This means that the fastest growing healthcare segment has ample of room for growth in the China market, projected to reach total value of RMB 326 billion by 2021, expanding at an annual rate of 16.4% (Chart 1).

Chart 1: Fastest Growing Biologics Market Have Ample Room To Grow

At the same time, however, biomedical treatments required for the increasingly complex illnesses are becoming more expensive. Biologics, while more effective, are priced way more costly (on average 22 times more) than traditional chemically-synthesised generics. As a result, medical costs in China has increased annually by 10% in the last two years - more than four times the rate of local consumer price inflation (2.4%). This prompted the Chinese government to step in to implement strict controls on drug pricing, amidst intensifying pressure on its healthcare budget.

Yet, despite being the world’s 2nd largest drug producer, much of China’s biomedicine comes from foreign imports from the US and Europe. With China’s population aging and increasingly ill, demand and expenses for medication are projected to grow exponentially. Naturally, this over-reliance on foreign drug imports made the Chinese government uncomfortable, and this was repeatedly flagged out by President Xi as a critical concern, especially amidst intensifying trade tensions with the US.

2. Pharmaceutical Made In China 2025: Mass-Produced Generics to World-Class Innovators

This over-reliance on foreign drug import largely stemmed from the inadequate capability of China’s domestic pharmaceutical industry to produce top-tier biologics. Instead, most Chinese drug-makers mass produce generic chemical drugs with razor-thin margins, a direct result of a highly fragmented industry. The top 10 drug-makers in China took up just 10% of industry sales in 2016, compared to 46% in US. Such fragmentation has kept research and development (R&D) investment low among the Chinese firms, rendering the industry incapable of developing innovative biologics.

To that end, China has set plans in motion to prod its pharmaceutical industry up the value-added chain. Outlined in “Made in China 2025”, the pharmaceutical sector was identified as one of the top high-tech industry China wishes to develop. This is similarly echoed in its 13th Five-Year Plan (2015-2020), where China mandated that biopharmaceuticals should exceed 4% of GDP by 2020, as well as its “Healthy China 2030" plan to tackle high morbidity from chronic diseases.

After all, developing its domestic biopharmaceutical industry serves multiple purposes. Not only will China be able to cut its dependence on imports, it can potentially make treatment costs more affordable and reduce its domestic healthcare burden over the long-term. At the same time, China can tap on this lucrative opportunity, arising from its massive domestic demand, to create its own globally competitive biopharmaceutical industry.

3. Boom in China Pharmaceutical Backed by Strong Regulatory Support

To start the ball rolling, the Chinese government has implemented a series of favourable policies to pave way for its growing pharmaceutical industry. China did a major update to its National Reimbursement Drug List (NRDL) last year, adding a total of 375 drugs (16% of its 2009 list) eligible for reimbursement of up to 70% (100% in special cases) by the government. Regulators has also instituted a dynamic update mechanism that grants new therapies periodic reviews for reimbursements.

More recently, the Chinese Food and Drug Administration (CFDA) – China’s drug regulatory entity – has also expedited its drug approval process, greenlighting 390 new drugs for clinical trials last year (Chart 2), allowing new drugs that have proved effective in fighting life-threatening diseases to hit the market quickly. For the very first time, the CFDA has also allowed the usage of data from trials conducted outside of China in the approval application for drug distribution in China.

Chart 2: China Accelerated Its Drug Approval Process In Last Two Years

While this accelerated approval process will mostly benefit foreign drug-makers like Pfizer (NYSE: PFE) and Roche in the near-term (which conduct majority of their tests overseas), we believe that in the long term, this is a huge advantage for the larger local drug-makers. We foresee innovation in the local pharmaceutical industry will be boosted to a rolling start via the technology transfers, since the Chinese government continues to pursue foreign-domestic partnerships as a requirement for access to the Chinese market.

China’s expanding medical insurance coverage is another key growth driver for its pharmaceutical industry. Both state-sponsored and private health insurance have been expanding rapidly in recent years, with growth momentum continuing strongly. Private health insurance market is projected to accelerate by a CAGR of 35% to over RMB 1 trillion by 2020 (Chart 3). This will inadvertently improve the overall affordability of healthcare and fuel the ever-increasing medical expenditure in China, boosting sales of the pharmaceutical industry in the process.

Chart 3: Private Health Insurance Market Emerging to Boost Growth of Pharmaceutical Industry

Under such a sophisticated regulatory environment, we believe that the larger Chinese drug-makers are the main beneficiaries of these government policies, and thus likely to outgrow the market. Furthermore, they have strong cash flows to support active merger & acquisition (M&A) activities, enabling them to purchase patents for innovative biologics overseas.

(Related Article - Ping An Insurance Group: Undervalued Insurance Titan With Huge Growth Potential)

4. Take Part In The China’s Upcoming Healthcare Boom Through KURE!

KURE is a strong representative of China’s pharmaceutical industry and thus efficient in capturing the upside potential of China’s healthcare industry.

Incepted in Feb-2018, KURE currently have an AUM of USD 38M and a reasonable expense ratio of 0.79%.

We value KURE at USD 26.00, which represents an upside potential of 24.3%.

Kraneshares MSCI All China Health Care Index ETF (NYSE:KURE) is a US-listed ETF designed to track the MSCI China All Shares Health Care 10/40 Index, and it reflects the equity market performance of Chinese companies engaged in the healthcare sector. KURE comprises 58 China A-Shares and H-Shares and we like that more than 80% are large-cap pharmaceuticals, which we believe are poised to outperform the industry in the long-term (Chart 4).

Chart 4: KURE’s Equity Allocation Among Its Holdings of 58 China Healthcare Counters

We think that KURE’s equity allocation provides a strong representation of China’s healthcare industry and will therefore be efficient in capturing the upside potential arising from the boom in the industry.

More importantly, we are particularly optimistic about the top three counters in its equity allocation: Jiangsu Hengrui Medicine Co Ltd, CSPC Pharmaceutical Group Ltd (HKEX: 1093) and Sino Biopharmaceutical Ltd (HKEX: 1177). CSPC Pharma and Sino Biopharma are the only two healthcare components in the Hang Seng Index. Table 1 details some information on these three stocks.

Table 1: Detailed Description Of KURE’s Top Three Equity Holdings

Investment Risks

Pharmaceuticals is a High-Risk Industry, due to the high failure rates owing to strict regulations in clinical testing. While healthcare is normally regarded as a defensive sector across economics cycles, biotech is highly cyclical and is thus vulnerable to boom-bust cycles.

Heavy Influence from Government Regulations. Chinese Pharmaceuticals face a huge risk arising from the price cuts of biologic drugs. In China, most biopharmaceutical firms need their drugs to be successfully listed on the NRDL to be commercially viable. Negotiations between regulators and firms on the level of price discounts will determine the drug-makers’ margins since the NRDL has considerable pricing power.

Currency Risk. While KURE consists of almost exclusively China A-Shares and H-Shares, the ETF is listed on NYSE and is thus traded using USD. Therefore, Singapore investors are subjected to currency fluctuations between USD, HKD, RMB and SGD, which could be slightly chaotic and volatile at times.

Fair Valuation

We value KURE at USD 26.00, based on a weighted average of the consensus’ end-2019 target prices of all 58 equities in KURE’s portfolio (Table 2). This implies a weighted average current PE ratio of 19.0X, which we think is cheaply valued, considering the strong growth prospects of the industry.

Based on KURE’s closing price of USD 20.91 on 12-Nov-18, this represents an upside potential of 24%.

Table 2: We Are Optimistic About Top 10 China Healthcare Equity Allocation in KURE’s Portfolio

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.