Healthcare stocks – oversold opportunity or a value trap?

The healthcare sector has experienced one of its most significant de-ratings in 35 years, with valuations now at a 30% discount to the broader market. This disconnect from fundamentals has created a polarising debate among investors: is this a compelling entry point into a sector that is driven by human innovation, or do structural challenges justify the pessimism?

Recent developments suggest the tide may be turning. Policy clarity is emerging on key overhangs that have weighed on the sector, including tariff concerns and drug pricing frameworks. With an ageing demographic, inflection points approaching and innovative pipelines delivering breakthrough treatments, we examine both sides of the healthcare investment case.

What has driven healthcare’s underperformance?

Healthcare stocks have faced a perfect storm of challenges since 2021. The sector’s relative performance versus the S&P 500 has reached levels last seen during previous major policy overhangs: the Clinton healthcare reforms (1993), the tech bubble (2000) and Obamacare implementation (2010). Each period ultimately proved to be an attractive entry point for long-term investors.

Four key factors have weighed on sentiment:

• Policy uncertainty around drug pricing and potential ‘most favoured nation’ (MFN) frameworks.
• Tariff concerns on pharmaceutical imports following the 2024 US election.
• Rising interest rates disproportionately affecting growth-oriented biotech stocks.
• Technology sector outperformance drawing capital away from defensive healthcare.

The result is that healthcare’s S&P 500 weighting has plunged to just 8.5%, approaching 1994 lows, while ETF flows show investor exposure at two standard deviations below historical norms.

Why might policy clarity change the narrative?

October 2025 marked a potential inflection point. The Trump administration announced a 100% tariff on pharmaceutical imports, but crucially exempted companies building US manufacturing facilities. Most major pharmaceutical companies had already announced significant US capacity investments, effectively neutralising this concern.

More importantly, individual deals between the US government and pharmaceutical companies are establishing a framework for drug pricing that preserves innovation incentives. Pfizer and AstraZeneca have agreed to MFN pricing for Medicaid channels while maintaining flexibility in commercial markets. These agreements suggest a collaborative rather than a confrontational approach to healthcare policy.

The approaching mid-term elections historically favour healthcare performance. During the second year of presidential cycles, healthcare has typically outperformed as markets anticipate congressional gridlock limiting major policy changes.

What fundamental drivers support the bull case?

Beyond policy developments, powerful secular trends underpin healthcare’s investment case:

Demographics: The US population aged 75+ will nearly double from 2025 to 2040, with healthcare spending accelerating dramatically after age 75. This demographic inflection is not a forecast but a mathematical certainty based on current population structures.

Innovation renaissance: FDA drug approvals are running at multi-decade highs, with breakthrough treatments for obesity (GLP-1s), Alzheimer’s disease and various cancers creating entirely new markets worth tens of billions of dollars annually.

M&A acceleration: Eleven major healthcare acquisitions in 2025 signal renewed confidence, with premiums between 40% and 100%. A decade ago much of the R&D and innovation was done inside pharmaceutical companies, while today the majority is within biotechnology companies. With the looming patent cliff large pharma companies face, this suggests continued consolidation opportunities.

Utilisation recovery: Post-pandemic procedure backlogs are driving sustained volume growth, with UK NHS waiting lists still elevated at 7.5 million patients, supporting medical device and facility revenues.

What about the valuation opportunity?

Healthcare trades at historical valuation discounts across multiple metrics. The sector’s forward P/E ratio sits at just 0.75x the S&P 500, in the fifth percentile historically. Small and mid-cap healthcare stocks have been particularly punished, with the Russell 2000 Healthcare Index down 30% since 2021 despite improving fundamentals.

This creates an asymmetric risk/reward balance. Historical analysis by Polar Capital shows that when healthcare valuations reach current levels, subsequent five-year returns have averaged 15% annually. The wide performance dispersion within subsectors also creates alpha opportunities for active managers.

Exhibit 1: S&P healthcare constituent performance

What are the risks to the recovery thesis?

Several factors could derail healthcare’s recovery. Further policy surprises remain possible, particularly around Medicare Advantage reimbursement rates. The sector’s defensive characteristics may limit upside if economic growth accelerates and investors favour cyclicals. Technology disruption through AI could pressure traditional business models, particularly in diagnostics and drug discovery.

Additionally, if interest rates remain elevated, biotech funding could stay constrained, as businesses with revenues in the distant future will have lower valuations, resulting in higher dilution in a higher rate environment, thus limiting the innovation pipeline that drives long-term growth. The wide valuation dispersion suggests stock selection will be crucial – indiscriminate sector allocation may disappoint.

Edison Insight

Healthcare’s current valuation discount reflects maximum pessimism at a time when fundamental drivers are strengthening. While policy uncertainty has not completely dissipated, the emerging framework suggests pragmatic solutions that balance innovation with affordability.

For investors with a multi-year horizon, the combination of demographic tailwinds, innovation breakthroughs and historical valuation discounts creates an asymmetric opportunity. The key is distinguishing between temporary policy noise and permanent structural advantages.

Healthcare may not lead the next market rally, but current levels offer compelling risk/reward for contrarian investors willing to look beyond near-term headlines.