The healthcare sector has moved past the disruptions caused by the Covid-19 pandemic, but new regulatory and legislative risks have emerged alongside the potential macroeconomic challenges of tariffs and renewed inflation. Despite the heightened uncertainty facing healthcare companies, we believe the sector’s defensive characteristics are a likely source of stability. The need for healthcare is not dependent upon GDP growth, in our view, and structural demand is well supported by aging US demographics.

Healthcare is a broad economic sector, however, and a range of trajectories are likely across subsectors. To capture the diverse factors driving a healthcare company’s creditworthiness, from the perspective of both direct lenders and loan investors, analysis should extend beyond typical metrics like profitability, margins and balance-sheet strength. For example, a provider’s payor mixes the ratio of revenues from government programs like Medicare and Medicaid, private insurance coverage and direct consumer payment—can significantly impact profitability and margins. So, too, can its geographic exposure, as strong national demand for healthcare can camouflage regional, demographic-based variations. Meanwhile, certain subsectors appear to face outsized legislative and regulatory risks under the Trump administration.

In today’s evolving environment, our current preferred subsectors include:

• Revenue cycle management and payor services/cost containment, which have historically generated strong margins and highly recurring revenue streams and are largely insulated from tariff and legislative risks
• Behavioral health, where growing demand for services is outpacing the supply of providers
• Outpatient surgery/ambulatory care centers, which tend to have lower cost structures and more favorable exposures to private-pay revenues than hospitals/acute care facilities 

Regardless of business line, the strongest companies, in our view, will be those able to manage through any potential headwinds by right-sizing their cost structures and/or negotiating higher reimbursement rates from commercial payors, as well as optimizing their footprint to more provider-friendly jurisdictions.

In the pre-Covid world, many investors assumed that small caps provided the best exposure to fast-growing stocks, juicing the odds of potentially generating massive returns—the elusive “ten bagger.” Today, this presumption is under scrutiny as hypergrowth from huge businesses has propelled the market capitalizations of single companies—including Nvidia and Microsoft—beyond that of the entire Russell 2000. 

The litany of factors contributing to the underperformance of small stocks relative to large in recent years is familiar but worth revisiting. In our view, the unique confluence of zero interest rates and money printing by the federal government combined with notable earnings from the largest companies in the US triggered the divide. Meanwhile, Russell 2000 Index earnings left much to be desired from 2021 to 2024, providing investors with further motivation to avoid the asset class. 

However, we now find ourselves at a juncture where many of drivers of poor performance have dissipated. Although the US still has a massive budget deficit financed by massive bond issuances, we are no longer printing money at the same frenzied pace as the Covid era. Gone, too, are the zero policy rates that plagued the Russell 2000’s small banks while bolstering earnings for large cap, high-growth, long-duration tech stocks. Small cap earnings trends, too, have shifted to the positive after several years of declining growth. 

To us, these mounting tailwinds combined with what we consider attractive valuations suggest there is more than enough potential opportunity in turnarounds, undervalued growth stories and asset plays to compensate for the risk of owning small stocks.