Q&A series: China Healthcare – a fast-growing and necessary sector

Although China is already the second largest healthcare market globally with total healthcare expenditures reaching USD 1.2 trillion in 2020, strong growth is still expected at a 13% compound annual growth rate in the next ten years. Which, is much higher than the expected 3% and 2% growth in the US and Japan respectively. 

The long-term growth drivers of China healthcare include the key broad themes of a growing aging population, rising incomes and increasing urbanisation. 

Introducing the KraneShares MSCI All China Health Care Index ETF

The KraneShares MSCI All China Health Care Index ETF (NYSE: KURE) tracks the MSCI China All Shares Health Care 10/40 Index, which is a free float adjusted market capitalisation weighted index that includes companies listed in Mainland China, Hong Kong and the United States.

The ETF gives exposure to Chinese companies involved in the health care industry – including patent and generic pharmaceuticals, hospital administration, biotechnology, medical equipment production, healthcare IT, and traditional Chinese medicine.

Top holdings of the ETF includes companies such as Wuxi Biologics (HKEX: 2269), Jiangsu Hengrui (SSE: 600276), and Beigene (HKEX: 6160). 

Table 1: Key information of the ETF

FSMOne.com: With healthcare reforms, how is the progress of China’s healthcare industry? 

KraneShares:  Indeed, China has been working on healthcare reforms for many years. 2009 was pivotal when they expanded the Basic Medical Insurance (BMI) program to cover 99% of Chinese citizens. In 2018, the government launched the National Health Service Agency (NHSA), which established the central procurement program that required pharmaceutical companies to go through a bidding process before being able to sell products. The objective of these efforts was to lower healthcare costs, especially for generic drugs, and shift the sector's business model from one based on generic drugs to one driven by innovative drugs for sophisticated diseases. 

Also, to set a solid foundation for the sector, the government overhauled its drug approval process, making it more equivalent to top drug approval agencies in the world, such as the US Food and Drug Administration (FDA). The new rules streamlined the drug approval process and shortened the approval period considerably, especially for first-in-class and/or breakthrough drugs. In addition to all of this, the government approved a budget to overhaul the healthcare infrastructure and promoted the establishment of the health technology industry. However, the government is not done yet. The reform process will take years, and there will always be finetuning and new laws coming out. We believe the Chinese government aims to create a global healthcare industry equivalent to the US and Europe.

However, at the moment, China is still lagging, and the sector has a great deal of growing up to do, which, in our opinion, is a huge opportunity for domestic Chinese companies. 

FSMOne.com: What are the growth drivers for China healthcare?

KraneShares:  The attractiveness of China’s healthcare industry stems from the fact that it has many long-term growth drivers simultaneously at work. In many mature healthcare systems, growth is driven by companies’ ability to create blockbuster drugs that will allow them to earn unchallenged revenue for years to come. The trial process is a significant driver, making stock prices highly volatile around the phase announcements. In China, the story is different. 

First, China’s population is growing older, and, very soon, the country will possess the largest senior population the world has ever seen. This will generate demand for drugs to deal with rising chronic diseases. Also, China’s health infrastructure is outdated and underdeveloped compared to developed countries. As a result, China has embarked on a journey to build and update its infrastructure, especially after COVID. 

In my opinion, the most critical driver is the switch from generic to innovative drugs. Biotechnology companies and innovative drugs tend to be much more profitable and in high demand. The commercialization of an innovative drug can generate billions of dollars of revenue for biotechnology companies, and innovative drugs have the potential to serve unmet needs in China and globally. 

The last driver is globalization. The pandemic has shown that Chinese medical manufacturers are some of the most reliable globally. As a result, many medical device companies’ exports increased dramatically after COVID. This allowed these companies to develop new markets and cross-sell. Also, many Chinese biotechnology companies are now making deals with multinational companies to sell their drugs in the US and EU. These are two major markets that could unlock long-term growth for the sector.

In the short term, recent market action has brought prices and valuations to a multi-year low, making the sector more attractive.

FSMOne.com: How has the KURE ETF performed, and what can we expect going forward?

KraneShares:  The performance of the KraneShares All China Health Care ETF (Ticker: KURE) has been impacted by the events outlined above for the year to date (-30.7%) and 1-year periods (-45.75%) as of May 5th, 2022.

The negative performance was driven by the share price declines of companies in the healthcare technology and healthcare equipment industries due to draft regulations for the industry. The biotechnology and the life sciences industries also declined substantially after WuXi Biologics was added to the US Unverified List (UVL), meaning that US inspectors were unable to inspect the end-use of the company’s imports of sensitive materials due to COVID, fears of delisting, and the FDA’s rejection of Innovant and Eli Lilly’s PD-1 immunotherapy cancer drug. 

However, China's premier Liu He's speech on March 15th regarding dealing with China's economic issues, including delisting, ignited a rally in China's Health care sector led by biotechnology and life science companies. The rally was reinforced by WuXi's strong earnings report later that month.

Figure 1: Developments in China’s health care industry

Figure 2: Life sciences tools & services segment has done better in recent months

We believe the impact of the recent events to be limited, especially since many of the issues at hand are either solvable, as in the case of Wuxi Biologics, or manageable and priced in, as in the case of Innovent and other China biotechnology firms looking to globalize. Investors should continue to expect more drugs to be added to the Central Procurement program. However, these additions should be welcomed as they will serve as an impetus for pharma companies to step-up research, development, and innovation.

FSMOne.com: What is a unique selling point of the KURE ETF compared to other healthcare ETFs?  

KraneShares:  The main difference between the Global X MSCI China Health Care ETF (NYSE: CHIH US) and KraneShares MSCI All China Health Care Index ETF (NYSE: KURE) is that the latter includes the A shares opportunity at full inclusion as it follows the MSCI All China Health Care Index. This provides a higher exposure to A shares, which include quality companies such as Jiangsu Hengrui, WuXi Apptec, and Aier Eye hospital, all of which are leading healthcare providers in the pharmaceuticals, research, and private hospital sectors.

Furthermore, KURE offers a lower exposure to companies listed in the US. Also, KURE’s AUM is over $100 million as of May 5th, 2022 vs. only $14 million for CHIH. 

The CSOP China Health Care Disruption Index ETF (HKEX: 3174) tracks a Solactive index while KURE tracks an MSCI index. As a result, KURE is powered by MSCI’s leading equity index research and may benefit from the further inclusion of Mainland China-listed A-shares in MSCI indexes. 

FSMOne.com: What are your views on the delisting risks of Chinese ADRs? 

KraneShares:  The delisting issue has mainly impacted China's biotechnology stocks as many are listed in the US. These include shares in BeiGene, Zai Labs, and other leading companies. BeiGene recently restructured its auditing process, making Ernst & Young US solely responsible for auditing its US operations. 

Vice Premier Liu He's speech on March 15th raised the probability of a deal between the SEC and the CSRC and initiated a rally in China's health care sector. Furthermore, PCAOB officials were reported to be on the ground in Beijing on May 6th, 2022 to negotiate a potential solution that would avoid having these stocks delisted from US exchanges.

FSMOne.com: What is your take on the impact of the new draft rules for stricter regulation of the internet healthcare sector?

KraneShares:  We believe the new draft includes a set of much-needed rules and regulations given the nascency of the industry and the sensitivity of drug sales, storage, and distribution. The draft targets good manufacturing practices for pharmaceutical companies and quality management for retail distribution. 

The new regulations also entail ensuring that doctors are not oversubscribing online and that doctors’ compensation for medical services is independent of drug prescription. We believe the impact of these new rules will be manageable, especially for the prominent players with the strongest brand and logistical presence. These include JD Health, Ping An Good Doctor, and Ali Health. 

Despite the new regulations, we believe China is committed to “healthcare + the internet” as online health services widen the access to high-quality medical services across China, especially in rural areas. Furthermore, the new strategic direction has helped lower wait times at doctors’ offices and hospitals from an average of 3 hours to 8 minutes or less. “Healthcare + the internet” has been mentioned frequently in high-level government working papers.

We believe the market is already pricing in the potential impact of the regulations, even the most pessimistic scenarios. JD Health’s recent second half of 2021 earnings report revealed a +61% growth in revenues year-over-year, beating expectations by 11%. That growth was driven by a +37% increase in subscribers and a +11% increase in average revenue per user. 

FSMOne.com: Any other must highlight closing words?

KraneShares:  China's health care stocks have been hit with many adverse developments over the past nine months, shaking investors' confidence in the sector. The current macro backdrop and the rotation from growth to value are also not accommodative to the sector.

In times of high stress, it is easy to forget about the big picture. The long-term potential of China's health care sector didn't change. There is a major need for innovative drugs as the Chinese continue to age and require medical care. Currently, valuations are at a multi-year low, reflecting investors’ bearishness. However, despite a few non-material adjustments due to recent events, sector growth and long-term potential remain evident. Now maybe an opportune time to add high-quality companies that we believe are currently selling at a discount. 

Figure 3: Key data points of the top 10 holdings

Figure 4: KURE is trading below historical PEG average 

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