The hedge fund believes the sector is overvalued.
Fund managers starved of growth options are inflating the value of Australian healthcare stocks and will face a shock when revenue growth is hit by falling prices, as is playing out in the US, analyst Nick Cameron says.
Cameron, of Sydney hedge fund Watermark Funds Management, says investors who only have a mandate to invest in Australian equities are ignoring a significant slump in the value of US health stocks, even though they are driven by factors that also affect local stocks. In the past year, healthcare stocks in the S&P/ASX 200 have jumped 15 per cent, compared to a 5 per cent fall in the S&P500 healthcare index and a 14 per cent fall in the NASDAQ biotechnology index. 
"There's a real bubble forming in Australian healthcare," Cameron says.
Watermark is "net short" Australian healthcare stocks, meaning the fund will profit should valuations fall. Healthcare bets - both long and short - account for about 15 per cent of Watermark's close to $1 billion funds under management, which includes leveraged investing. Cameron has a mandate to invest locally and overseas. More than half of his healthcare picks are in international names.
"On an overall basis our inclination is to be net short the Australian healthcare names," he says. "We see many of their valuations as extreme compared to offshore peers. We see much better value overseas. There's been a significant correction in both large pharma and mature biotech and medical devices offshore." Cameron's thesis has a lot to do with how the recent quarterly earnings reports from big US healthcare companies played out.
The big news was slowing revenue growth, which was mostly due to funders of healthcare, whether it be governments, private health insurers or patients, putting downward pressure on prices as they try to rein in budgets.
This trend, along with political pressure on drug companies to rein in the sky-high cost of medicines, has weighed on US healthcare valuations. Democratic presidential candidate Hillary Clinton sparked a selloff in biotechnology stocks in   September when she weighed into the debate about controversial company Turing Pharmaceuticals, saying on Twitter that: "Price gouging like this in the specialty drug market is outrageous."
"The pricing debate is at what I would argue a generational high," Cameron says. "The risks can't be ignored."
"Companies such as CSL,   Mayne Pharma and some of the other biotech names are exposed to the same risk yet we have seen them rally despite this."
Healthcare stocks are often favoured because they benefit from strong demographic trends, such as the growing and ageing population. However Cameron, who began his career at the lab bench as a molecular biologist and has previously worked in the research divisions of Deutsche Bank and Credit Suisse, says falling prices counteract this.
Many local healthcare names generate a large proportion of their earnings from North America such as CSL (47 per cent), Cochlear (46 per cent from "Americas") and Sonic Healthcare (22 per cent), although it should be noted the pricing pressure is a global trend too.
Exposure to the US markets, which delivers US dollar revenue, has also delivered a fillip to earnings from foreign exchange, although with the dollar trading around US72Â¢ Cameron argues most of this benefit has had its run. "Watermark still sees downside risk to the Australian dollar but we think the major benefit has largely played out."
On a price-earnings basis Cameron says the Australian healthcare index is about 65 per cent more expensive than the S&P 500 healthcare index. He points to large companies such as blood plasma product maker CSL and hearing implant manufacturer Cochlear as two stocks trading significantly higher than their peers.
Australian Ethical fund manager Andy Gracey is a holder of Cochlear shares, and although he acknowledges that at 32-times forward earnings it is expensive, he argues the stock is worth it.
"Cochlear is the leading company in its space and it's a space that provides a lot of savings to society in terms of getting people hearing and participating in society," he says in response to arguments that governments will try to crack down on the price of implants. Similarly Gracey's other medical device pick ResMed, which at about 21-times forward earnings is more in line with the average PE of 17 to 18-times among US health stocks and cheaper than the 24-times PE among Australian health stocks, has shown an ability to respond to pricing pressure.
"I would argue that these guys have been operating in a pretty price-conscious environment and there's been successive cuts and they've found a way through," he says.
Hyperion Asset Management's Joel Gray, who controls stakes in Cochlear, and private hospital providers Ramsay Health Care and Healthscope, says concerns about inflated valuations matter less to long-term investors.
"We buy businesses with predictable earnings streams ... If we find a high-quality business we tend to look through some higher near term PEs and believe you'll still get an adequate, attractive return."
"[The three stocks] are high return on capital business models and we think they have sustainable comp advantages around them," he says.
Cameron says one factor holding up the value of Australian healthcare sector is it is rare in offering growth amid mature industrial stocks and challenges facing banks and mining.
"Fund managers running long-only strategies have very little choice when it comes to growth," he says.
"The weight of money coming into these stocks is creating abnormal, or overshooting valuations in our view. I don't envy the long-only managers."