Les Funtleyder serves as healthcare strategist for Miller Tabak + Co. He previously managed the health-care portfolio of the Minneapolis-based hedge fund Provident Advisors. Funtleyder makes frequent appearances on CNBC, Bloomberg, and National Public Radio.

HEALTH-CARE INVESTING

Profiting from the New World of Pharma, Biotech, and Health-Care ServicesBy Les Funtleyder

The McGraw-Hill Companies, Inc.

Copyright © 2009 The McGraw-Hill Companies, Inc.
All right reserved.
ISBN: 978-0-07-159748-7

Contents

Chapter One

The Investment Case for Health Care

Benjamin Graham and David Dodd famously defined an investment as an operation that, upon thorough analysis, promises safety of principal and adequate return. Investors want above-average returns with no more than average and preferably below-average risk. While achieving above-average returns with average risk is no easy feat to accomplish on a routine basis, the possibility of doing so cannot be dismissed out of hand. Health care is an industry that has undergone significant change since its inception as therapies and delivery mechanisms have evolved. This industry is entering an era of reform, and with reform comes change and the opportunity for investment gain. According to Graham and Dodd, "Detecting change earlier than the rest of the market and acting promptly on the conviction of change are the critical steps to exploiting mis-priced securities."

Some investors will be skeptical about the broad macro thesis that health care is about to change radically and that the mispricing of risk and reward will result in significant opportunity. However, several other factors make this industry worthy of analysis. The health-care market is big and is growing rapidly. It is a complex market, something that often leads to share mispricings (a disconnection between value and price). There is also a social interest component, meaning that socially conscious investors can contribute to positive change by rewarding those companies that address health care in the most socially efficient way. Health care also represents a significant portion of the overall investable market, so that for an investor to be diversified, he must participate in health care.

Health-care demand is not as elastic as demand in most other industries, which makes it more predictable and less sensitive to shifts in the economic landscape. There are major inefficiencies in the system, leading to investment opportunities in companies providing products and services that can improve them. There are numerous significant health problems that have not been addressed; if these are solved, the result will be revolutionary changes in health care, which can lead to extraordinary stock returns. There are several factors that make health care a particularly attractive industry to invest in, even in the absence of large-scale reform.

SIZE AND COMPLEXITY

At $2 trillion annually in the United States, and double that globally, there are few markets that are as large in absolute terms, and opportunity is in proportion to the size of the market. Health care as a sector is growing faster than the rate of general inflation in the United States (and even faster globally), which by definition suggests that investing in health care will deliver above-average returns (returns greater than the growth rate of GDP), assuming that investors do not overpay for the growth rate.

Health care is different from other industries, which makes traditional investors cautious when investing in a health-care service or product. There is a wide range of investments within the sector, from the smallest biotech or service company addressing a profitable niche to a mega-cap multiline pharmaceutical company, and the investor needs to weigh the advantages and disadvantages of each.

Health care is a highly regulated industry, with numerous bodies, all with differing agendas and requirements, overseeing its operations. A drug needs to be approved by the FDA, not run afoul of patents, be advertised appropriately, and be eligible for reimbursement by insurance companies. What is required for approval can change between the time a drug or therapy begins clinical trials and the time it reaches the market (typically as long as 7 to 10 years), depending on the development of other treatments and medical understanding. The delivery of services is similarly challenging, with insurance and antikickback laws dictating how and when services may be provided. There are numerous reimbursement systems. Health care has a bewildering number of payment systems, each with its own methodologies for paying for services and products. The almost mind-numbing complexity of reimbursement causes many investors to give up and decide that investments in this industry are not worth the time it takes to understand the risks.

Despite all its complexities, the health-care industry is unique in its opportunity for differentiation. There is no one definitive approach to most medical problems, and any drug or service available to the market is subject to direct competition. Different treatments and services can be provided for any one ailment, but there is often no consensus on optimal therapy—which means there is always room for improvement, and ultimately profit.

SOCIAL INTEREST

Public health has always been one of society's biggest challenges. There are societal pressures to ensure that adequate health care is provided for citizens. Besides access to food and housing, access to health care has remained one of the bright lines between the haves and have-nots. Religious groups, charitable organizations, and advocacy groups exist to promote health-care issues ranging from vaccinations to universal care to more research into particular diseases. If investors fund only those products or services that improve health, this is also a form of public advocacy. If the market rewards products that lead to good health, then companies whose products do not lead to better health will need to adapt by improving their product or service or will be made extinct by market forces alone. Health-care investors could create a virtuous health circle by rewarding good companies. There is a role for the capital markets to play in restructuring health care, though that role is still to be defined.

DIVERSIFICATION

Diversification is a cornerstone of investment policy. The idea is to reduce the amount of risk by investing in different types of assets. When investing in stocks, it is prudent to invest across several different industries to reduce concentration risk. Over the last 10 years, health care has accounted for between 8 and 15 percent of the S&P 500, or about $2.5 trillion in market capitalization. Health care represents a similar proportion of the smaller-cap indexes (e.g., the Russell 2000), though the market capitalization is smaller ($280 billion). Although major pharmaceutical companies (the DRG index) are the largest component of the sector, with roughly $1.2 trillion in market capitalization, there are ample opportunities in other subsectors in health care, such as managed care and biotech. If investors want to be diversified from an industry perspective, they simply cannot avoid being in health care, given the striking performance of some of the subsectors and companies and their respective stocks.

INELASTIC DEMAND

Investors do not like uncertainty because it can lead to more volatile business performance, which translates into more volatile share price performance. For most products, demand is elastic: the lower the price, the more of that product is demanded, and the higher the price, the less of that product is demanded. Demand for health care is relatively inelastic. If a patient has a heart attack or some other type of acute disease, the demand will be completely inelastic. With chronic diseases and elective procedures, there is a little more elasticity, with the level being dependent on the demographics of the sample. This inelasticity makes health care more resistant to changes in the economic cycle. At the margins, elective and cosmetic procedures may be affected by changes in the overall economic picture, but overall, changes in the economy should not alter demand in a material way, unless the financial burden on patients is raised significantly. In general, the predictability of the demand for health-care products and services means that investors can have more confidence in the revenue projections of these companies. Reliability, being prized by investors, is often rewarded a premium valuation, which is a plus for health-care investors.

MARKET INEFFICIENCIES TO EXPLOIT AND REVOLUTIONARY POTENTIAL

Health care is an inefficient industry, with variations in care, costs, process, and outcomes that are greater than those in most other industries. Even if demand stays at its current level, innovations that can improve efficiencies and drive profits provide ample opportunity for investors. Health care has advanced significantly over the last 50 years. The rate of change has accelerated, and new discoveries that are being made at the molecular level are changing the way we view disease. There are still numerous conditions for which there is no completely effective treatment: strokes, Alzheimer's disease, cancer, and heart attacks, to name just a few killers. A company that can find a cure or even a more effective treatment for any of these maladies will benefit financially, and the opportunity that this provides is enormous. Health care remains one of the few areas where the possibility of a revolutionary change exists, and with it the potential for dramatic profit. Health care policy has not kept up with the innovation in the industry and thus investors can profit by trolling in the wake of policy failures over the last 50 years.

WHAT HEALTH-CARE INVESTING ISN'T

Health care is not contrarian investment most of the time. Being a "contrarian" investor is a prized distinction. It means that the investor does not run with the herd; instead, she goes out on her own and is able to find opportunity. Contrarian investing has been shown to outperform many other strategies. However, the opportunity for contrarian investing will occasionally also present itself in health care. Changes in the political and regulatory climate happen with some regularity. When these changes occur, they create uncertainty for the health-care industry and the stocks of companies in that industry. One of the more famous examples is the reaction of the pharmaceutical group to the whirlwind of news flow surrounding the first Clinton health-care reform package in 1993. The shares sold off substantially, but they ultimately recovered and outperformed once the outcome of the program was known.

If earnings power and valuation are the key determinants of long-term share price, then changes in share prices that are unrelated to changes in the businesses' core operations and are the result of investor sentiment offer the chance of contrarian profits. Analysis and understanding of companies are much more important in times of stress for the industry's stocks. A plan for reforming health care could lead to further upheaval in stocks and open the door to contrarian profits.

Health Care Is Not a Monolith

Health-care investment opportunities can be found anywhere within the industry, from the execution of cutting-edge research into unmet medical needs to the disposal of medical waste. Given the diversity of the companies involved, it is often difficult to generalize about the industry, yet these companies do share some common traits: the more patients treated and the greater the reimbursement, the more opportunity there is to capture and generate returns for shareholders. Although there can be some competition between various parts of the health care industry (HMOs versus pharmaceutical companies, for example), ultimately the entire sector is competing with other parts of the economy for resources.

Change Drivers

Two trillion dollars is a lot of money. Health-care inflation has substantially outpaced the growth in gross domestic product (GDP) for at least 50 years. Medicare forecasts that health-care spending will outpace inflation by at least 1 percent for the foreseeable future. While that might not seem like a very large percentage increase, the current growth rate is much higher than that both in the United States and globally, and the change amounts to multiple billions of dollars in absolute terms (see Figure 1-1).

When basic health statistics and costs for the United States are compared to those for the rest of the world, it appears that Americans are not getting their money's worth. Making the public health metrics look worse is the fact that, while most other industrialized nations provide at least basic care for their populations, the United States does not provide basic care for roughly 45.7 million people (15 percent of its population). There are also wide variations in the quality and cost of care in different geographical areas, for patients with different economic status, and for patients of different ethnicities that cannot be explained by chance alone. However, the health-care system is not a complete failure. The United States has been, and continues to be, on the cutting edge of most health-care breakthroughs, from polio vaccine to the present-day biotechnology wonder drugs and robotic surgery. Although many people view the access to care as inadequate, emergency care is available to everyone.

In terms of perception, the negatives outweigh the positives in the mind of the public. There has been perpetual and arguably growing dissatisfaction with the way health care is delivered and accessed. Americans are more dissatisfied with their health-care system than people in most other industrialized nations. Presidents have proposed universal health care or other health-care reform efforts since Theodore Roosevelt. However, vested interests, entrenched constituencies, and institutional inertia have made the progress toward increased access slow.

What does the public's dissatisfaction with health care have to do with investing? Reformers and investors have common goals. Both would like to see change. Change will improve the system and provide investment opportunities. With the growing problems of the uninsured and public dissatisfaction with its operations, the health-care system is on the cusp of major change. Determination of the true rewards and risks will be difficult for investors who are not prepared. In the confusion resulting from times of radical change, there will be ample opportunity for above-average investment returns. Change need not even be radical; even moderate movement toward reform that stops well short of universal health care will be enough to generate outsized returns.

REFORM IS ON THE WAY

Polls consistently show that Americans favor some type of health-care reform. But why should the movement suddenly be picking up speed after nearly 100 years of slow development? There are four interdependent reasons why this movement is inevitable: unsustainable cost inflation, demographics, globalization, and technology changes.

Globalization and Increasing Economic Insecurity

Markets are becoming more global. Both human and financial capital are freer to travel than ever before. This trend is going to accelerate as less-developed countries continue to gain economic clout. The United States is the only industrialized nation without a universal health-care system. The lack of universal health care puts American corporations at a significant cost disadvantage relative to their international peers, as companies and industries in other regions are not burdened by health-care costs or retiree benefits.

The lack of universal health care has other less quantifiable but still important impacts on American economic life. Globalization has increased competition for reasons other than health-care costs, and this has fostered increased economic insecurity among Americans. Catastrophic health-care issues are a leading cause of bankruptcies. Fear of financial ruin can lead to "job lock," or lack of workforce mobility. This concern probably also leads at least some potential entrepreneurs to defer any attempt to leave a corporate job in order to develop a new product or service. Since entrepreneurialism is a cornerstone of American economic life and a key contributor to its standing in the world, any diminution of this process will be harmful to the economy, and potentially to society as a whole. If people were less concerned about their health-care security, they would be more likely to take more financial risks, including investing in the stock market. Increased investment in risky assets would be a positive for all markets, including equities.

Another economic consequence is that workers may defer their basic health-care needs as a result of cost concerns. Although the economic impact of deferred health maintenance has been difficult to quantify, certain screening procedures have been shown to be cost-effective compared to later treatments for acute disease episodes, so deferral of at least these tests could lead to higher costs downstream. Deferred health care also hurts the economy in that workers' failure to deal with easily solvable health-care issues involving either themselves or their dependents leads to a loss of worker productivity; this is an insidious but tangible impact of the lack of a safety net.

Globalization and its associated economic insecurity will eventually lead the voting public to put pressure on elected officials to ameliorate the problem. One way politicians can do this is to establish a greater health-care safety net or face the possibility of being turned out of office. It will be in politicians' best interests as well as the country's to address the issue.

Demographics

As people age, their health-care utilization increases. In absolute terms, the older a population gets, the more expensive its health care will be for society. The biggest generational cohort, the baby boomers (those born between 1945 and 1962), will soon be entering their prime medical utilization years (age 70 and above). People are living longer, ironically as a result of better health care. Potential patients will live longer in their high health-care utilization years. This demographic shift will put increased pressure on the government, which will need to respond in some way. The Medicare Trust has forecast that the system will be bankrupt by the year 2019. The government has few options: it can reduce benefits in some way, increase revenues to pay for the program, let the program go bankrupt, or expand the program to broaden the risk pool.

None of these options is politically appealing. The path of least resistance (if history is a guide) is to respond to voters who want more care. This path almost always requires raising taxes, though there may be a quid pro quo involved: as the government expands the safety net (a move toward universal care) and reduces cost pressures on the uninsured and businesses alike, the employed and the employers are likely to face an increased tax burden.

Costs

Independent of the increasing utilization associated with the aging population, health-care costs per patient are rising. There are several reasons for this. The most obvious is that new technologies cost more than old technologies. New technologies have advanced health care to the point where previously fatal diseases like certain forms of cancer are now survivable.

(Continues...)

Excerpted from HEALTH-CARE INVESTINGby Les Funtleyder Copyright © 2009 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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