It's a question all healthcare investors want to know the answer to first. How will Obamacare affect the health insurance sector? Judging by the price action in the shares of the largest health insurance companies by market cap since the passage of the Affordable Care Act in March 2010, evidence suggests that investors are cautiously optimistic, though there is no overwhelming evidence that investors are placing bets one way or the other.
Is the health insurance sector already outperforming because of Obamacare?
The Google chart above shows the four biggest health insurance companies compared with the S&P 500 ETF SPY since the passage of the Affordable Care Act. While the general stock market has gone up 40% since the bill's passage, United Health Group (UNH), Aetna (AET), and Cigna (CI) have outperformed at 72%, 75%, and 89% gains respectively. The exception is Wellpoint (WLP), which has gained a paltry 4.3%.
It's hard to say whether the outperformance of the first three companies has anything to do with Obamacare specifically, or whether health insurance is just following the outperformance of other healthcare subsectors like biotech, which has put up similar numbers since March 2010. Considering the underwhelming evidence, I'd say that investors really have not decided one way or the other regarding how they think Obamacare will materially impact health insurance companies. I would seriously doubt that any major hedge funds or money managers have sat down to read the 900-plus page bill (pdf), and even if any major player in the investment community actually did, I doubt anyone would be able to divine the financial impact from the language of the bill. In the end, I believe the only ones who will actually read the bill or have read it are government regulators tasked with enforcement, and lawyers looking to sue companies that violate it, or protect companies from other lawyers out to sue. As for investors, I believe most people will be waiting for the first earnings reports in 2014 when Obamacare takes full effect in order to determine if the legislation is helping or hurting health insurance companies. Then the herd will get moving and the trend will build. (The trend will be up, and I will explain why in a minute.)
The important question is not the law itself, but who lobbied for it
For the sake of transparency and full disclosure, I will admit that I have not read the bill either, nor do I intend to, as I am neither a lawyer nor regulator. I do, however, have a decent understanding of que bono regarding big government regulations in general, and I will try to apply that here and explain my reasoning.
To take one example from the past, the Banking Act of 1933, otherwise known as the Glass-Steagall Act, forbade investment banks from accepting any deposits. Clothed as a way to "get the bankers under control" for allegedly causing the Great Depression, the act was really a stage in a finance war between the Rockefellers and the Morgans banking dynasties. Glass-Steagall was more likely a Rockefeller-sponsored attempt to destroy or at least weaken JP Morgan & Co., whose main business was an investment bank that accepted deposits, using the Depression as an excuse to push through the legislation. Section 21 of the bill, that which forbade investment banks from accepting deposits, was actually written (pdf - see page 316) by a man named Winthrop Aldrich on behalf of Senator Carter Glass, the bill's namesake. Aldrich's sister was the wife of John D. Rockefeller.
Point being, in order to correctly predict how a given law will affect the market, much more important than reading the bill, is knowing who lobbied for it. That health insurance companies including the largest-United Health Group-lobbied for and fully supported the Affordable Care Act is well documented. That and the largest companies generally benefit the most from massive regulations as a matter of course anyway. That's why we have Too Big To Fail in banking. The same will happen now in health insurance.
That being the case, the chief companies to benefit from the Affordable Care Act will be the largest health insurance companies in the market today. According to the American Enterprise Institute, Obamacare plans will be bare bones and expensive. As regulations set a minimum for what a plan legally needs to cover, it will be a race to the bottom on covering as little as possible within the legal limit, much like the legal minimum for banking reserves is 10% and virtually no bank goes above that minimum. And since pre-existing conditions will need to be covered under threat of lawsuits, costs will have to rise for everyone else in order to insure people with pre-existing conditions and will be newly insured.
The Big Four, a closer look
But first, the large caps. What will their earnings look like in 2014? Being that coverage will be at the legal minimum, costs will rise, and everyone will be required to buy insurance, revenues will almost certainly rise dramatically. The cost of revenue in turn will also go down, increasing gross profit margins. Operating expenses should increase with inflation, but these will be more than offset by the increased margins. In short, earnings statements will look very healthy at the end of 2014. While all the large companies will gain, some will gain more than others. Here are my guesses.
Let's start with the fourth biggest by market cap, Aetna. Aetna is a $16.6B company. In the last year, revenue was up 8.3% since last year and the cost of rev up a higher 9.3%. Operating costs were up 15%, and income down 16.5%. By the end of 2014, revenue should start rising a lot faster than the rise in the cost of that revenue and income should start heading much higher. Aetna is currently priced at a little over $50 a share, but with a low P/E of 10.5 and annual dividends of 70 cents a share at less than 14% of annual income, there is room for both capital as well as dividend growth. The negative is that total debt ($6.5B) to market cap is 40%, which is a bit high, though not dangerously so. Conclusion: Dividends will grow with earnings and the low P/E ratio suggests capital growth ahead. A safe buy, but keep your eye on the long-term debt.
Third largest is Cigna at $17.8B. Now at $62 a share, Cigna has been on a tear since July when it was at $41. Sounds exciting, but the stock is at all-time highs with no dividends, which suggests resistance ahead. Revenues are up 33% since last year, but the cost of revenues is up a higher 43%. Expect that 43% number to be much lower in 2014 and the revenue increase much higher. Income is up 28% since last year, and total debt to market cap is 30%. Conclusion: A growing and successful company which will grow even more with Obamacare, though resistance is ahead until Obamacare kicks in fully. Wait a month or two for consolidation before jumping in, as there are no dividends to holding it anyway.
Second largest is Wellpoint at $19.6B. Wellpoint is an underperformer in the sector, consolidating with support at around $55, tested three times since August 2011. Revenues and income are going nowhere, and P/E is an incredibly low 7.9. As the second-largest health insurance company in the sector, Obamacare will be a big help in getting Wellpoint moving again. The biggest negative is that total debt of over $15B is 78% of its market cap. If new Obamacare profit margins will be enough to pay down its debt, WLP will move up faster than the others. If not, it will continue underperforming. However, annual dividends of $1.15 a share at 13% of annual income make it an appealing choice despite its debt. Conclusion: It shouldn't be your largest holding in the sector, but with dividends it's worth buying now and holding through 2015/16 at least.
As for the No. 1 company in health insurance outweighing the other three combined at over $56B, United Health is the safest company to buy of the big four. Currently at $51, support has been holding for over a year at $51, so there isn't much downside risk from a technical standpoint. Revenues are up 8.6% from a year ago, and cost of revenue is up 7.9%. Once again, expect that spread to increase handily by the end of next year. Total debt is a respectable 35% of market cap, so no danger there. Conclusion: With no dividends, it may be worth waiting until Q4 this year to pick up your shares, but keep UNH in the back of your mind and buy it before 2014 earnings start coming in.
Large caps will not be the only ones to benefit
While it is my belief that the Affordable Care Act was designed and lobbied for by the largest health insurance companies and they will be the direct beneficiaries, there are others that would also benefit from side effects, one of those being overcrowded hospitals. CBO estimates are that 30 million more Americans will be insured by the end of the decade, and the number of hospitals with emergency rooms has been shrinking, 27% over the last 20 years. Any company that can step in the breach and help relieve that shortage effectively will benefit. There are numerous midsize companies in this space like Community Health Systems (CYH) and Health Management Associates (HMA) that manage hospitals all over the country, and though I see these companies as also benefiting from Obamacare tangentially, I see little innovation or excitement in them, and if you want the bigger gains, you may as well just stick with four stocks above.
A new one though that deserves mention is Capital Group Holdings Inc.,(CGHC.PK). Let me stress that this is not a company to buy without due diligence and will have to prove itself, but the concept and numbers to date are impressive. CGH opened its doors in the middle of last year and it only has two quarters of earnings so far. It owns and operates seven urgent care centers in the Phoenix area, which are like mini emergency rooms that are much cheaper and quicker than your average mainstream hospital. Revenues started at half a million in Q3 2012 and more than tripled to $1.7M in Q4, so there is something going on here though it is not yet net positive. With an asset-to-liability ratio of over 4:1, its balance sheet looks healthier than other stocks of its $5M size. This quarter's earnings statement may surprise, and moving into 2014 we'll see what effect Obamacare will have on this tiny company. One thing's for sure though, Capital Group Holdings wasn't the "man behind the curtain" pushing for Obamacare.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.