Home Healthcare: Weighing the Business, Thinking About Markets

This is the seventh in a series of articles covering the home healthcare industry. See part 1 here, part 2 here, part 3 here, part 4 here, part 5 here and part 6 here.

Facts are simple and facts are straight, facts are lazy and facts are late,
Facts all come with points of view, facts don’t do what I want them to,
Facts just twist the truth around, facts are living turned inside out,
Facts are getting the best of them…

(David Byrne’s “Crosseyed and Painless”)

In a way, numbers are the most extreme form of facts, and they too frequently offer a false sense of security. When in a foreign, abstract environment, the brain will search for definition, and the man-made convention of numbers offers a reassuring foothold. Quite to the contrary, the foundation of this series is conceptual in nature, oriented around the business of home healthcare and the markets in which the shares of its public companies trade. Those four very non-conceptual, precision-oriented models from the previous article could prove to be counterproductive.

Warren Buffett has likened eyeballing the weight (value) of a stock to eyeballing the weight of a person. If the simple and singular objective is to accurately identify people who weigh over 200 pounds, then we should look for people who weigh well over 200 pounds. An audience would be awed by a master guesser who, though selecting people on the low side of 200 pounds from time to time, consistently selected 203 and 207 pounders. An audience would be bored to tears by the simpleton who, though always on the high side, only picked really big, fat people who obviously weighed no where close to 200 pounds. The trick is not to be precise (there is no penalty if one incorrectly opines a 350 pound person weighs only 280 pounds), the trick is to be certain the person is over 200 pounds.

The significantly more challenging objective of identifying under-priced stocks is best approached along similar guidelines. If the objective is to buy stocks with a margin of safety, we should try to buy them at as big a discount to intrinsic value as possible. If an investor has the option of buying Stock A at a precise 30% discount to intrinsic value or Stock B at a difficult-to-estimate 50-90% discount, there is simply no question—other things being equal, and if given enough time—which course of action will lead to superior results. As investors, we should strive to be simpletons rather than entertainers.

In this series, we have reviewed compelling evidence that the incredible admissions growth this century within home healthcare has been spurred by systemic changes—evidence that flies in the face of conventional wisdom. These systemic changes are rooted in two obvious and overwhelming features that bode well for long-term shareholders: 1) care at home is preferred; and 2) home healthcare holds the unassailable position as the lowest cost provider of pre-acute and sub-acute care.

Forces— predominantly political and economic—appear to be aligning now that will accelerate what has already been impressive admissions growth. If we humbly admit that healthcare reform may create some unpredictable changes that prove this thesis incorrect, home healthcare is still destined to grow at an impressive clip within the next eight years due simply to demographic forces.

Congress has historically—and wisely—allowed for more than minimal profits via PPS for Medicare providers. Double-digit net margins are always nice, but should never be expected. But even if only minimal profits were allowed, our industry leaders would remain profit leaders. They will continue to consolidate this market for years to come—a result for which those in Washington are cheering, if only to manage a more simplified industry. The executive teams that survived the perfect storm at the end of the previous century know well how choppy reform waters can get. They will navigate cautiously— supremely confident in their proven skills to change tack quickly—and be certain not to drown their companies in debt.

Let us revert from this maritime metaphor to the original weighty analogy. We could say that these publics represent four really big, fat guys who may weigh anywhere from 300 to 1,000 pounds, but who certainly weigh more than 200 pounds. [[AFAM]], our case study, has an intrinsic value—in my opinion—of somewhere between $600M and $1.25B ($70 to $150 per share). Stocks like these usually trade significantly below their intrinsic value; but recently—and for reasons that will persist in the immediate future—the discounts have been too great.

Fat Guy in a Little Coat

Ben Graham once famously stated, “In the short run, the market is a voting machine; in the long run, it’s a weighing machine.” In the fourth article of this series, we reviewed how the votes affecting these stocks at the beginning of this year had severe ramifications in the short term. Though more extreme than usual, this is nothing new.

Hindsight is often used to paint tantalizing pictures of what could have been had one purchased a stock at the exact low point and sold at the exact high point during a given time frame—again, a goal that is unwise to hope to achieve. To be sure, the reader would have a hard time finding a more tantalizing buy-sell scenario over the past decade than AFAM from the autumn of 1999 through the autumn of 2008.

Instead, however, let’s invert that exercise and identify the worst possible scenario during a similar time frame. If one had been so perfectly unlucky as to purchase AFAM at its multi-year high price of $5.38 in October 1997, and sold at the bottom of the bear raid this past March for $14.91, the total return for that twelve-and-a-half year stretch would have been 177%—which is an infinite improvement over the approximate 30% loss one would have taken during that same time period in the S&P 500.

Had an investor done such a poor job of timing, his first two and a half years—had he focused solely on stock quotes—would have been mentally debilitating: $100,000 invested in AFAM in October 1997 would have turned into about $37,000 by the Spring of 2000. It is easy for us to take all of ten seconds to read the previous sentence and dismiss the investor’s self-induced 29 months of misery because we know that since he held on, all is right with the world. In fact, we think it a pity the investor didn’t buy more during that 29-month stretch.

That same investor might dare us to be so bold with our own money today as we stare into the dense fog of the future. If we buy these stocks fully aware of the long-term opportunities, then we can regularly reflect on the intrinsic value of these companies (or go on a sabbatical to the Congo) rather than focus on erratic and inefficient stock market quotations in the short term.

All of these publics are relatively small companies with limited institutional ownership and low (though vastly improved) trading volume. Their rag-tag group of shareholders is tossed up and down the valuation hierarchy regularly.

Last November, Deutsche Bank analyst Darren Lehrich downgraded AMED, an act which played a very meaningful role in the stock falling from $54 to $38 in five days. Investors interested in these companies should pay close attention to two telling features of this story. First—and of least importance—Lehrich offered concern over AMED’s receivables as his reason for the downgrade. His opinion was admirably unconventional.

AMED, of course, lives and dies by Medicare—which regularly affords a litany of potential reasons for a downgrade. However, as it is federally funded, Medicare reimbursements come from the single most deep-pocketed entity in the world, which prints its own fiat currency. One could easily argue that since these companies have no pricing power, our fiat currency might eventually create severe problems, as market-driven and inflated costs and expenses may outweigh watered-down revenues (i.e., slow-to-increase governmentally-dictated revenues worth less in real dollar terms). Mr. Lehrich simply questioned whether or not AMED’s receivables will be collected, without giving any other reason(s) or explanation for the downgrade.

The second—much more incredible—telling feature of this story: his inexplicable downgrade flattened the stock.

If our publics can be viewed as four fat guys, then we should be fully prepared for some clever tailors periodically dressing them up in little coats. The tailors, essentially, are attempting to take advantage of our credulity. They are trying to trick us—the relatively unsophisticated home healthcare investing community—into believing that these are four rather thin men. Some of the coats will be of superior craftsmanship, but none of them will last longer than a couple of years: Our publics will tear through these feeble facades time and time again.

In conclusion, we should accept a self-evident reality: These stocks are not for faint-of-heart traders. Brave traders can attempt to benefit from the tremendous stock price fluctuations our four publics offer, but there is simply no surer bet than to go long at today’s discounted prices—and generally ignore the market for several years. Because of the vagaries these companies’ businesses and stock prices are subjected to, we should periodically look for opportunities to decrease our average purchase price. Significant (or even hypothetical) reimbursement cuts, bear raids or analyst downgrades all provide such opportunities. Bad news can be the value investor’s best friend.

Disclosure: Long AFAM, AMED, LHCG and GTIV

Comments

[Daryl Davis:]

Epilogue

Prideful stock analysts usually put a premium on the value of their research. I am no exception, and I always try to be economical with my work. I am compelled, therefore, to explain why I would offer this work—which I believe to be the best research currently available on home healthcare from a professional or amateur—for free.

In January of this year, I put together an application to Joel Greenblatt’s Value Investor’s Club (VIC), in which I recommended AFAM at $30. For that reason, I finally put down on paper years worth of thoughts, analysis and research regarding this industry (and had to fill in many blanks with significant and conclusive research). I’d like to believe my subsequent rejection was caused by Obama’s budget proposal (compounded by the bear raid) that flattened the stock price—but I was rejected previously with a recommendation on AMPH (a recommendation that, thus far, has proven to be quite prescient). As they are usually long on analysis and short on preparation, VIC articles are often poorly written—and my two submissions were, sadly, no exception.

While I take nothing more seriously than my investing, I am also a prideful writer, and hope to write a book over the next decade (A Philosopher’s Journey Through Corporate America).

(Yes, I’m swerving here. A bit of latitude from the reader is all I need…we’ll get there.)

I’ve consistently viewed my shares of AFAM (purchased periodically since 1994) like a father views his talented son’s growth. There was no moment that more clearly demonstrated that AFAM had grown up than when Jim Cramer plugged it (for the wrong reasons) last fall. With significant pain, I realized that it was only a matter of time before all of the secrets of home healthcare were told. It may take a few more years, but the cat is out of the bag in this industry: “Call some place paradise and kiss it goodbye.” In coming months, many more value investors— genetically programmed like me—will go through the same routines I have gone through. Competitive market forces will dictate a more level playing field quicker than I would like—eventually leading to less and less discounting, and more appropriate valuations in this market as the Baby Boomers continue their relentless march onward. What might appear to be impressive research now will be considered old hat soon enough.

Somewhat aligning with that out-of-my-control market-force time frame is my not-as-controllable-as... professional career. Just after the bear raid earlier this year, I was offered an incredible opportunity to work as a business development manager for the insurance division of AIG, AIU Holdings. I decided to accept the job—which, of course, will distract my attention from investing for the short term (making it more reasonable to let go of this research). While I have been around the insurance industry for years, I’ve never been in it, or achieved any great insights about it. I will now dedicate myself to learning this critical and all-encompassing industry. While there would be plenty of sex appeal to this opportunity for any business-head because of the AIG story (what an incredible vantage point!), I truly am more interested in using it to achieve an unfair investing advantage in the world of insurance for the rest of my life.

Separately, I honestly felt that even I put out this research for free, no one would read it—which, for the most part, has proven true. (My experience with people leads me to believe that only a small percentage would even consider reading 17,000 words on such a dry subject.) Still, I have long considered running a hedge fund for the non-accredited investment community. As SeekingAlpha’s reader base is comprised mostly of non-accredited investors, I thought this series would at least afford me the opportunity to test the waters and see if, on the off chance, I could achieve enough of a following over the next few years to pull off this rather far-fetched and altruistic goal (altruism is not one of my strong suits).

Related to that, in the past, when I have discussed the potential of managing money professionally, it has been difficult to explain to potential customers what type of investor I am. It is difficult (impossible?) to succinctly describe my style of focus investing, where I am in the top 1% both of “most researched” and “least diversified” managers. The concept “fewer than 10 holdings” is easily understood—if still avoided like the plague by most. With this series, I can now point to a resource that explains my research characteristics.

Almost finally, I have always wanted to work for a hedge fund manager to learn the various non-investing aspects of the industry. I thought this series might just catch the eye of one or more hedge fund managers who are seeking cheap (possibly free) research help. “Lemme hear from ya,” if you are interested.

Put all of the above together, and I still did not want to give away my research.

As I was sorting through all these thoughts and decisions (which was a couple of weeks after the bear raid) I felt it my duty to contact the SEC to report the insider trading that I detailed in my fourth article. After communicating with that commission, I didn’t have enough faith it would do anything. I quite selfishly wanted to give a cocky wink to those short managers—that fourth article wound up being the most fun to write. That was the tipping point.

To decide to write this series is quite different than actually writing it. There are research freaks like me all over the place, but few—or none—would foolishly and unnecessarily subject themselves to such a convention for communicating their findings. Independent analysts generally leave their detective work in their heads—not having to communicate unconventional ideas is one of the perks. Assimilating all my research and analysis in a digestible (and, hopefully, enjoyable) format was by far the hardest aspect of this task. But I was curious if I had the skill and patience to actually write a book, and this series gave me a chance to cut my teeth.

I couldn’t have presented anything remotely digestible were it not for my brother. He is a professional writer and editor, and, though a slave driver, he was magical for this series. I decided to save a few dollars for this self-indulgent and informal epilogue: he didn’t see it. Daryl Davis has nothing on Warren Buffett, but Carol Loomis has nothing on Mike Davis. He allowed me to mention his name, and suggest his services to those writers who want to take their game to the next level, only on strict conditions. I have to make a couple of things very clear: 1) he did not edit everything published; 2) many of the editions that he finalized were subsequently changed by SeekingAlpha’s editorial staff (the fifth article was the most butchered, with countless arbitrary paragraph breaks and deletions/changes).

So there you have it.

And now I turn my attention to property and casualty insurance. I’m looking forward to it.

D

May 27 06:47 AM

[tciminieri:]

Daryl:

I was an unofficial follower of your series, and quite frankly, it saved me! I am analyst for a healthcare system working on a home health project and found your work extremely insightful, well articulated, and not to mention an incredible bargain! I appreciated your 17,000 words, which I read more than a few times so not sure what that says about me, and wish you continued success in your new endeavors.

Regards,
Tara Ciminieri

May 27 11:57 AM

[tc1:]

Daryl, a big THANK YOU for an exceptionally thorough and insightful series of articles on this home-healthcare sector.

You've no doubt read my comments about AFAM and AMED's short-sellers to earlier installments of your article-series. I'd love to finally hear your response, whether posted back in the context of those earlier articles or right here in the comments section at this article.

You were interested in your "following" at Seeking Alpha. Notice that a Seeking Alpha author like John Petersen (who writes a lot of articles about energy storage and batteries) gets a huge following. One of the simple reasons is that he takes time to respond to those who comment on his articles. He gets a real dialogue going and many folks participate. It's not uncommon that his articles elicit a give-and-take of 30 to 60 responses, with John himself posting some 10 times or more to respond to the queries, comments, rebuttals, etc. that come in.

So now that you've completed your article series, Daryl, how about a bit of give-and-take here? We don't need to stretch it out as far as Petersen and his interlocutors usually go, but it would be good to get a tiny bit of discussion going about AFAM and a few of the other significant players in this sector.

And the triple question i would love to have answered is this:
1) How did the SEC respond to your complaint about evident naked short selling of AFAM? 2) How is an investor or prospective investor to make sense of AFAM and AMED when the short-sells evidently have recently INCREASED as a percentage of the share-float? and 3) Given that AFAM's officers did nothing when the nasty "bear raid" took AFAM's share price down from $50 to $16 from Nov to March 09, are they now informed by you and ready to deploy the strategy you identified (i.e., refusing to let their shares be borrowed by short-sellers) if another bear raid is launched against AFAM's share price?

Thanks again, Daryl, and all best wishes to you in your new gig in the insurance field.

Timothy Conway

May 28 10:39 AM

[tc1:]

Thank you, Daryl, for privately responding to my questions by email. I just wanted to post this fact here for the record so that any future readers who have read my posts and queries to Daryl at various points in this really fine, informative series of articles won't think he never responded to me.

We can all be very grateful, Daryl, that you've so freely shared all your extensive, in-depth, and quite original research for FREE here on Seeking Alpha.

I hope one day you do indeed start that hedge fund-- it's evident that you're a really thoughtful guy who maturely examines issues from a wide range of angles. Very impressive.

May 29 12:48 PM

[hinge:]

Hi Daryl,

thanks for a very insightful series of articles on home healthcare. This is an area of investment interest for me, and I was wondering if it would be possible to talk to you, and how best to get in touch with you.

Best,

Rohit

Sep 08 06:09 PM