Questions surrounding final legislation have forced institutional investors to the sidelines in healthcare stocks. Given the most recent quarterly filings of major institutional investors, money managers are widely underweight the healthcare sector versus the benchmark S&P 500.
In today’s Boston Globe, the article “Health costs to rise again” makes the front page fold – and should be required reading for investors.
In U.S. history, healthcare reform has included the creation of Medicare, Medicaid, Part D and SCHIP. At each stage, reform has increased the population of insured and failed to control cost.
In 2008, Mitt Romney, former Governor of Massachusetts, ran for the Republican Presidential nomination. His credentials include negotiating the universal coverage of Massachusetts’s residents. The plan has been widely touted as a boilerplate for the current legislation making its way through Congress. Massachusetts plan mandates insurance for all citizens and imposes fees on non-complying residents and businesses.
In one measure, the program has been widely successful. Only 2.5% of Massachusetts’s residents are without coverage. In another measure, controlling costs, Massachusetts plan has been ineffective; despite the prevalence of non-profit insurers.
In the study cited in the Globe, the Kaiser Foundation found insurers would raise plan prices by about 10% next year; well above the 5-7% national average. Overall, premiums in Massachusetts have doubled in the past 10 years.
When asked about rising premiums, leading insurers in the State referenced the age-old economics theory of supply and demand: a shortage of doctors and an influx of newly insured patients demanding treatment.
As such, our history of reform has two distinct accomplishments:
- Increasing the population of the insured.
- Increasing the profits of healthcare companies.
At each juncture of reform, pundits question the sustainability of free-market economics. To date, free markets have both evolved and thrived thanks to rising demand.
We believe current and likely legislation will prove similarly over time. We expect a higher population and corporate profit growth.
- We assume mandated coverage will get the U.S. insured population to 97.5%, roughly the rate in Massachusetts.
- This adds 38 million newly insured, who, at a conservative $2,000 annual premium, will add $76 billion in annual healthcare insurance payments to the industry. NOTE: as of 2006, there were 633k physician and surgeon jobs in the U.S. As of 2005, 12.3% worked in family medicine and general practice (see here). This suggests an additional 488 patients per family physician.
- At an 85% Medical Care Ratio, $64.6 billion annually will flow into payment for healthcare services for the insured.
- For the healthcare insurance industry itself, assuming a 3% profit margin, an additional $2.2 billion will end up in profits each year.
As a result, as the risk pendulum swings from fear toward greed, expect investors to move back into the basket. Post legislative clarity allows market differentiation of winners and losers, increasing volume and providing upside. Healthcare short interest remains too high, providing upside as focus shifts back to business models and away from legislative risk. The focus on gross margin risk is priced-in and somewhat offset from cost cuts. We also believe margin compression will prove far less than feared. On higher revenue growth, this allows more dollars to drop to earnings per share; suggesting prices are cheaper to earnings than they appear.
As a result, we have been advising our institutional clients to increase healthcare weights, believing differentiation of winners and losers post legislation will drive volume and upside returns.