The simple question, "Who is going to do it?," posed by legendary value investor Bruce Berkowitz, puts the consensus concerns surrounding the managed care industry into perspective. The bottom line is that the health insurers are the only shot we have at managing this mess. As much as he might like to, Obama does not have another entity to do it. And our growing government does not have the expertise or efficiency to manage the process.
The bear case for these stocks is well known and well discounted even at today’s levels. Let’s take Humana (HUM), for example – 60% of the analysts that cover the company rate it “hold” or worse. To help put this number in perspective, a whopping 1% of the S&P 500 is rated “sell” today. So suffice it to say that the “bad stuff” is in the price. And when the bar is set low enough, it is not difficult to surprise on the upside. Perhaps this is why earnings estimates for the company have been marching steadily higher in recent months. So let’s consider some of the potential “good stuff” that might shift sentiment in the period ahead:
- Roughly three quarters of Humana’s premium revenue is driven by government programs. It’s safe to say that as long as the printing press is still running, Uncle Sam will pay his bills.
- Humana has experienced spectacular growth from these programs driven by Medicare Part D and the trend towards private plans.
- Management effectively capitalized on this opportunity when it was presented. As such, shareholders have been well served by the company’s strategic focus.
- Those receiving insurance through employers has declined this decade, but Medicare enrollments are rising steadily and expected to accelerate as baby boomers enter retirement.
- Humana’s decades of experience in Medicare programs gives the company a competitive advantage in dealing with new government programs for boomers and the uninsured.
- Humana spends much more on SG&A than peers, resulting in significantly lower operating margins, and offering plenty of potential to ‘cut the fat’ out of the business.
But rather than throwing darts at potential positive surprises, James Montier recommends turning the process on its head:
Analysts are called analysts, not forecasters, for a reason. All investors should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future . . . Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth.
This echoes Ben Graham’s words that you don’t need to know a person’s exact weight to know whether they are overweight or underweight . . . The idea of investing without pretending you know the future gives you a very different perspective, and once you reject forecasting for the waste of time that it is, you will free up your time to concentrate on the things that really matter. So, when trying to overcome this behavioral pitfall, remember what Keynes said, “I’d prefer to be approximately right rather than precisely wrong.”
This is an exercise we perform regularly at Broyhill. If nothing else, we think we know what we don’t know. Accordingly, we seldom make forecasts. Lucky for us, accurate forecasting is not a prerequisite for portfolio construction or superior risk adjusted returns.
Working backwards from today’s price is more consistent and a much simpler exercise. In analyzing Humana, and most of the managed care space, margin assumptions clearly drive intrinsic value. So it is critical to understand what margin expectations are priced into the stock today. Using consensus forecasts for long term top line growth (recall this is a group that is generally bearish on the industry) we estimate that current prices imply long term EBITDA margins of 2.4% using AFG’s Value Expectations. This implied margin should be viewed in the context of the company’s five and ten year median margins of 4.5% and 3.0%, respectively.
In other words, Mr. Market is already pricing in a near 50% haircut in Humana’s recent EBITDA margins by Uncle Sam. That’s pretty aggressive, even for Obamacare, and leaves plenty of room for upside surprises. We use the matrix below, click to enlarge, to estimate the stock’s sensitivity to changes in consensus sales and margin assumptions. The bottom line is that investors would require an additional 100 basis point reduction in consensus margin assumptions to justify modestly lower valuations. More importantly, upside surprises offer the opportunity for extremely handsome profits. We can live with those odds.
Bruce Berkowitz of Fairholme Capital Management tries to kill the company rather than looking for all the information that would support an investment:
We look at companies, count the cash, and try to kill the company. . . We spend a lot of time thinking about what could go wrong with a company — whether it’s a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can’t kill it, maybe we’re onto something. If you go with companies that are prepared for difficult times, especially if they are linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness . . . Companies die . . . Here are the ways you implode: you don’t generate cash, you burn cash, you’re over – leveraged, you play Russian Roulette, you have idiots for management, you have a bad board, you ‘de-worsify,’ you buy your stock too high, you lie with GAAP accounting.
Apparently, he was not able to murder Humana. Fairholme owns over 9% of the float.
Disclosure: At the time of publication, the author was long Humana Inc., although positions may change at any time.
Disclosure: Long HUM