Dr. Market's Prescription for Healthcare: Rose-Colored Glasses

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Includes: AET, CI, HMA, THC
by: Ockham Research

Last night, Congressional Democrats were able to secure 219 votes in support of sweeping reform for the healthcare industry, three more than the minimum necessary to pass the bill on. For more than a year, politicians have debated and waxed philosophic about the bill and the current state of the health insurance industry, but after last night’s vote, it appears something similar to the current bill will reach the President’s desk before long. It was my impression that the market would react negatively to the proposed legislation, as it would hand the government far greater influence over a massive sector of the economy; some estimates place it at 16% of the US economy and growing.

However, the market rallied on the news led by hospital administrators like Tenet Healthcare (NYSE:THC) and Health Management Associates (NYSE:HMA) on the assumption that 32 million additional insured will bring in greater ongoing revenue in the future. Other healthcare stocks have rallied higher on Monday as well, including health insurers like Aetna (NYSE:AET) and Cigna (NYSE:CI) that have been regarded as a primary target of the legislation. Again, the thinking is that the proposed bill should add to their customer base by extending coverage to many Americans currently living without it.

Today’s market action is of course a small sample (especially considering the anemic volume), but it flies directly in the face of a number of analysts and pundits who believed healthcare reform would squeeze profits out of the largest insurers and other healthcare-related companies. Many of the biggest proponents of healthcare reform have placed much of the blame for rising costs on the industry’s pursuit of profits. However, as we all know, from a fundamental analysis prospective, profit is what underlies value in stocks. Equities are at their core a claim on future cash flow, and anything that derails a company’s ability to make profits or reduces visibility into those profits should be met with resistance from the market.

Clearly, the market and the American people are just beginning to establish what impact this legislation will have, and certainly we will have a better understanding of the market’s reaction after a few months. For one, it seems likely that the government will force greater medical loss ratios, meaning a greater percentage of premiums must be used to pay medical claims. Whatever the political implications, this will put a squeeze on profits, and one analyst from Oppenheimer estimated by 20% on some insurers. At present, it strikes me as odd that a bill directed at lowering profits in the healthcare sector would receive even a slightly warm reception, even as it may raise revenue by covering a greater number of people.

These healthcare stocks may in fact turn out to be above average investments, as they were in the years following the passage of Social Security under LBJ. However, the point is that we simply do not know what the effect will be and we expect the sector to be relatively more volatile as details continue to be ironed out in Washington. Just looking at the numbers, there are plenty of stocks, especially health insurance stocks, that look like a bargain as profits have come in quite strongly in recent quarters. However, the uncertainty in the sector is enough to make us reticent to recommend buying these shares. Today, the market seems unfazed by the landmark legislation, but the rose-colored glasses may come off as more details come to light.

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