Health Care Stocks Could Be The New Bubble

Summary

• Health care spending has grown from 5% to 18% of GDP.
• Health care spending now eats up 20% of per capita income.
• Voters seem to have had enough, naming health care as top issue.
• What happens to health care stocks if the sector is reformed?

The political trends of the last few years point to potential problems in the health care sector. The health care sector is a very popular one for investment. The health care sector is the S&P 500’s second largest (13.89% weighting as of 5/31/2017) and for years has been characterized by growth that easily outpaced overall GDP growth. Among investors that are more conservative, the temptation to overweight health care companies in their portfolio is very strong. The sector offers very low volatility (a beta of .82 using the Health Care Select Sect SPDR ETF (XLV) as a proxy) and many companies pay generous dividends. Growth, low volatility, and dividends, what’s not to like?

However, we see some dark storm clouds on the horizon for the sector. Since perhaps the 2008 presidential election, the topic of health care has been one of the most significant in voters’ minds. Indeed, there is a good argument that backlash against the ACA was the driving force behind the Democrats losing a combined 1,000 state and federal legislative seats since 2010. There is also every reason to believe that health care will be a significant factor in the 2018 midterms and 2020 presidential election. Whether the BCRA passes or not is largely irrelevant to this thesis. We will either have a situation where some 20 million lose health care coverage (BCRA passes) or a situation where the existing health care system still needs fixing.

In 2016, the US spent an average of $10,345 in per capita health care costs. This compares to an OECD34 average of $3,453 per capita in 2015. The US is spending almost three times as much on health care as the average developed country. In fact, as the graph below from the Kaiser Family Foundation shows since the 1960’s, health care costs have grown from 5.0% of GDP to over 17% of GDP!

But to best understand why reducing health care costs has become one of the most preeminent issues for voters, it’s helpful to look at health care costs in relation to income. We looked at same per capita health care spending data from the Kaiser Foundation shown above, but this time graphed it as a percent of per capita income.

We can see that in 1960, health care spending was about 6% of per capita income. Today, the number is over 20%. Add in the fact that medical debt is the number one cause of personal bankruptcy filings and it’s easy to see why voters have pushed health care reform to the top of the political issues heap.

The big question is, when true health care reform does come to the US what will it look like? We think the best answer to that question is to simply look at where the US health care system is spending more money than other OECD countries. The two biggest cost drivers we identified were administrative costs and prescription drug prices.

In the US, administrative costs average around 8% of all health care spending compared to just 3% for the worldwide OECD average. This should be no surprise as the US is the only developed country without some form of universal, single-payer health care. We have a disjointed system made up of government entities (Medicare, Medicaid, VA, etc.), a myriad of private health insurance companies, and self pay customers. In fact, the 8% figure likely underestimates the true administrative burden, as many health care practitioners who would not be formally counted as administrative staff undoubtedly spend significant time on administrative tasks. Not only that but administrative management employees, not physicians as many assume, tend to be the highest paid employees of a health care organization. In fact, physician wages make up only 9% of all health care spending, which is below the OECD average.

The other outsized cost center in the US health care system is prescription drugs. In the US, prescription drug spending accounts for 10% of all health care costs. In 2013, this amounted to about $1,026 per person (measured in USD purchasing power parity). As the chart below from the Business Insider shows, this is double the OECD average.

In every other country, single-payer systems have allowed the government to bargain down drug prices. By contrast, the US largest single payer, Medicare, is legally prohibited from negotiating with pharmaceutical companies for lower drug prices. When change comes, drug prices are likely to be one of the areas where companies see profit margins reduced.

Summary

While we have no idea what true health care reform will end up looking like, we can be pretty sure it will significantly impact the two largest profit centers in the health care industry (administrative services and drug pricing). This is particularly important for investors because pharmaceutical companies make up over half of the health care sector! The chart below shows the industry type breakdown for the Health Care Select Sector SPDR ETF.

Pharmaceutical and biotechnology companies make up 55.13% of the index. Additionally, health care providers and services which contain health insurance companies make up 19.79% of the index. Almost 75% of the sector is at risk of undergoing radical changes over the next decade.

In investing, it’s always dangerous to assume that the future will be exactly like the past. We seem to have reached the limit as to what voters are willing to tolerate when it comes to seeing their income transferred to the health care sector. The industry’s past performance has been predicated on health care growing from 5% of GDP to 20% of GDP. What happens to health care stocks if and when that figure begins to be driven back down to the OECD average? Even if the health care industry is able to lobby to avoid say the introduction of a single-payer system, we seem to be reaching the point at which consumers have basically refused to pay more for health care. What will the performance of the health care sector look like when price increases are simply in line with or below GDP growth? We think caution is highly recommended when investing in the health care sector, particularly when it comes to pharmaceutical and health care administrative stocks.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

We do not own shares of XLV; however, we do own a select few individual health care stocks.