Healthcare Sector Investment Strategy

The three initial goals of healthcare reform that President Obama highlighted during his candidacy were reduced costs, improved quality, and expanded access, but the bill that was passed does very little to address cost and quality. While no strategic business decision, merger/acquisition, single piece of legislation, or even series of incremental bills, could ever deliver 32 million brand new customers to a single industry in one fell swoop, the Patient Protection and Affordable Care Act attempts to do just that. Obviously, a lot is likely to change between now and when the majority of the benefits begin in 2014, but the healthcare sector will be impacted by this legislation.

Companies that benefit from an uptick in healthcare utilization (i.e., hospitals with insured patients coming in the door, pharmaceutical companies and services associated with increased pharmaceutical utilization, etc.) should do marginally better, while companies with healthcare costs in their income statements (i.e., managed care) should do marginally worse.

To determine the most attractive areas for healthcare investments, it is important to highlight what the reform bill does not do.

It is not a deficit reduction tool.
The Congressional Budget Office recently revised its cost scoring for the new healthcare law to potentially add at least $115 billion more to previous estimates, bringing spending estimates "to beyond $1 trillion" over the next ten years. The White House still maintains that the healthcare overhaul will reduce the deficit, unless Congress changes it.

It is not a cost-containment mechanism.
With healthcare costs increasing significantly faster than wages and inflation, the lack of cost-containment provisions in the bill create a challenge for the future. Medicare continues to face significant fiscal issues that must be addressed soon. The Medicare Part A Trust Fund is officially scheduled to be bankrupt in 2016, but some experts speculate that the timeframe for insolvency could move up to 2014 or 2015, given the weak economy.

Consumer incentives have not changed.
Consumers are generally still removed from the cost decision because employer-sponsored insurance generally provides them with “pre-paid” healthcare consumption paid for predominantly by someone else.

Once fully implemented, the 10-year cost of the healthcare reform bill is estimated at $2.6 trillion. Thus, a cost-containment bill is likely to be a top priority for whomever is in the White House in 2013. This may help explain the lack of a relief rally in the overall healthcare sector after the bill was passed. In fact, the pharma/biotech sector was the second-worst performing sector in March, while healthcare equipment and services only slightly outperformed the S&P 500 Index.

Investors understand that to change meaningfully the nation’s chronic overuse of medical care, there will have to be substantial alterations in the way patients think about health care, how medicine is practiced and how we pay for it. Change eventually has to come because the nation is on an unsustainable path.

Although the full effects of the bill won’t happen until 2014, near-term performance of healthcare stocks should benefit from increased utilization. Soon thereafter, however, we will likely see more draconian efforts to curb healthcare costs. This ultimately could have a dramatic effect on growth profiles and price-earnings multiples. In this environment, we continue to focus on health technology companies developing breakthrough, cost-effective, proprietary products, as these will be the business models most capable of battling the gathering storm known as “pricing pressure.”

In addition to cost containment measures, the regulatory environment is likely to tighten further. Companies may face a stricter, more-proactive Food and Drug Administration (FDA) that will demand more extensive clinical data and longer review cycles before granting approvals.

Experienced companies and those with strong clinical programs should stand out as should companies with innovative products for life-threatening conditions. In contrast, we would avoid companies heavy on “me-too” products to treat well-managed conditions, especially where cheaper, generic options are available. We believe the notion that innovation will be paid for has not changed.

Within health services, we will focus on names that provide cost-saving solutions with minimal Medicare exposure.

For medical technology companies, strategic focus needs to shift away from the historical reliance on strong physician/salesperson relationships. A more sustainable model would be built on data supporting better outcomes and development of minimally invasive procedures for shorter rehabilitation and lower costs in order to protect historically strong pricing power.

For pharma/biotech companies, the attractiveness of historically low valuations and the potential to benefit from healthcare reform is mitigated by major patent expirations combined with payer push-back against “me-too” drugs. This may be why the sector did not enjoy a relief rally with the passage of the bill, despite the consensus view that drug makers should benefit from the legislation. We continue to focus on companies developing novel treatments for unmet needs and limited near-term generic exposure.

In addition to the healthcare sector, Sit Investment Associates’ domestic equity portfolios continue to emphasize the other traditional growth sector, technology, along with energy. In aggregate, these holdings are characterized by above average long-term earnings growth rates, along with relatively attractive valuations.