Investing in Health Care Reform

    by AAII Staff

    Like any piece of major legislation, the new health care reform law brings both opportunities and potential traps for investors.

    To help AAII members identify both, we contacted a few companies that run health care sector mutual funds. Fidelity, Janus and T. Rowe Price either made their health care fund managers available for comment or provided copies of internal interviews with their respective managers on this topic. Table 1 shows the performance of the health care funds managed by those whose views we present.

    A common theme, not surprisingly, was that the cloud of political uncertainty has been lifted from the health care sector. Going forward, mutual fund managers think the emphasis will be on cost controls and innovation. Health care companies that provide either, or both, stand most likely to benefit.

    Here is an overview of the mutual fund managers’ take on health care reform as it affects investors.

    Eddie Yoon, Fidelity Select Health Care Portfolio (FSPHX) and Fidelity Select Medical Equipment and Systems Portfolio (FSMEX)

    Eddie Yoon says that the legislation’s passage makes the future more predictable. As such, health care companies will be better able to adapt their business models. Yoon believes the new law will “shine a spotlight on those companies that are actually saving money for the system as a whole, and truly helping to ‘bend the cost curve.’”

    The fund manager predicts that the usage of generic drugs will rise significantly in the future. He cites three reasons as the rationale for this forecast. First, drug therapy is typically one of the “first lines of defense.” Second, a number of brand-name drugs will come off patent in the next four to five years. Finally, an additional 32 million Americans will have health care coverage in 2014, giving them access to prescription medication.

    Though these trends should bode well for generic drug makers, Yoon is cautious about them. He describes the industry as being “generally characterized by low margins and intense competition.” As a result, the fund manager suggests pharmacy benefit managers PBMs will really be at “the epicenter of this trend to control costs” instead.

    Yoon also likes life science tools and health care information technology (IT). Life science tools include equipment and technology needed to design smarter drugs and more targeted therapies. He says these innovations will save money in the long run. As far as IT, the fund manager states that the health care industry is at the beginning of a cycle to digitize medical records. Incentives by the government and a need to make the system more efficient could drive spending in this area.

    Yoon thinks there are some companies that will prosper regardless of health care reform. Specifically, he suggests “small-cap biotechs that are doing innovative research; companies that develop products to reduce rates of hospital-acquired infections; firms that help get patients out of hospitals faster; and companies that benefit as aging consumers spend more on cosmetic surgery.”

    The fund manager is more cautious about hospitals and managed care companies. Hospitals should see their bad debt burden drop because of fewer uninsured patients, but more baby boomers will be moving into Medicare, which pays lower rates to hospitals than private insurers do. Managed care companies are going to have more enrollees, but the final regulations are unclear.

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    Andy Acker, Janus Global Life Sciences Fund (JAGLX)

    Andy Acker views the recently passed legislation as being more about health care expansion than actual reform. He states that some of the proposals that would have really controlled costs and changed incentives were left out. As a result, he says the new law is more of a “stitch.”

    Nevertheless, Acker does think some companies will benefit from the increased number of insured individuals. He lists pharmacy benefit managers, drug retailers and generic drug makers as probable winners. Hospitals could potentially benefit because “one of things that really impacts their profitability is caring for uninsured with bad debt expense.”

    Generic drug makers have two other trends that could help their revenues and profits, as Acker sees it. First, brand-name drugs that top over $50 billion in sales annually face patent expirations over the next three or four years. Secondly, Acker says that the Food and Drug Administration FDA has been expanding its inspections out to countries like India. This is causing some drug suppliers to be pulled off the market and is also leading to increased consolidation. Finally, he says that “if you are purchaser of generic drugs, you’re looking for a one-stop shop where you can ensure you have good quality and a reasonable supply.”

    The fund manager singled out biotechnology as being potentially the biggest winner from health care reform. The new law gives these companies 12 years of exclusivity from generic competition, which Acker says “was actually higher than we were expecting.”

    Acker believes IT companies focused on health care may also be poised to benefit from the overall trend toward reform. Last year’s stimulus package included incentives to digitalize medical records. According to Acker, physicians can now get incremental reimbursements if they switch to electronic medical records.

    Managed care was singled out as having the “most mixed and negative outlook” by the fund manager. Acker thinks that these companies will face significant fees, increased regulation and limitations on how much of their expenses have to be for medical costs as opposed to administrative costs. He also believes that managed care companies will encounter significant cutbacks in the Medicare Advantage program.

    Kris Jenner, T. Rowe Price Health Sciences Fund (PRHSX)

    Kris Jenner believes the primary goal of health care reform to decrease the number of uninsured was achieved. He does not believe the secondary goal of controlling or slowing the rate of cost increases was achieved, however.

    Jenner’s response has been to make more investments “on the margin” thinking that the new legislation will have a significant impact in terms of winners and losers. However, his primary investing focus is “innovation, important innovative products that can be transformative to the physicians and the patients.” Secondly, the fund manager believes that we are “in a cost-conscious environment trying to find better mouse traps that provide quality outcomes but in cost-effective ways.”

    In terms of specific industries within the health care sector, Jenner expects that the influx of new patients into the system should result in higher drug volumes. His rationale is that pharmacology therapy is the most cost-effective part of the health care system. He singled out pharmacy benefit managers PBMs as companies that are providing value. Jenner describes PBMs as a “better mouse trap” because they only succeed if their clients do well.

    He predicts that hospitals should benefit from being reimbursed for more care thanks to increased coverage. (Fewer uninsured patients will show up in the emergency room requesting care.)

    Conversely, the fund manager singled out managed care as an industry that could face traps. He does not believe the health insurers have political allies and worries about high-risk pools comprised of individuals with illnesses that are expensive to treat.

    Medical equipment companies are likely to face both downward pressures on pricing and a new excise tax at the same time. This combination will place a drag on their earnings. However, Jenner opined that product innovation will be the biggest hurdle for these companies.

    Doctor Shortage

    One subject that was not heavily discussed was the projected shortage of primary care physicians. The American Academy of Family Physicians estimates that there will be a need for 40,000 more family physicians by 2020. At the same time, various studies suggest most medical students are not opting for family care and many physicians are cutting back on their hours.

    A possible beneficiary of this shortage could be an increase of visits to urgent care and retail medical clinics, the latter of which can be found at drug store chains such as CVS and Walgreens. The rationale is that it will be harder to see a traditional physician and many of the hourly workers being added to the insurance rolls will not be available for traditionally scheduled daytime visits to a doctor’s office.

    Health Care Reform Not Yet Implemented

    One common theme stated by all three managers is that the actual implementation of the law still requires a large amount of regulatory effort. Therefore, there is a possibility that changes could be made over the next couple of years. These changes could have the potential to alter the profit outlook for one or more of the industries within the health care sector.

    Nevertheless, although there may be broad changes, the views of these mutual fund managers can provide a starting point for identifying potential opportunities and potential pitfalls. Table 2 summarizes their forecasts.

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