Investors Face a New Health Care Landscape: An Interview with Michael Liss

Overview

After a year of intense partisan combat and fiery debates on Capitol Hill, President Obama signed a massive, nearly $1 trillion health care bill on March 23 that reshapes an industry that accounts for one-sixth of the U.S. economy. At its core, beginning in 2014, the legislation would extend insurance coverage to 32 million Americans who lack it through a “health insurance exchange” and ban insurers from denying coverage due to pre-existing conditions. For the first time in the nation’s history, most Americans would be required to purchase medical insurance, and face penalties if they didn’t.

No one at American Century Investments^® has followed the health care reform bill more closely than Michael Liss, vice president and portfolio manager for American Century Value, the company’s flagship value portfolio. Liss is also the chief analyst on the value team assigned to the health care sector, which means he is now factoring in the sweeping legislation as he examines and selects health care businesses for the portfolio. We spoke with Liss a week after the health care bill was signed to find out how he’s currently invested in the sector and to get his initial thoughts on how the legislation is likely to impact key parts of the industry.

Q. What is your initial take on the health care bill from an industry standpoint? Who wins and who loses?

Liss: I don’t think it’s much of an overstatement to say that in essence everyone wins—even the major health care insurers, who face much greater regulatory oversight and increased business risk associated with new rules on coverage that take effect in 2014. The reason is that for the industry the legislation actually represents a massive health care spending bill—by both the government and the 32 million Americans who are going to be added to the insurance rolls. In addition, there is an almost total absence of price controls. There are few instances where the government is dictating the prices that providers can charge newly insured consumers for health care products or services, or how much or how often people can receive health care outside of programs like Medicare or Medicaid. Without such controls, we’re going to see greater demand across the health care system, from doctor visits to drug prescriptions to hospital stays.

Q. Pharmaceuticals comprise the largest part of the health care weighting in the Russell 3000 Value Index. They also represent the bulk of Value’s health care holdings. How has the financial or competitive landscape changed for Big Pharma?

Liss: The pharmaceutical companies pushed for the legislation and it’s easy to see why. Congress is awarding them millions of new customers in the next few years, many in their forties and fifties who will increasingly need prescriptions as they get older. While it’s true that the drug companies will have to give up some pricing and provide larger discounts to consumers on Medicare or Medicaid—in addition to the $85 billion in taxes they’ve pledged to the program during the next 10 years—I think the lion’s of share any pressure on their margins will be offset by a much higher demand curve.

We favor large pharmaceutical companies because they typically have diversified businesses and/ or product lines, a major factor in collaring risk. Value’s holdings include Pfizer (2.68% weighting as of 2/28/2010) and Johnson & Johnson (J&J) (1.64% weighting). Amid the swirling health care debate (and the market’s preference for lower-quality stocks), these two industry stalwarts gained 8% and 11%, respectively, in 2009, but trailed the broad market, which was up 26%. Longer term, we believe both companies have positive outlooks. Pfizer’s acquisition of Wyeth Pharmaceuticals in October 2009 is expected to deliver cost savings and help offset patent losses. J&J has a well-balanced product line that includes consumer products, pharmaceuticals, and medical equipment.

Incidentally, generic drug companies also stand to benefit. They’ll see greater demand for the drug copies they make, both from the newly insured and from insurance companies pushing generics to keep expenses down. Importantly, while the new law gives the branded pharmaceutical companies 12 years to exclusively market biologic drugs (medicines that treat conditions like anemia, rheumatoid arthritis, hepatitis, and cancer), it also introduces a groundbreaking “biologic generic pathway,” laying out approval steps for generic versions of these biotechnology medicines. In addition, many of the generic companies already making these drugs are protected by high barriers to entry. Biologics are very complex drugs and expensive to make.

Q. Hospital stocks posted some of the largest gains when the health care legislation was passed. Why are investors looking favorably on them?

Liss: For years, emergency rooms have been the health care provider of last resort for the uninsured, leaving the hospitals to foot the bill for services patients couldn’t afford. It’s not uncommon today for uninsured patients to represent 10% to 15% of a hospital’s admissions—a huge drag on cash flow and earnings. This bad debt is going to shrink considerably in the years ahead as people insure themselves in accordance with the new law. That and the resulting rise in revenues is going to enable hospitals to increase their capital spending, which should benefit another part of the industry—makers of medical devices and equipment.

Q. Insurers, who strongly opposed the health care legislation, appear to face a much-changed business environment. Value currently owns three leaders in the field, Cigna, UnitedHealth Group, and Aetna. Will insurers still be attractive value investments going forward?

Liss: We purchased those three companies last summer when it became clear that the federal government was not going to be a competitor in the insurance exchange that’s going to be set up in a few years. Cigna (0.16% weighting as of 2/28/2010), UnitedHealth Group (0.30% weighting) and Aetna (0.32% weighting) had all been underperforming in the face of unknowns associated with the legislation, a slowdown in their unique business cycle, and a recession that reduced their memberships. They’re still very attractive in terms of valuation.

When it’s all said and done, I don’t believe the earnings of the major managed care companies will be jeopardized to any great extent by the new health care environment. They can’t help but benefit from the tidal wave of new subscribers entering the system. On the other hand, for insurers, the devil is in the details, most of which are still to come from the Department of Health and Human Services, the agency that will regulate their activities. What we know already is that down the line insurers won’t be able to disqualify people for pre-existing medical conditions or deny coverage because someone has achieved a certain level of spending. They will also be governed by “rating bands” that will dictate how much they can charge people who need the most medical care. Perhaps most significantly for the industry as a whole, while insurers will see increased revenues from millions of new customers, the legislation mandates the level of their “medical loss revenues”—the amount they must pay out in medical expenses for every dollar received in premiums. Note the absence of cost controls here as insurers (and their insured, for that matter) are being encouraged, if not forced, to spend more on health care.

As a result of this, I think we can anticipate increased consolidation in the managed care industry. A number of smaller players are going fall by the wayside as their operating margins shrink. Put another way, economy of scale is going to separate winners from losers; the most profitable companies will be those that can spread their costs over a vast network. The legislation also makes it more difficult for insurers to “price for risk”—that is, charge older or sicker patients more or deny pre-existing conditions because the likelihood of higher payouts is greater. That factor is going to have a disproportionate impact on smaller competitors that don’t have as much wherewithal to absorb costs.

Q. Many of the health care bill’s most far-reaching changes don’t kick in until 2014. Do you expect health care companies to raise their prices in the interim to build up their war chests?

Liss: That’s already been happening, and we can probably expect more. Surprisingly, the pharmaceutical companies increased prices significantly in 2009—while the legislation was still being worked out and they were under a microscope in Washington. We can also look for health care insurance companies to raise their premiums. With a cap of sorts on what they can charge people who need more expensive care, insurers are forced to charge new subscribers more to help cover those higher expenses. Alternatively, hospitals, which have been raising their prices consistently to recoup the costs of giving away free health care, will have less incentive to do so as insurance payments increase.

Q. From an investment standpoint, has the reform changed the way you analyze health care companies for American Century Investments’ value teams? Beyond your valuation and fundamental analysis work, are you adding new lenses to your analysis?

Liss: We’ve valued the health care stocks we own or are following as if the effect of the legislation on them is going to be neutral, a wash. Right now, given the uncertainties, we believe it’s more important to be protected on the downside. Many aspects of the legislation don’t occur for some time and the reach and stretch of many regulations are still being hammered out. It’s also nearly impossible to accurately forecast the financial impact elements of the bill may have for individual companies two or three years from now.

The trick now is to follow what gets implemented very carefully—the specifics within the specifics. Here’s an example: Health insurers are going to be required to spend 80 cents of every dollar they take in on medical costs from individual and small group policies. But what calculations will go into that 80 cents and what exactly will be defined as “medical costs?” Will managed care companies be able to include selling, general, and administration costs, which are a cost of doing business, as medical costs?

Another risk is the possibility that companies may do something irresponsible—drastically raising prices before the legislation kicks in, for example—that catch the eyes of those currently writing the regulations and lead to more punitive laws or rules.

This is a time for health care investors to be vigilant, patient, and risk-minded. The bill is the most sweeping piece of federal legislation since Medicare was passed in 1965. The changes will be phased in over time and a lot of specifics are still to come.

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