Rx for Capex: Hospitals Benefit from Recent Trends

No matter the industry, the Invesco small-cap team’s stock selection process is bottom-up, but some ideas lead us to others. Experience in health care through more than one cycle is leading Invesco Small Cap Equity Fund into stocks we expect will benefit as this cycle unfolds.

New money for hospitals

One theme in our portfolios over the last several years has been investment in hospitals, as I explain in a recent Barron’s profile titled “Big Ideas, Small Stocks.” And hospital stocks have seen revenues improve recently, benefitting from two themes in particular — the Affordable Care Act (ACA) and an improving economy. Specifically:

  • ACA reimbursements began paying the medical bills of uninsured patients who previously would have left those bills unpaid. This measure not only adds revenue hospitals didn’t expect before, but also reduces the bad debt on their books.
  • Hospitals have experienced increased “utilization” as the economy has rebounded, employing more people who now have insurance through their employers. Additionally, people who cut back during the Great Recession by skipping elective care are now obtaining that care.
  • Higher utilization rates mean more revenue, and because hospital costs are relatively fixed regardless of patient volume, lead to dramatically improved profits.
  • This all translates into more cash for hospitals for capital expenditures (capex).

Spend on what?

So, what have hospitals been doing with their cash? In the early years of ACA, which began phasing in during 2010, hospitals largely used their capex increases to upgrade their information technology systems and meet federal mandates for shareable electronic patient records. I believe the next level of capex will be directed toward medical equipment and devices that hospitals have underspent on in recent years.

In the Invesco Small Cap Equity Fund, we can see how these trends have played out. LifePoint Health (1.17% the portfolio as of June 30, 2015), which owns hospitals in small towns and rural communities, has benefited from the rise in doctor visits and hospital and urgent-care facility usage. Likewise, Team Health Holdings (1.06% of the portfolio as of June 30, 2015), which outsources medical and administrative support, has also benefited from increased utilization.

When utilization picks up, so do revenue and profitability, making more capital available. So it’s logical to anticipate a spending boost on medical equipment. Although medical equipment expenditures as a percentage of total us capital expenditure currently remain about 25% below previous peak levels,1 an uptick in hospital investment in new equipment is an evolving trend.

Translating our experience and expectation into holdings for our investors, Analogic (0.91% of the portfolio as of June 30, 2015), which designs and manufactures medical-imaging technology and supplies components for about half of CT scanners worldwide, is poised to benefit. Similarly, more hospital patients require more beds and drive a replacement cycle for older beds, a likely boon for Hill Rom Holdings (1.13% of portfolio as of June 30, 2015), a leading global manufacturer of hospital beds.

Stretched biotech leads to idea

But while sector expertise and experience have placed approximately 14% of the Invesco Small Cap Equity Fund into high-quality health care opportunities, that same experience is keeping the portfolio on the sideline in biotech stocks. In our view, valuations in small-cap biotech are stretched and out of step not only with historical trends, but also with the actual likelihood of company success. However, innovation in biotech has also led us to more ideas, such as Bio-Techne (0.98% of portfolio as of June 30, 2015), which develops components instruments and proteins for biotech clinical research worldwide.

In today’s information age, we believe having experienced, sector-expert analysts who develop deep insight into an industry offers an advantage that enables us to follow the investable idea trail to benefit our investors.

1 Source: US Department of Commerce, Bureau of Economic Analysis data, March 31, 2015

Important information

Holdings are subject to change and are not buy/sell recommendations.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com/fundprospectus.

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