Healthcare is a complex, highly regulated, and expensive institution, accounting for a whopping $3.5 trillion of spending per year. According to the Centers for Medicare & Medicaid Services (CMS) national healthcare expenditures are expected to grow faster than the overall economy, at an average of 5.5% annually from 2018 to 2027. If that comes to pass, healthcare will soon be 20% of GDP. These high and rising costs are driving an ongoing movement away from the old archetype of “fee-for-service” healthcare, whereby providers are reimbursed for every office visit, test, and procedure. The new paradigm places a greater emphasis on “value-based” outcomes, in which a provider has a vested interest in monitoring and improving a patient’s general condition before major issues arise. As a result, we are seeing vertical consolidation on a large scale within the healthcare sector. Hopefully, this will lead to a slowdown in the growth rate of medical costs. In our view, this process is positive, and we explore some of the investment implications in this Investment Strategy Update.
Changes Since the Affordable Care Act
The Affordable Care Act (ACA) was signed into law in 2010, when there were 45 million individuals in the U.S. without health insurance. In the subsequent eight years, it drove the number of uninsured down to 28.3 million. As more people became covered there was an understandably rapid rise in the utilization of health services, stretching existing resources and contributing to rising costs. However, with the effective repeal of the individual mandate starting this year, we expect the number of uninsured to rise again, as some of the younger, healthier population opts out of traditional healthcare coverage. The remaining population will by definition be less healthy, which will cause their insurance premiums to rise. In summary, the good thing is that the least insurable people can get coverage. The bad thing is that healthcare is still very expensive and getting more so.
According to the CMS, hospital care is by far the largest element of healthcare costs, accounting for 33% of total spending. Physician and clinical services are the second largest spending category at 20%, and prescription drug costs follow at 10% of spending. The major categories making up the remaining 37% of costs are nursing care facilities, mental health services, substance abuse clinics, ambulances, dental care, and home health care. Our focus is on the top 3 areas as they are considered to be the areas where expenses are growing the fastest, where individuals’ wallets are impacted the most, and in the case of hospitals, where catastrophically large costs are most likely to be incurred.
Is there a solution to rising medical costs? After all, it is well known that we are an aging society with enormous wealth and a strong economy. Is it even possible for us to bend the medical cost curve downward, while at the same time providing quality care? In the run-up to the next election, expect a bi-partisan explosion of demagoguery as politicians propose a wide variety of grand long-term ideas. Interesting to watch, perhaps, but don’t expect much to come of it. The movement toward value-based care has already begun. The first iterations came in 2012 and were mandated in hospitals serving Medicare patients. Some of these early programs focused on reducing both readmissions and hospital-acquired conditions. Now, skilled nursing facilities are receiving incentive payments based on Medicare patient outcomes. We also see the future of value-based care being driven by economics in the private sector.
The Delivery Mechanism
Basic medical insurance coverage includes emergency and hospital care, physician visits, and a prescription drug benefit managed by a Pharmacy Benefit Manager (PBM). Part of the PBM’s responsibility is to negotiate drug prices with the drug companies. The overall policy will usually include deductibles, co-pays, and a maximum out-of-pocket limit. In the old days (before the ACA), insurers would actively identify higher-risk patients and deny them coverage. In addition, under the fee-for-services model, insurers would aggressively try to limit what they actually paid out on claims. On the other hand, hospitals, physicians and other providers, along with the drug companies, all had the incentive to grow revenue by increasing the volume of tests and procedures performed, and drugs prescribed.
Now that the managed care providers have been forced to take on a larger population that is skewed to less healthy patients, it is in their best interest to keep those more expensive patients from getting sicker and thereby incurring costlier procedures in the most expensive (i.e. hospital) settings. As a result, we are now seeing aggressive, proactive management of patients with chronic conditions that have proved to cost more if not properly addressed early and consistently. For example, assigning case managers to large patient populations to help them control their blood sugar more effectively, could lower the number of expensive vascular, vision, or nerve complications requiring higher acuity treatments. We are also seeing a ramp-up in offerings of wellness programs, including free weight-loss counseling, fitness monitoring, and smoking cessation programs.
Another important part of the cost-saving equation will be shifting the setting in which care is provided toward less expensive and more convenient options. One example would be utilizing an urgent care facility for less severe problems rather than an emergency room. Retail pharmacies are building out clinics within their stores to handle some routine medical needs with a pharmacist or nurse-practitioner. Technology is also allowing more immediate and less expensive access to doctors via online video consultations instead of an office visit.
Because managed care providers are now taking on more financial accountability for patient outcomes, they have determined they need more control of the entire delivery system. This has been one of the driving forces behind some of the recent industry mergers. With greater scale as well as scope within the healthcare delivery process, there should come a greater ability to generate useful data, such as adherence to a prescription regimen. And the more control a company has over the entire delivery process, the greater its ability to manage and apply artificial intelligence to the data to generate better outcomes. Hence, vertical integration is causing the lines to blur between insurers and care providers.
While not without its drawbacks, Kaiser Permanente has been at the vanguard of this integration. Nearly everything is under one roof. Its doctors are employees, the facilities are its own, it controls patient data, and it has been gearing toward wellness and prevention for decades. As such, Kaiser has generally been able to provide their services at a lower overall cost than others.
Also expanding in scope under the new paradigm is United Healthcare, which has quietly bought up facilities and care providers, as well as a PBM, and now controls a much more substantial portion of the ecosystem than five years ago. It still has a broad network of outside service providers, but the trend is clearly toward owning more of its own.
Accelerating the vertical integration of the industry, two large healthcare mergers occurred in late 2018 and involved managed care providers combining with PBMs. Aetna merged with CVS Caremark, and Cigna merged with Express Scripts. Both of these combined entities are clearly trying to control more of the process to better compete in the changing environment. The CVS/Aetna matchup is intriguing in that it includes a huge retail store element, which the company will try to utilize to provide options to their insured customers. In the wake of these mergers, most of the large managed care companies in the U.S. now control their own PBMs, and as there are now no longer any major independent PBMs, this significant part of the value chain has effectively been collapsed into managed care. Like it or not, healthcare is becoming more concentrated.
Healthcare stocks account for roughly 15% of the value of the S&P 500 stock index. Approximately half of that value is in pharmaceutical and biotech stocks, 22% is medical equipment and supplies, 20% is managed care, providers, and services, while the remainder is predominantly life science tools.
We expect the drug companies to be the continued targets of political ire, and not without cause. Drug prices have historically risen well in excess of inflation, and some of the new breakthrough formulations have carried hefty price tags, all of which is reflected in their dominant index weighting. While we find the drug companies’ finger pointing at the PBMs and others in the value chain for high drug prices to be somewhat hollow, we also recognize the pharmaceutical lobby’s clout. On balance, drug companies that continue to provide innovative therapies should continue to get pricing that compensates the research and development effort, and therefore be rewarded by the market. Those that are milking a stagnant product portfolio by relying on price increases or strategies to extend end-of-life patents probably won’t do so well.
We should continue to see more vertical integration between insurers and providers, and we believe these large managed care providers can do extremely well if they can use their expanding resources to drive down the cost of delivering healthcare while maintaining or, even better, improving outcomes. However, this group is not without political risk, either. Case in point, we do not expect to see meaningfully higher profit margins, which would be a political lightning rod. Instead, most of the lowering of expenses growth is likely to be passed on in the form of lower premium increases.
Ongoing demand for medical devices should continue to be robust due to our aging population, while the outcomes from “replacement” operations continue to improve. While some companies within this sub-sector were, in our opinion, inexplicably targeted in the ACA, we see no current evidence that they are under major political threat. Those companies that continue to innovate and make products that improve lives should continue to prosper.
The life-science tool sector has been, and should continue to be, a stellar performer. It has the benefit of not selling products or providing services to individuals, but rather major research and testing facilities and healthcare services providers. As such, these companies should be fairly insulated from political risk.
Finally, the anticipated generation of Big Data within healthcare necessarily draws technology companies into the discussion. One area of focus is the health monitoring devices that generate some of those data, while another is the artificial intelligence that is being applied to them. Whether there is an investment in either arena that is enough of a pure play to interest us remains to be seen.
Investors breathed a sigh of relief as the stock market rebounded strongly in early 2019 from the sell-off late last year. However, doubts about the pace of economic growth here and abroad have surfaced recently, along with ongoing uncertainty about a successful trade deal between the U.S. and China. Interest rates have fallen, and some parts of the yield curve (including our focus, the 3-month/10-year spread) are now slightly inverted, which is a potentially important signal of approaching recession.
Nonetheless, the U.S. economy and corporate earnings should continue to grow this year despite a near-term flat patch, though not at last year’s pace. The Federal Reserve, in response to still-moderate inflation and recent financial market turmoil, has decided to put any further hikes in the Fed funds rate on hold for the rest of the year. Therefore, we still believe that we are not quite at the end of this cycle’s bull market, as long as inflation remains moderate and the Fed does not have to raise rates further. In the meantime, though, the combination of higher stock prices and slowing earnings growth has caused us to become more cautious for now with our asset allocation decisions.