Headwinds Could Blunt Long-Running Rally In Health Care Stocks

Guest post written byPaul Karos

Paul Karos is a senior portfolio manager at Minneapolis-based Whitebox Advisors, which manages over $4 billion in hedge and mutual funds.

Health care stocks have enjoyed a persistent bid in the markets over the past three years. Health care was second best performing sector in the S&P 500 during the choppy markets of 2014 (up 23%, behind only the utilities sector), repeating its second-place finish from the boom market of 2013 (up more than 40%).

I see obvious reasons for this. The implementation of the Affordable Care Act has brought a flood of new patients and revenue into the health care system. A wide array of successful drug launches also increased revenue across the industry. M&A activity has also increased over the past several years, especially in specialty pharmaceutical and biotech companies, which are motivated to expand their offerings in order to leverage their respective sales forces. We’ve also seen service providers enter the M&A game in an attempt to vertically integrate every step of the patient experience, from doctors’ offices to specialists to hospitals, allowing them to capture revenue from multiple sources.

Given that these trends are likely to continue, one might expect the health care sector to sustain or even build upon its strong recent performance. Continued expansion of the ACA will bring ever more patients into the health care system, providing ever more revenue to an ever more consolidated industry. But a close look at trends within the system reveals a number of headwinds of which we feel investors should be wary.

By and large, consolidation within the industry is a good thing, a sign of a maturing industry. But, frankly, we thought the premiums paid on many recent acquisitions were exorbitant. While the volume of deals over the past year has been basically flat (289 in the first half of 2013 and 281 in the same period of 2014, according to a PricewaterhouseCoopers report[1]), the value of those deals surged 43%, from $17.2 billion in 2013 to $24.6 billion in 2014. It may be that we’re near the top of a seller’s market for M&A activity, and many of the frequent buyers are overpaying. We believe there is a strong argument for avoiding persistent acquirers, instead targeting companies with more organic growth. This may be a good rule of thumb for investors heading into 2015, especially those who avoid the guesswork associated with investing in potential M&A candidates.

The increased use of high-deductible health plans could also work against another strong year for the health care sector. The National Business Group on Health estimates that almost one-third of all large employers will offer only high-deductible health care plans, a 50% increase from 2014.[2] Since consumers on high-deductible plans are required to pay out-of-pocket for their medical services (up to a negotiated cap), an increasing number of consumers will have incentive to shop around for the best rate on a given procedure. In Minnesota, for example, a study released this summer by Castlight Health[3] revealed that a head/brain CT scan can cost anywhere between $326-$1,519. As more and more customers paying out-of-pocket shop around for the best deals, providers will be forced to become more competitive on rates. These market forces will likely bring down costs and margins.

Finally, a relatively unknown clause of the Affordable Care Act may create similar pressures on margins. In 2007, the federal government created a quality rating system for Medicare, ranking private Medicare plans on a variety of process and outcome measures, taken in total as a proxy for efficiency. The Affordable Care Act cut payments to these private Medicare plans, but also attached financial rewards and other competitive advantages (like early recruiting and enrollment of new customers) to firms with high ratings in these measures. The pursuit of better ratings on these efficiency measures could also temper profits and increase costs.

The Affordable Care Act will bring more patients and more revenue into the US health care system. But with those new patients come new strictures and pressures designed to make the health care system more efficient, customer-friendly, and yes, affordable. Investors may want to take a closer look at the industry before deciding that more automatically means better.

[1] ^{Q2 2014 US health services deals insights, PricewaterhouseCoopers health services specialists, August 2014.}[2] ^{The Large Employers’ Health Plan Design Changes Survey, National Business Group on Health, August 2014.}[3] ^{Analysis Details: Most and Least Expensive Cities for Common Medical Services, Castlight Health, June 26, 2014}

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Headwinds Could Blunt Long-Running Rally In Health Care Stocks

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