Two veteran investors discuss the winners and losers of reform and where they're looking for future growth.
With recent breakthroughs in science and the passage of the most massive change in U.S. health-care policy in decades, many opportunities and challenges exist in investing in health-care securities. To help investors navigate the sector's complexity, I moderated a panel of expert health-care investors June 24 at the 2010 Morningstar Investment Conference. On the panel were Andy Acker, manager of Janus Global Life Sciences
More Expansion Than Reform
Damien Conover: How do you see health care's investment landscape changing in light of the passage of reform? Have you repositioned your portfolios?
Kris Jenner: It's a type of question that has been posed quite frequently since I started running our health-care fund in 1999. How do you position your fund relative to public policy or legislative changes that are occurring in Washington? For seven or eight years, I would just say that the changes were so incremental and so hard to predict that they didn't really have a lot of bearing on the investment philosophy. But now we have the most comprehensive piece of social legislation since the enactment of Medicare under the Johnson administration in the late 1960s. It's time to pay attention. For the first time in my investment career, I have really thought about the positioning of the portfolio relative to how we see things unfolding, not just this year or next year, but what we see far down the road.
There were three goals of health-care reform. One was to provide insurance for the uninsured. The second was to improve the quality of health care. And the third was to achieve goals one and two while at the same time having lower health-care expenditures. I would say that this legislation really addresses goal number one, which is to have some 30 million Americans who were not insured to be insured. Our expectation is that down the road costs are going to accelerate. Somewhere in the latter part of this decade, I predict that we will have something like Health-Care Reform II that will be highly focused on cost.
As for what groups are in the crosshairs of this legislation versus those that are likely to benefit, investors should think about volume-- more medical stuff, more physician visits, more health-care consumption. At the one end of the spectrum might be the hospitals. The hospital group, with its services to the uninsured and its so-called bad debt, is the only group that I know of that will be paid for doing something that they are doing for free today. Another beneficiary will be IT areas within the health-care system. The electronic technology within health care is a decade behind the financial-services industry. There's definitely going to be some winners in the hard wiring of the health-care system. One that we're playing is Cerner
But at the same time, there's going to be tremendous cost pressures. So, at the other end of the spectrum is the medical-insurance industry: They have no friends anywhere. None, whatsoever. During this time of colossal change, they have no constituency. And that's a bad place to be, because this bill was written hurriedly. There are many elements in there that have to be interpreted by Health and Human Services. The core bill is 2,500 pages long, and there's 1,400 places where it says "the secretary shall." This language leaves a tremendous scope for bureaucratic interpretation. So, the details are yet to come, and when you don't have any friends anywhere to be found, it puts you in a very perilous position.
Andy Acker: This was really more of a health-care expansion than a health-care reform. We're going to have 30 million more customers coming into the system through insurance by 2014, and that's good. The flip side, at least in the near term, is that in order to make the budget work we got the stick before the carrot. So many of the new industry fees, taxes, and regulations come up first. That's affecting the pharmaceutical companies now. We're going to see a bit more of that impact next year. People thought that once we had certainty on health-care reform that we would see a rally. We haven't really seen that yet, mostly because we're getting this negative impact in the near term.
I agree with Kris about health-care IT. One company that we think has a large oppor- tunity is Athena Health
Jenner: Andy, why do you think that we have not gotten the rally that we thought we would? I think it has to do with what's happening in Europe with the austerity programs and price controls, but I want to get your point of view on it.
Acker: I would say it's two things. One is the fact that I mentioned: We're getting the pressures from the taxes and fees now. For example, the bill was passed in late March. Pharma companies had already given their guidance for 2010 earnings, and then some aspects of the bill were made retroactive. So, we had earnings revisions as these taxes came into effect. Everyone saw earnings going down. Then on top of that, you've had the cuts in Europe. Pricing pressure is usually higher in Europe than in the United States. Companies see, on average, 2% to 3% price cuts per year in Europe; in the United States, we generally see price increases in the low-to-mid-single digits. This year, however, with the austerity measures and the budget deficits in Europe, we're seeing price cuts in places like Greece, Spain, and Germany that are higher than we've ever seen before. I think there's a worry that this is going to become the norm. We've got 10% budget deficits. Are we going to see 5% price cuts every year? Longer term, people realize that the health-care costs in the United States are going to be much higher than expected, and that will be an issue.
Jenner: Yes, I agree. It's much easier to whack an industry and say you're going to get 10% less today than you did yesterday than see pensioners riot in the streets and have it on CNN.
M&A: A Path to Growth
Conover: Let's talk about mergers and acquisitions. In 2009, we saw some massive acquisitions. Pfizer
Acker: A lot of the mergers were a response to pressures in the pharmaceutical industry. We've seen global pricing pressure; R&D productivity that has been declining for years; very high regulatory barriers, where it's more difficult to get new drugs approved; and the generic patent wave--which some people call the patent cliff, which peaks in 2012 when a lot of old drugs lose their patents. All of these factors are making pharma companies figure out how they can grow. One way is to look for sustainable franchises. Pharma companies want to get off of this treadmill of having a drug on the market for 10 years, getting a lot of sales, but then seeing it go generic. There's new focus on things like vaccines, which generally persist even after patents expire; consumer products, which tend to have higher multiples because you establish a brand; and emerging markets.
So, when Pfizer buys Wyeth and Merck buys Schering-Plough, they're getting access to products that have longer lifecycles, but they're also taking out significant cost, above what we've ever seen before in the pharma industry. Pfizer and Wyeth combined had an $11 billion to $12 billion R&D budget. We expect that to come down to about $8 billion for the combined entity. Everyone's cutting back. They're not developing me-too drugs anymore. They're really pushing for more innovative therapies.
We always focus on innovative companies, companies that are addressing unmet medical needs. If you have a company that has a new therapy for cancer, a new therapy for diabetes, a new therapy for Alzheimer's-- these are unmet medical needs. Even in a tougher reimbursement environment, people are going to pay for these drugs. So, they are attractive assets, and they tend to get taken out from time to time.
Jenner: That's right. Damien, you asked, how can investors benefit? Statistically, large mergers have not created value. Pfizer, for example, bought Warner-Lambert in 2000 and then bought Pharmacia in 2004, and now they have bought Wyeth. If you go back and march through time and ask what was Pfizer's market cap, what did they pay for these companies, and what is it now, you will see a stunning example of value destruction. That is not to say that one of these can't work. I'm just saying caveat emptor, because statistically these have not been opportunities for investors.
Conover: That's a great point. I think the most dangerous words in the investing community are, "This time it's different." But is this time different? The purchase prices on some of those acquisitions were lower and the cost synergies appear to be higher.
Jenner: I'm hopeful that it can be different, but I'm skeptical. I'm hopeful that Merck and Schering-Plough will be more valuable than they were individually. But I'm not making a large bet that it will be different. What generally happens with these mergers is that both companies have substantial cost infrastructures that get reduced because they eliminate duplicative efforts, and there is some value in that, but it's a one-time thing. Then, on the back end, what happens is that you have dysfunction in the pipeline, and the core essence of these companies is to bring important new medicines to the market. Dysfunction in the pipeline, in my opinion, is why these mergers haven't added value.
Areas of Innovation
Conover: When you invest in health care, you have to be cognizant of scientific innovations. Where are you seeing true innovation, and which stocks look best positioned to capture that innovation?
Jenner: One of this country's global assets is our biomedical infrastructure. What I mean by that is our universities, our biotechnology companies, and the pharmaceutical industry-- that whole gestalt is something that is trying to take scientific innovation and discovery and turn them into medicines and devices that are both more effective and safer that what we have now. I think you'll hear from both of us an optimistic assessment, but I would caution everyone that it takes quite some time to play out because what we're talking about is the natural rhythm of scientific innovation. That process takes 10 to 15 years. I'd also caution everybody that you have to be selective. In many cases, something positive occurs at a company, but it is offset by a negative, so they counteract one another. As a result, you've got a wash in the stock. What we're looking for is a significant, innovative product that will have the most meaningful effect on the stock price.
But to your specific question, I think that the hepatitis C area is one where we're about to see some real improvement--where the cure rates for a life-threatening illness is going to go from about 50% of individuals to maybe 70% or 80%, and the duration of therapy may get cut in half. Human Genome Sciences
Acker: I agree with Kris on Human Genome Sciences and Benlysta. It's a compelling, high unmet medical need. We're seeing areas in immunology that are getting addressed with new therapies. We're starting to learn how to harness the immune system to fight cancer. At a conference about three weeks ago, we saw the first immune-based therapy for metastatic melanoma. This was the first trial to show a survival advantage. The drug is called ipilimumab from Bristol-Myers. Another company that just got a drug approved is Dendreon, which has an immunotherapy. This is where you take cells from the body, activate them against the tumor, and then re-inject them back into the body.
In the device space, one of the exciting areas is heart pumps. Heart failure affects 5 million people in the United States, and 500,000 people are in class four, the worst part of the disease. There are not enough heart transplants to go around, so hundreds of thousands of people die--with medical therapy you get a two-year survival rate in the 10% range. They started with artificial hearts, but this technology takes a long time to develop. Now, they have artificial heart pumps that they can install inside of a person's heart. This is a huge growth area. They're doing about 4,000 implants today. The pumps use a magnetic levitation system, so there's only one moving part and no friction. Technically, they can last as long as the patient does. With these devices, they're seeing two-year survival rates expanding to 60% to 70%. There are a couple of companies that dominate this space. We're invested in one called HeartWare
Potential of Emerging Markets
Conover: A lot of interest is starting to bubble up over emerging markets. Ten years ago, emerging markets didn't contribute much to the top line for a lot of health-care firms. Today, companies are saying that emerging markets are going to be a huge growth trend. Is there potential for health-care firms in these markets?
Acker: One of the most important and least-appreciated growth areas is emerging markets. We invest there directly and indirectly. Our team was down in Brazil, for example, where we met with the management of OdontoPrev, the country's leading dental insurer. Our thesis here is that there is an emerging middle class in these markets, so more money will be spent on health care. Dental insurance in the United States is about 70% penetrated, but in Brazil, it's about 15%. OdontoPrev has more than three times the market share of its next largest competitor.
We can also indirectly invest through large, multinational companies that have a strong presence in emerging markets. For example, five years ago, I don't think China was among the top 20 global pharmaceutical markets. Today, it's number five. In five years, it'll be number two. Companies such as GlaxoSmithKline
Jenner: Life expectancy in emerging markets will increase. People won't die of infectious diseases and parasitic diseases. They are going to start to die of things that have the morbidity and mortality that we have in the Western world, and they will devote more of their gross domestic product to health care.
When you're going to these emerging markets, what you're really seeing is green-field opportunities. Now, what we're talking about may look easy to do on TV, but don't try this at home, because there is substantial reward, but there is substantial risk. To put it simply, this is an away game. That means that the refereeing, the home fans, everything has the potential to be against you. That doesn't mean you can't win, but I would leave it to people who frequently get down to Brazil, get to China, and get to India. Even then, for people like Andy and myself, we're not going to get it correct all the time. But emerging markets is a very important theme.
The Case for Generics
Question from audience: I'm surprised that you haven't talked about generic drugmakers because this is an area that will introduce some savings into the system. What are your feelings about Teva
Jenner: We own Teva. You're right thematically-- generics do provide a cost benefit. The issue that you have to think about is these across-the-board price cuts. Whatever you're getting today, a single payer--i.e., the European government--just said that you're going to get 10% less tomorrow. Those types of price cuts are really hard to outrun. The other thing is that while I think Teva offers good value, remember that its market cap is $40 billion. If Teva is going to double in the next five years, it's got to add $40 billion in value for your stock, and that is a mouthful. It would be easier to find a company that's $2 billion to $3 billion in cap. If it were to double, it would have to add only $2 billion to $3 billion incrementally. Teva is a fine company. It's had a marvelous track record. At $52 or $53, the stock is a very good value, but is it going to be a company that is going to double in the next five years? If it is, we need to find a path for it to find $40 billion of incremental value, and I'm a little skeptical about that.
Acker: We also own Teva and another one that's interesting, Mylan
Jenner: To your point, Japan's generic penetration rate is 10% to 15%. The government recognizes that generics is part of the solution to the cost issue. There's no reason why Japan's generics market, 10 years down the road, can't look more like that of the United States. The two firms we're most excited about are Sawai and Towa; both are Japan-domiciled.
Damien Conover, CFA, is Morningstar's pharmaceuticals equities strategist and editor of Morningstar Healthcare Observer.