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How Investors Should Approach Health-Care Stocks After ACA

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How should investors think about investing in health care against the backdrop of the rollout of the Affordable Care Act? I'm here today with Matt Coffina. He's editor of Morningstar StockInvestor to take a look at this question.

Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start with a big-picture look at what the Affordable Care Act is trying to accomplish and how it's been going so far. What were some of the big goals of this law?

Coffina: The two big goals, I think, are slowing the growth in health-care spending and increasing the number of people with health insurance. Currently, the U.S. has about 15% of the population that's uninsured, and health-care spending growth has exceeded nominal gross domestic product growth by about 270 basis points a year for the last 50 years with few exceptions.

In terms of how well the law is going to do in actually solving these problems, I think the law tends to do much more to increase the number of people with insurance than it does to slow the growth in health-care spending. The way it accomplishes that first goal is through expansions of the Medicaid program. This is the program that historically has been only for low-income families, and now they are expanding coverage to all low-income people. Of course, some states are participating or not participating--it's a joint federal-state program. In the states that are participating, the CBO, Congressional Budget Office, expects about 12 million people to gain health insurance coverage by 2016.

Then the other major way that insurance coverage is being increased is through these insurance exchanges, both state and federal insurance exchanges, and the CBO estimates that about 22 million people gain insurance through that source by 2016. Of course that's assuming that the current implementation issues get sorted out. Then all of that is going to be offset by about 10 million people expected to lose coverage from existing employer-sponsored individual policies. It translates into about 9% net increase in the insured population, again in 2016.

Glaser: How about on the health-care spending side, how does the law expect to slow spending there?

Coffina: That's a good question. There are explicit cuts to Medicare spending as part of the funding of the law, and then there's also direct fees and taxes on health companies, the insurance sector, the device manufacturers, and pharmaceutical companies are all contributing directly to the cost through increased taxes and fees. Other than that the law includes a lot of demonstration programs and pilots and things like that. Probably the most prominent would be accountable care organizations, the idea being to incentivize health-care providers to slow the growth in health-care spending by providing them a share of the savings.

Another way that the law attempts to slow health-care spending growth would be by taxing very high-benefit plans, so-called Cadillac plans, the idea being to encourage employers from not offering such generous coverage to begin with. And then one more way would be by pressuring premium rates at insurers.

The federal government has higher oversight over premium increases, which is making it harder for the insurance sector to raise their prices over time, which in turn is causing them to push back more on price increases at the provider level. So, we are seeing more heated negotiations between health-care providers like pharmaceutical firms and hospitals and insurance companies or pharmacy benefit managers on the payor side.

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Glaser: Let's take a closer look at those exchanges. I think it would be charitable to say that it's been a rough start so far. Do you expect that the exchanges will get up and running successfully, and do you think that it will displace employer-based health care over time?

Coffina: That's a very good question, and it's really anybody's guess at this point. I'd say it's already too late to say that the exchanges are up and running on time as intended. The challenge with this law, I think, is that there are a lot of moving pieces and a lot of things that need to work well together for the law to really be effective.

As you said, it'd be an understatement to say that the rollout has not gone well. I think this does have implications for the employer-sponsored market over the long run. A lot of people had been worried or interested in whether these exchanges could displace traditional employer-sponsored plans, which currently provide coverage to about 55% of the population. And I think the challenges with the rollout really point to the difficulty of making such drastic changes to a sector that accounts for 18% of our economy overnight.

I think it's always been our position that employers are going to take a wait-and-see approach and they are going to want to make sure that these exchanges actually work before considering dumping their existing employer-sponsored plans, and I think it will take several years yet before we see any kind of a significant shift in that direction.

That said, I think employers are very interested in ways to control health-care spending growth over the long run. This has been one of their fastest-growing costs over time. In general, health-care spending growth outpaces wage growth even. I would say it's very much analogous to the shift in retirement benefits from defined-benefit plans to defined-contribution plans. Employers are open to the possibility of plans that allow them to tap their exposure to overall health-care spending growth over time.

And that could take the form of the public exchanges, where there are subsidies available from the federal government. That would probably be more in the low-end kind of employers, employers with a lot of relatively low-wage employees. But we're also seeing increasing popularity of private exchange alternatives. That'll be a key area to watch going forward.

Glaser: Sounds like there's still a lot of uncertainty here, though. We don't know when the exchanges are going to be working. It seems the rules are changing. What kind of risk pools are going to be in those exchanges, these pilots to lower costs, if that's going to hit earnings?

With all of this going on, does it make sense to still be looking at the health-care sector from an investing standpoint? Or should you go someplace where maybe there aren't these policy uncertainties?

Coffina: I think the key takeaway for health-care companies is that we don't think most of them were affected all that much by the law to begin with. So I don't see it as a major driver of our fair value estimates. Really, there's two key things to watch is the benefit of volume growth for a health-care company, so more people gaining insurance coverage, people having more generous policies over time. That's been the latest controversy, people having their policies canceled. That pretty much results from having policies that were less generous than the health-care law requires.

In general, I would expect most, or the average health-insurance plan, to become more generous as a result of the law because of a variety of minimum-benefit mandates and other provisions. So, all told, there is going to be more people with more-generous health-insurance coverage, and I think it's reasonable to expect that they're going to increase their consumption of health care over time. 

That volume benefit is offset by reimbursement pressure, which takes a variety of forms, both explicit cuts in Medicare spending, the industry taxes, and fees. But also a shift in the population toward more people on Medicaid, which tends to reimburse at lower levels than commercial plans or Medicare, and the variety of other factors, for example, the kind of care organizations, which are encouraged to lower health-care spending growth and increase bargaining power of payors, all of which could weigh on reimbursements for health-care companies.

The net effect of these two things, I think, is that for most companies they offset each other. That said, companies that are more exposed to the volume side of the story, where I would include pharmacy benefit managers, distributors, generic drug makers, they could come out somewhat ahead, facing relatively little reimbursement pressure, but seeing the volume boost.

On the other hand, device companies won't see much of a volume boost, since most of their patients are over age 65 and already covered by Medicare, but they will see a meaningful reimbursement pressure. So, devices come out somewhat behind as a result of the law.

When it comes to other sectors, I think pharmaceuticals and biotech are a net neutral. Although, I would mention that a lot of the negatives of the law are already baked into run-rate earnings at this point, whereas the volume boost remains in the future. So, on a forward-looking basis, pharmaceuticals and biotech could come out somewhat ahead.

Insurers and hospitals: The outlook for those industries is much more uncertain. We think that the positives offset the negatives, but there is a much greater uncertainty surrounding that outlook, and we don't know exactly how this is going to play out. For example, if hospital systems are going to consolidate and a small number of hospital systems are going to end up with a lot of bargaining power, possibly at the expense of smaller systems. Similarly, on the insurance side, we could see market share consolidating with the biggest companies, which would be bad for pretty much all other health-care companies. But we can also see barriers to entry fall in insurance and in a more fragmented insurance space, which would be bad for the incumbent insurance companies.

Glaser: Are you finding any bargains in health care right now?

Coffina: What I look for in health-care companies is really innovation and especially, a cost-effective innovation, as well as companies that can control health-care spending growth without compromising quality. Two companies that come to mind that we own in StockInvestor's Hare portfolio would be Novo Nordisk. We think this is a relatively innovative company with a strong pipeline in diabetes care, and diabetes is an area where drug treatment is really the most cost-effective option. If diabetes goes unmanaged it will result in much higher costs down the road as you have complications like heart disease, kidney disease, and so on.

Another company would be Express Scripts, the leading pharmacy benefit manager. This is one of the few companies that benefits from actually controlling, rather than encouraging health-care spending growth. The stock price is relatively depressed as investors are concerned about what the exchanges in the Affordable Care Act will mean for their employer customers. But we think that there is a need for effective pharmacy benefit management regardless of where people are getting their insurance. This is an area where there is significant savings to be had and a company like Express Scripts brings unique scale and capabilities that are always going to be in demand.

Glaser: Matt, thanks for your thoughts today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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