U.S. Healthcare System: Evolution Towards a Better Outcome

By Igor Golalic, CFA
June 2013
“Investors have recognized that the new paradigm should be positive for the sector long-term.”

The U.S. Healthcare system is unlike any other in the world. It is driven simultaneously by benevolence and greed, tilting to one side or the other depending on the circumstances and the type of criticism that it faces. It is the largest healthcare system in the world, and it has the most resources at its disposal, including the best-trained physicians, innovative medical devices, and cutting-edge pharmaceuticals. Many patients from around the world come to the U.S. for help not available at home. The country where I was born, Serbia, recently sent an eight year-old girl suffering from restrictive cardiomyopathy to Texas Children’s Hospital in Houston for a heart-replacement surgery. That is how special and advanced healthcare is in this country – it gives meaning to the term “hope”.

However, there are aspects of the system that are dumbfounding, troubling, and unsustainable. In the dumbfounding category is the fact that while the best care in the world exists here, it is also inaccessible to millions. The system discriminates on the basis of the ability to pay or the ability to keep a job with employer-provided medical insurance. The troubling part is the lack of pricing transparency. Chances are we, as patients, have no idea how much we are paying for a procedure or a service until after the fact. In essence, we are really not the consumers – our doctors are. The unsustainable part of the system is the steep annual growth rate of healthcare premiums over the last three decades. When coupled with a shift in the burden of expenses toward the individuals via higher deductibles and copays, the growth in healthcare premiums has created a feeling of healthcare crisis. Adding fuel to that fi re is the increasing share of our economy’s productive capacity that has gone to healthcare. The U.S. spends per capita on healthcare more than twice the Organization for Economic Cooperation and Development (OECD) average1. The U.S. healthcare system, however, ranks poorly relative to its OECD peers in some basic measures like quality, access, efficiency, equity, and life expectancy2. Given that, the question is how to adjust the system in such a way that its output becomes more reflective of the quality of its inputs. President Obama’s healthcare reform law, the Patient Protection and Affordable Care Act (PPACA), also known as Obama’s care, is an attempt to nudge the system in that direction.

The Impact of “Obamacare”

The Act was signed into law in March 2010. It promises to expand healthcare coverage to those who currently do not have it while keeping costs in check at the same time. It does this by requiring that everyone carry health insurance or face a penalty, or a “tax”. Under the law, Managed care companies can no longer use “pre-existing conditions” as reasons for rejecting coverage to individuals. They can also no longer place dollar limits on coverage. The law offers individual states additional resources to expand Medicaid coverage by widening the qualification criteria. States can choose whether to participate or not, but terms are such that they are being irrational if they do not. Next year we expect to see the emergence of Health Insurance exchanges, where individuals and small businesses will be able to shop for standardized healthcare policies. The law also allows for a change in the payment mechanism by the system’s largest payer, Medicare, from “fee-for-service” to “bundled payment”.

It is this last aspect of the law, the shift toward bundled payments, which is of greatest interest to us as investors. The current system rewards those who produce volumes largely independent of the quality of care they provide. The critical link between pay and performance is weak, at least from the patient outcomes standpoint. The Centers for Medicare and Medicaid (CMS) reported in a recent study that within the group of 3,300 hospitals that service the system, pricing differences for the same routine procedure can be 5-6x with no evidence of any differences in outcomes3. In general, the more admissions the hospital gets and the higher its prices, the better off it probably will be. In that kind of a system, healthcare dollars are spent on establishing commercial networks capable of reaching important volume centers and Key Opinion Leaders (KOLs), who can further influence decision makers to favor a particular product or service. The manufacturer’s voice is heard via the size of its SG&A spending, the provider’s voice goes to support what they buy from the manufacturers, and Managed care companies are happy to see the pie grow as long as they can protect their margins and re-price risk quickly. The innocent bystander, the patient and the taxpayer, is caught in the middle and pays the price over time.

Why Do Bundled Payments Matter?

Payment bundling means that healthcare providers will be given one payment by Medicare per patient based on his or her condition. The healthcare provider will then have to make the best use of this payment to provide quality care with an eye toward improving outcomes. Re-admissions of that same patient, which once were an additional revenue stream for the provider, are now potentially a cost and a risk. The repercussions of such a shift are tectonic in nature – they move slowly but are irreversible. The emergence of Accountable Care Organizations (ACOs) is a testament to that. The ACOs involve more partnerships between hospitals and Managed care and the formation of risk-sharing platforms and systems to facilitate information sharing and ultimately profit and risk sharing. We would expect similar HMO-type products with narrower network designs to re-emerge, offering employers savings and control over premium growth. Managed care companies are becoming more interested in managing the healthcare risk of their coverage pool in order to prevent future volumes. That means more focus on wellness and prevention. Similarly, we would expect Managed care companies to help the hospitals improve the way they practice care by sharing information on best therapeutic care-paths in return for lower pricing or a piece of that bundled payment. The hospitals should be happy to oblige if they can offload some of that risk of re-admission to Managed care. Medicare will also look to reward those systems that deliver best care by increasing their payments in the future. As patient knowledge increases about provider tiers, quality metrics should ultimately allow for some pricing power, and we would expect better outcomes to be rewarded in the marketplace. Lower growth of premiums and better outcomes will follow over time.

Who Will Thrive under the New Healthcare System?

From an investor standpoint, the focus should be shifting to recognizing those attributes that will allow companies to thrive in the new system. Durable competitive advantage no longer means simply having large R&D organizations and expansive commercial networks that are hard to replicate. It does not mean having a budget large enough to support a KOL network around the world. Gone are the days of making a new drug or a medical device and charging a premium just for a few bells and whistles on it without much evidence of improved efficacy. What lies ahead involves knocking on new doors and breaking the stereotypes. Competitive partnerships will be required in Big-pharma to find drugs for medical conditions that are not treatable today. We are already seeing that in Hepatitis C and melanoma. Those companies that are aligned with the customer’s focus on optimizing care within limited budgets will do well, whether that means reducing hospital acquired infection rates, or improving the efficiency of provider’s staff, or generating savings through better drug-formulary management or biosimilar innovation. Information sharing and Electronic Medical Records (EMRs) are coming at the right time and will improve transparency in deliverability of care. They will be crucial in fostering the formation of the ACOs, allowing them to focus on prevention, primary care, and chronic disease management, the latter arguably the biggest source of system savings over time.

Investors have recognized that the new paradigm should be positive for the sector long-term. The healthcare sector has been the second-best performer year-to-date and over the last five years as of May 31, 20134. In choosing stocks for our strategies, we have identified those companies that we believe have recognized the paradigm shift (e.g. Abbott Laboratories (ABT), Greatbatch, Inc. (GB), Pfizer, Inc. (PFE), Teva Pharmaceutical (TEVA), UnitedHealth Group, Inc. (UNH), and Universal American Corp. (UAM)), have assets that should be valuable under PPACA (e.g. Alere, Inc. (ALR), Natus Medical Incorporated (BABY), Baxter International, Inc. (BAX), CareFusion Corp. (CFN), Quest Diagnostics, Inc. (DGX), and Express Scripts Holding Co. (ESRX)), or have embraced the concept of “value” and are willing to disrupt the current marketplace with innovation (e.g. Boston Scientific Corp. (BSX), Forest Laboratories (FRX), and Medtronic, Inc. (MDT)). We see disconnects between current expectations and long-term prospects for these companies, which is reflected in market prices below intrinsic values. They are either not being rewarded for the investments that they are making today to compete more successfully in the future or their innovative ways are being overshadowed by shorter-term dynamics. While valuations in the sector are not as attractive as they were at the time the healthcare law was adopted, we see opportunities for the companies that we own to grow their intrinsic value within the new framework being introduced by healthcare reform.

Originally published June 20, 2013

1 Source: OECD Data 2012
2 Source: The Commonwealth Fund
3 http://www.nytimes.com/2013/05/08/business/hospital-billing-varies-wildly-us-data-shows.html
4 Source: Morningstar

The views expressed are those of the portfolio manager as of June 2013, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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