One of the largest companies in this industry is amongst our top five holdings. In this blog, I discuss several aspects I like about the industry.
When I first started working as the investment analyst on a global midcap fund in 2007, one of the first companies I researched was WellPoint. WellPoint subsequently changed its name to Anthem. It is one of the largest US health insurance companies. Such companies are sometimes referred to as managed care organizations (MCO’s) or health maintenance organizations (HMO’s).
At that point in 2007, I already had a lot of experience analyzing financial companies. I had previously covered the large Canadian banks and life insurance companies when I was an analyst for several large Canadian funds.
With the help of that experience, when I examined our holding in WellPoint in 2007, I liked what I saw. So when its share price proceeded to decline by over 50% as the financial crisis unfolded, at no point did I feel we should sell out of our position. I continued to recommend we hold on, and at times I recommended we add more shares to our portfolios. After the stock price bottomed in March 2009, we were handsomely rewarded for this conviction over the ensuing years.
I continued to follow the industry, and since 2007 I have been invested in U.S. health insurance companies, professionally and personally. Today, one of the industry’s largest companies is amongst our top five holdings.
What is it I like about these companies? What is it I like about the industry? Below I discuss six aspects I like.
I like the demographics. Like most rich developed countries, the United States is aging. As people age, they require more healthcare (more visits, more prescriptions, more tests, more operations, etc.). Therefore, the healthcare industry should continue to grow at an above average rate. Unlike Canada, almost all healthcare expenditures in the U.S. are paid for by health insurance companies. Since these companies effectively take a markup on these expenditures, their revenues and profits should grow as total healthcare expenditures expand. That is great for us as shareholders.
The U.S. has a healthcare spending problem, and the managed care companies play an essential role in fixing that problem. The U.S. already spends the most per capita on healthcare of any country. Certainly, there is some waste and duplication within total U.S. healthcare expenditures and the MCO’s are in a critical position to help reduce these. There are many ways these companies can control or lower healthcare costs. For example, they have clinical programs in place to improve adherence to prescriptions, promote preventive care (e.g., immunizations), promote mental health and worker health, treat addiction, and diagnose problems earlier (using technologies such as mammographies, colonoscopies, cervical cancer screenings, etc.). They can negotiate lower prices with providers and pharmaceutical companies. They can move patients to generic or biosimilar versions of drugs, or alternate lower-cost medicines. They can move patients out of traditional settings such as hospitals and retail pharmacies to lower cost settings such as telemedicine, homecare, clinics, and mail order pharmacies. Managed care companies have extensive data they can use to lower costs. They will be big contributors in the move to digital health records which should help improve efficiency and eliminate waste and errors. They can also incentivize the move to “value-based care” (i.e., payment for outcomes rather than each service provided). The fact that U.S. health insurance companies play such an important role in managing costs in an industry that has a cost problem gives me comfort they will be fixtures for years to come.
The business has become less cyclical. Years ago, the profits of the health insurance industry followed a cycle. Periods of high underwriting profits were followed by price competition which then led to insufficient insurance reserves, which then led to price increases, which led to improved underwriting profits, and on and on went the cycle. Over time, data improved, regulators improved, and the industry consolidated. Underpricing was identified faster, and pricing was adjusted more quickly. As a result, industry profits have become steadier and more predictable.
The businesses are quite diversified. The U.S. health insurance industry can be sliced and diced into many customer types, different products, numerous regulators, etc. Although we lump all these together and call them an industry, that industry is made up of a mind-boggling large number of small local markets. So, when a regulation changes, or when there is price competition, or some new product turns out to be unprofitable, or there is a dispute with a supplier, the problem can frequently be unnoticeable in the consolidated financial results, even though it was plastered on the front pages of the largest newspapers.
The financial model of these businesses is attractive. The profit margins vary by company due to different business mix, but all the top players have operating margins above 5%. The components of return calculations can vary considerably depending on the timing of past large acquisitions, but all the major industry players earn returns well above their cost of capital. This is partly because the businesses do not require much capital. Since much of their business is fee-based and not actually insurance, and the insurance liabilities they do incur are short-term in nature, the reserve buffers that regulators require these companies to set aside are low. Also, these companies generally do not own large physical facilities so there is no need for high capital expenditures. Investors call this being “capital-light” and it means profits can be more easily and quickly converted into cash flows. Those cash flows can then be deployed into buying back shares, paying dividends, or acquiring other companies, all of which can be rewarding for us as shareholders if done properly.
The valuation of some players’ shares is attractive in my opinion. Despite the attributes I have listed above, several trade for price to earnings multiples well below the average for the S&P 500. A cheap share price makes share buybacks more potent.
While there are similarities and overlap, each of the big U.S. health insurance companies has a different business mix and focus. Some focus more on Medicaid. Some focus more on Medicare. Some focus more on individual customers. Some focus more on serving small companies. Some focus mostly on large companies. Some have a large presence in just a handful of states, whereas others are nationwide, or multinational.
These differences in business focus can contribute to differences in stock valuations.
At times, some investors prefer certain business lines. Investors might worry about regulation in a particular state. Investors might see a certain product as having a particularly promising growth profile. At times they may feel more comfortable with the diversity of the largest player, while at other times they might prefer a smaller, more nimble niche player with exposure to a high growth area. These emotional and psychological reactions by investors can lead to overvaluation of some companies’ shares and undervaluation of others. In my opinion, this creates opportunity for long term, value-oriented investors like us.
Of course, investments in these companies are not risk-free. One need only look at their share prices over twenty years. They can be volatile. Alternatively, just open one of their annual reports. Inside, many risks are listed including politics, regulations, investment risks, balance sheet risk, product risks, etc. I do not want to pretend shares in these companies, or any equity investments, are sure things. However, in my opinion this industry contains several growing, well-managed companies, with good market positions and attractive economics. We feel this is a good example of an area where we can invest to grow your wealth (and ours) over time. Which companies are my favourite? Maybe I will save that for future blogs.
Please contact us if you would like to learn more about our investments in the U.S. health insurance industry. We would be happy to discuss with you how we decide which companies make it into our portfolios. We are always eager to discuss our investment philosophy and how we feel it can help build wealth over time.
Until next time!
This material is for general information, illustration, and discussion purposes only. It is provided “as is” to give the reader something to think about and to illustrate our firm’s investment process and strategies. This material is not intended to convey specific investment, legal, tax, or individually tailored financial advice and it should not be relied on as such. The contents of this material should not be relied upon in substitution of the exercise of independent judgment. This material should not be considered a solicitation to buy or an offer to sell a security. Any such offer or solicitation will be made only by means of delivery of an investment management agreement, and only to suitable investors in those jurisdictions where permitted by law. This material does not consider any investor’s particular investment objectives, strategies, tax status, or investment horizon. Past performance is not indicative of future results. The comments herein are not predictive of any future investment performance. The performance of a specific managed account may vary based on the account’s specific holdings and restrictions. Details on the compilation of performance figures are available upon request. This material is based upon sources of information believed to be reliable but no warranty or representation, expressed or implied, is given as to its accuracy or completeness. All beliefs, assumptions, opinions, and estimates contained in this material constitute the judgment of the author as of the date of this publication. All opinions, estimates, information, data, and facts presented in this material are furnished as of the date shown and are subject to change and to updating without notice. They are provided in good faith however we disclaim legal liability for any errors or omissions. No representation is made with respect to their accuracy, adequacy, timeliness, or completeness, and they may not be relied upon for the purposes of entering any transaction. Certain information has been obtained from third party sources and, although believed to be reliable, the information has not been independently verified and its accuracy or completeness cannot be guaranteed. This material contains forward-looking statements, which are subject to important risks and uncertainties that could cause actual results to differ materially from current expectations. No use of the Greenfield Investment Management name or any information contained in this report may be copied or redistributed without prior written approval. Greenfield Investment Management Limited is registered with the Ontario Securities Commission as a portfolio manager. Any investment is subject to risks that include, among others, the risk of adverse or unanticipated market developments, issuer default, risk of illiquidity, and loss of capital. Our firm, directors, officers, and employees may, from time to time, hold the securities mentioned herein. Please see the Legal link in the footer of our website for more detail concerning the disclaimers listed above. We ask clients to please notify us of any changes to your contact information and to your financial situation or your investment objectives which may have an impact on the management of your assets by Greenfield Investment Management Limited.