The Health Care Sector Affects All of Us and Presents Exciting Investment Opportunities
It could be argued that no economic sector affects us more than health care. Each of us spent our first night or two in this world as "guests" at the local hospital. We have prescriptions filled, glasses fitted, appointments with doctors, surgeries performed, and insurance claims paid. We come into contact with some part of the health care sector nearly every day.
"Investing in health care means learning about some of the most exciting businesses in the world. It involves a combination of macroeconomic theories, demographics and good old fashion company analysis."
The health care sector is equally important from an economic standpoint. Over $2 trillion was spent on health care in the United States last year and, at 16% of gross domestic product, it represents the third largest component of our economy (behind only government spending and real estate) and is equal to approximately $6,700 per American. By 2015, health care spending is expected to rise to $4 trillion per year. The anticipated annual growth rate of over 7% is more than twice the current rate of inflation and should easily surpass the growth of the overall economy. Demographic trends will make health care even more important as our population ages, putting stress on Social Security and retirement savings. The first wave of baby boomers will turn 65 in 2011 and qualify for Medicare, leading to an acceleration in enrollees and nearly doubling the number of beneficiaries.
| Medicare Enrollment (in thousands) |
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| Health Care Industry Performance (1-Year Total Return as of 10/4/07) |
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The challenge of covering these Medicare recipients is exacerbated by the expected decline in the number of workers per beneficiary. Those in the work force essentially support Medicare through their payroll taxes similar to the way Social Security is financed. The current ratio of four workers per Medicare beneficiary is expected to drop to a ratio of 2.5:1 within the next 25 years.
"Demographic trends will make health care even more important as our population ages."
It will be years before we reach agreement on how the government, the private sector and individual taxpayers will pay for the increased cost of these demographic shifts, but there is no doubt that it will be one of the driving forces of performance for health care stocks going forward. At Calamos, our job is to differentiate the winners from the losers.
Not all health care stocks are the same
Not all health care stocks necessarily perform the same. The government may lump all health care spending together, but health care is actually an economic sector comprising of several industries that perform differently.
The sector could almost be considered a mini stock market of its own. While the underlying industries share some similarities, they respond to market forces differently. More importantly, the performance of the different industries within the health care sector can deviate to a signifi cant degree. It is imperative for us to properly gauge the unique opportunities and challenges facing each industry in picking the right stocks.
How do we invest in health care?
Calamos relies on several principles within our one-team, one-process approach that help us find the best health care opportunities:
- The importance of R&D
Longtime Calamos clients are aware that we focus on economic earnings and not accounting earnings as defined by GAAP. One example of the difference between the two is how research and development expenses are treated. Under GAAP, research and development costs are treated as an expense and have the direct effect of reducing profitability. But we believe R&D to be an investment that will generate future returns and are not just a cost of doing business. Thus, we capitalize the money spent on R&D over a specific time horizon and then gauge management's ability to create shareholder value with these expenditures.
This helps us to assess the quality of a company's cash flows as well as the quantity. Put another way, in looking at two similar businesses with identical sales and operating costs we choose the firm invested more heavily in R&D.
While this adjustment for R&D is made for every company that we research, it is extremely important for certain health care companies given the dollar amounts involved. For example, the average pharmaceutical firm spends 14-18% of its revenue on R&D. This is significantly higher than the average U.S. manufacturer, which spends only 3-4%.
- Prudent corporate financing
Similar to the way we analyze a company's cash flows, we also look at the structure of the company's balance sheet. This is of paramount importance as it will help determine the sustainability of the company's growth prospects. A business overly dependent upon debt financing may find itself at risk of needing to access the capital markets during a period of weakness.
Although the cause of this weakness (a change in Washington politics, the expiration of a key patent, an adjustment in reimbursement rates) may result in a vulnerability that is only temporary, attempting to refinance during that time will be expensive, cause a reduction in returns, and hinder the company's growth prospects.
- Diversified product line
Like in any other sector, there is always the risk of bad news coming from an individual company. But this risk is amplified when the company's prospects are tied to a single product. Such is the case with numerous biotechnology firms. Many of these companies have spent considerable sums of shareholder money trying to discover new compounds that can be developed into ground-breaking new drugs. These efforts are typically well intended and, if successful, can result in hugely profitable franchises.
But this "bet the ranch" model leaves the companies and their shareholders exposed to the risk of significant or even total loss of capital in the event of a poor clinical trial or an adverse FDA ruling. This type of investing should actually be considered speculation and it is not representative of what we do at Calamos. For example, when looking for opportunities in the biotech space, we typically focus on companies that have products already on the market and the type of balance sheet structure mentioned above that will allow the company to finance the creation of new drugs.
- Complexity
We are not biochemists and do not attempt to analyze the drug components.
At Calamos, we spend time analyzing "big picture" items such as secular themes, returns on capital, quality of management and valuation metrics that will drive long-term performance. At the same time, all this is done with an eye on preserving capital.
- Washington Impact
Conducting rigorous fundamental research is a critical step of the Calamos investment process no matter the company, sector or asset class. But perhaps more so than with any other sector, we look for opportunities within the health care sector that require us to monitor the political environment as well. Washington is always something of a "wild card" for the sector and, with a presidential election on the horizon in 2008, investors can be sure that the heath care rhetoric will only heat up.
Our job as analysts is not to predict who will become President in 2008. Rather, we need to be able to look at the vision spelled out by the candidates and gauge the ramifications of their policies in the event they are elected. The reason for this is that history has provided numerous examples of how new legislation (whether it is actually enacted or simply proposed) may impact the markets.
- 1992-1993 - Fears over "Hillary-Care" and price controls lead to a 40% decline in pharmaceutical stocks. However, Congress eventually defeats the proposed changes and the drug stocks go on to be one of the best performing groups over the next five years.
- 1997 - Congress passes the Balanced Budget Act of 1997, which mandates deep cuts in Medicare spending. Hospitals and home health agencies are particularly impacted as the reduction in reimbursements eventually is double what the government originally estimated. Though most of these cuts were reversed in later years, it was too late for a number of firms that were forced to file bankruptcy and investors in these companies suffered significant losses.
- 2003 - The Medicare Modernization Act provides the opportunity for managed care organizations to greatly expand their share of the Medicare market. The HMO index subsequently triples over the next three years.
- 2006 - The addition of a prescription drug benefit (Part D) arguably represents the most significant change in the 40-year history of Medicare. Winners initially include drug stocks, pharmacy benefit managers (PBMs) and managed care. Recently however, investors have been concerned about possible rate cuts within the program.
Why do we invest in health care?
With all the risks and turbulence, why do we see opportunity in the health care sector? The first reason is the attractive demographic trends.
A second and more exciting reason we invest in the sector is that it contains some of the most innovative companies that are creating new technologies and making ground-breaking discoveries:
- Biotechnology companies that have changed the way new drugs are discovered
- Life science firms, which are utilizing new fields such as nanotechnology to conduct work at the molecular level
- Breakthroughs in orthopedics that allow people to live fuller and more active lives
When we talk about innovation, we also look for "low-tech" enterprises that can adapt their business models to the dynamic changes that are constantly occurring. Examples include:
- Assisted living companies, which provide an alternative to traditional long-term care that did not even exist 20 years ago.
- Managed care firms that will capitalize on the trend towards consumer directed health care plans (CDHP). Though still in its infancy, this type of health insurance may be commonplace within the next 5-10 years.
Investing in health care means learning about some of the most exciting businesses in the world. It involves a combination of macroeconomic theories, demographics and good old-fashioned company analysis. Long-standing clients of Calamos Investments have prospered as the sector has provided some of our biggest winners over the years. We will continue to utilize our talent and experience to try to discover more of these great opportunities in the future.
Biography
Steve Klouda, CFA, has been a member of the Research Department and Investment Team at Calamos since 1995, responsible for researching companies in the health care and consumer staples sectors and evaluating investment opportunities and portfolio strategies. A graduate of North Central College, he earned his MBA with a concentration in Finance from the Keller Graduate School of Management.