Sector Analysis: Healthcare

Why is it important to look at equities from a sector perspective?

• Each sector is different and has different characteristics. Every sector has different capital needs, and the biggest question becomes, “how does the business actually run from a sector basis?” For example, utilities tend to operate with higher debt levels because there is less volatility in the cash flows. It all comes down to how volatile the cash flows are, how much you can leverage that, and how much you have to invest in the business. And that tends to differ from sector to sector. The different cash flow dynamics are why it’s helpful to look at stocks from a sector basis. Or at least an acknowledgment of what sector a company is in and an appreciation for the risks involved.

Focusing on the healthcare sector in particular, what are some general characteristics you would use to explain healthcare?

• Healthcare has multiple facets within it. It has hospitals, some of which are traded, some of which are for-profit, and some of which are non-profit. You have the managed care companies which used to be called the insurance companies, but now they call them managed care companies like United Healthcare, CVS/Aetna, Cigna, and Express Scripts. These are companies where you pay into the system, and they allocate that money, whether for your own care or to subsidize care for others. So that’s the second bucket. The third bucket would be pharmaceuticals. You’ve got biotechs, generics, and big blockbuster pharma companies with cancer drugs that make three billion dollars a year. So, there are subsectors within that segment of the market as well. In addition to these three major buckets, there are more ancillary segments like telemedicine services, senior living centers, and outpatient surgery centers.

For investors, is there a particular subsector that is more robust within healthcare?

• I think the one that is most attractive to investors tends to be the pharmaceutical business. And especially with biotech, because that is where you can make a ton of money if you hit it right. It’s also where you can lose everything. Not to say you can’t lose everything in other sectors, but it happens more frequently when a company only has one speculative drug in the portfolio, and if it works, great, if it doesn’t, they go bankrupt. Some people like to use healthcare as a ballast for a portfolio, as a sector that is a little bit stickier, safer, and more like a consumer staple. For a lot of those investors, some of the bigger pharmaceutical companies like Johnson & Johnson and Novartis are ones that people like to have in their portfolios. Some gravitate toward hospitals, but a lot of time, hospitals are levered, and they are competing with non-profit, so it’s pretty hard to compete with non-profit and still make a profit. Generally, their strategy has been to grow through acquisition. Hospitals get distressed because they’re mismanaged, and these large for-profit hospital chains come in to purchase and run them better with lower debt loads.

From the Narwhal world of investing choices, who are some class clowns and class favorites within the healthcare sector?

• We’ve had some successes, and we’ve had some failures in healthcare. At Narwhal, we look at healthcare more as a ballast. We’re not trying to pick the right horse, because, at the end of the day, you can tell a false story by fudging the numbers on the data and on the promise of these new life-saving drugs. We tend to stay away from biotech, and instead, we focus on some of the larger, more stable companies. We try to prioritize lower debt. Some of the companies we like are Novartis, United Health, and Johnson & Johnson. And we like Abbot. Abbott has a very interesting business. They are probably one of the more innovative mega-cap healthcare companies, just from how they run their business and from the divisions from which they play. They are constantly looking for that blue ocean, where there aren’t a ton of piranhas yet. They are trying to find new ways to solve customer needs that no one is thinking about. A great example of that is the FreeStyle Libre glucose monitoring system they have. So, we really like Abbott. As for the class clowns – thankfully, we own fewer of them now. You could argue Pfizer is doing too much on the M&A side. I think what they are doing will work, but for now, they could arguably be a class clown. But there are two of them that take the cake. The first one is Gilead. And that’s where the stock went from $120 to $110, $100 to $90 and the whole time everyone was asking if they can bring in revenue growth. Gilead had these massive blockbuster vaccines that performed pretty well, but also cost a fortune. So, they were in the spotlight from a pricing perspective, and they were also in the spotlight from a decline perspective because they couldn’t innovate. It’s tough to make a 5-billion-dollar business. I don’t care if you’re a pharma company, it’s tough to generate a 5-billion-dollar business in order to replace a business line that is going down. If it was easy, everyone would be doing it. You end up having to buy that. That’s what Gilead ended up having to do, and the jury is still out on whether or not they made the right acquisition with Kite Pharmaceuticals. The other class clown that we don’t own anymore was Teva Pharmaceuticals. The whole generic drug industry was built on this idea that “we’ve just got to get bigger and increase the pricing on generic drugs,” which was a fallacy. You can increase the pricing on generic drugs, but you must assume a ton of debt in order to do that. You’re going to be in for a shock, because that debt isn’t going away, and some of that pricing power is going to get eroded. That’s what happened with TEVA, and they ended up getting crushed under a mountain of debt.

Looking at the next decade, what are some challenges/events/things that come to mind to look out for?

• The base case is that the market continues to look the way it does. You’re going to have to see something change in terms of the hospital and healthcare delivery mechanism. I think you’re going to see more outpatient care, more of the CVS centers, and more of the telemedicine come into effect. Telemedicine might simply involve texting my doctor with my symptoms and asking to hop on the phone for five minutes to see if I need to come in. I think that you’re going to see a lot less of actually going into the hospitals or ER because it’s going to be cost prohibitive. And healthcare companies are going to increasingly advocate against it. That’s why United Healthcare and CVS/Aetna are building out their own internal networks because they want to reduce the cost of peoples’ visits to the ER. I think what you’re probably going to see is a little more consumer-facing involvement from these big insurance companies as they broaden out and become more of a healthcare provider organization than just a health insurance company. And then there are a few areas where things could change dramatically. I don’t think this push toward universal healthcare is going away. Companies like United Health, CVS, and Anthem have to put forth a better product that is convenient and aware of the price. But definitely a priority on convenience. If they do that, consumers might not push so much, and politicians might not push so much for universal healthcare.

Narwhal owns the following symbols for clients and personal accounts: UNH, CVS, CI, JNJ, NVS, ABT, GILD.