The extremely complex and polarizing subject of healthcare reform is dominating the airwaves. First off, let me say that we don’t even pretend to have all the answers to this very difficult subject. However, the resolution to this debate has the potential to have profound implications for our client portfolios as well as the investment landscape at large. Therefore, we feel obliged to provide our “quick and dirty” thoughts as this debate continues to unfold.
Today, healthcare spending equals roughly 16% of U.S. GDP, a percentage far higher than in other developed economies. Despite this huge amount of spending, a large chunk of the population remains uninsured, and medical outcomes in the US fare no better than those experienced in other developed countries. This situation causes most to agree that SOMETHING needs to be done to improve our system.
We believe that some form of legislation will be passed this year, but the details of the final plan are still very uncertain. In the interest of getting a bill through Congress, it now appears Democrats may back away from their earlier requirement of some form of pure public insurance. However, it also seems likely that coverage will be extended to most of the country in some form or fashion. Concerns about the large expected cost of the various proposals are likely to shape the debate into the final stretch.
Healthcare companies in the US have long enjoyed above average growth as spending on healthcare has grown significantly faster than overall GDP. The majority of the increased spending is due to the fact that healthcare costs have risen much faster than overall inflation. Going forward, we think that it is prudent to assume that, one way or another, limitations are imposed on healthcare cost increases relative to those historical growth rates. This means that it is prudent to assume that future growth rates for many of our healthcare companies will likely be slower than those enjoyed in the past.
So what does any of this mean for our client portfolios? As I write, healthcare stocks comprise roughly 19% of Farr, Miller & Washington’s fully-discretionary equity composite. This sector has generally played a prominent role in our client portfolios due to the fact that our conservative growth philosophy favors companies with long, stable track records, above-average earnings growth, strong balance sheets, high returns on capital, and solid free cash flow generation. Our requirement for above-average earnings growth means that we won’t own a stock if we don’t believe that its growth rate has a high probability of exceeding the growth rate of the S&P500 over the next 5 years. In order to estimate any company’s future growth rate, Farr Miller’s research team develops a 5-year growth algorithm for each company. This estimated growth algorithm is based on assumptions about 1) the growth rate of the particular industry sub-sector (e.g. drug-coated stents), 2) the firm’s competitive position within the industry (e.g. share gainer or share loser), and 3) operating margin expectations (e.g. if margins are depressed, it could be presumed that margins will expand over the next 5 years).
The assumption that some sort of healthcare legislation will be passed and that healthcare prices will ultimately be pressured is likely to lead to a downward bias to each company’s expected revenue growth. However, this does not mean that many healthcare companies are not good investments at current trading levels. Rather, we continue to believe that many healthcare stocks are attractive for long-term investors. This is because the current valuation differential between our healthcare stocks and the S&P500 more than reflects the assumption of lower growth already. Specifically, the healthcare stocks in our fully-discretionary portfolios currently trade at a 10% discount to the overall market on 2010E EPS. It is important to note that this 10% discount rises significantly if the huge expected earnings growth for the S&P500 next year (+26% vs. 2009E EPS) is not realized. Therefore, our general conclusion is that after a 50%+ run-up in the overall market (led primarily by cyclical stocks), many healthcare stocks remain attractive for long-term investors.