Consolidation, the implementation of the Patient Protection and Affordable Care Act (PPACA), and efforts to use capitation for Medicare patients will all have an impact on health-related stocks, over then next few years. So says Gary Taylor, senior equity research analyst at Citigroup. He presented “Wall Street Perspectives on Trends Shaping the Health Care Industry” on November 13, 2012, at the Ninth Annual American Health Care Congress, held in Anaheim, California. Taylor’s clients are mainly institutional investors, mutual funds, and hedge funds. Taylor specializes in publicly traded health-care providers; his clients look to him for advice on whether to invest in those stocks. “The sectors I cover,” he explains, “are all directly reimbursed, and they’re extraordinarily fragmented. There are between 35 and 40 publicly traded health-care–provider stocks, and the total capitalization is $110 billion. Compare that with the capitalization rates of the two largest pharmaceutical companies: Johnson & Johnson, at $193 billion, and Pfizer, at $173 billion. The largest payor, UnitedHealthcare®, is capitalized at $54 billion.” He continues, “The questions my clients want answered are these: How should they approach the uncertainty of health-care reform? How will Obamacare affect it? What other changes may happen, independent of Obamacare? What is the outlook for the payor–provider balance of power?” Investor uncertainty in the health-care sector is nothing new, Taylor says. In the 1960s, entitlement programs such as Medicare were game changers; the inflation of the 1970s led to consolidation; and a series of incidents (culminating in the Balanced Budget Act of 1997) proved detrimental to reimbursements. These various events, and this ongoing uncertainty, have caused a decline in the aggregate value of the hospital sector. Hospital stocks have lost 25% of their value in the past decade. In contrast, publicly traded providers of medical devices have gained 300% over the same period. During the past five years, health-care stocks have dropped 15%, compared with 13% for the market overall. The Government Effect What seems to affect these stocks, in particular, is their degree of dependence on government reimbursement. Thus, a nursing-home stock might perform at a rate of six times earnings, while a laboratory-company stock, with less government exposure, might perform at 13 times earnings. “Government involvement is not the only factor, but it’s a big one,” Taylor says. “The sectors most exposed to Obamacare underperform the market. Providers of pharmaceuticals and other products actually outperform the market. As we speak, hospital stocks are performing at 9.4 times next year’s forecast earnings. They’re trading at a 28% discount to the market today, compared with an average of 7% underperformance in the past decade—obviously because there’s uncertainty about future reimbursement. Every major sector of health care is trading at a smaller premium, or larger discount, compared with the last decade, due to investor confusion and concern about the effects and implementation of Obamacare.” Over the past 20 years, in a similar way, health-care bonds—in a high-yield market—have traded at a discount of about 200 basis points to other high-yield bonds because they are seen as defensive investments. In times of crisis, such as 2008–2009, they perform well, for the same reason. Taylor says that this spread has recently shrunk to less than 50 basis points, which indicates that investors’ appetite for health-care bonds has diminished considerably. Health-care stocks’ prices can change dramatically in response to anticipated events, Taylor remarks. When the US Supreme Court was considering the question of the individual mandate in 2012, and it looked as though the mandate would be struck down, hospital stocks dropped. This not only affected investment returns, but also had a negative impact on those hospitals’ cost of capital. The Upside for Hospitals The PPACA could bring 30 million more insured individuals into the mix, along with more restrictions on insurance companies. Taylor estimates that over a fully implemented decade (from 2014 to 2024), the cost of health-care reform will be about $2 trillion. From an investor’s point of view, he says, hospitals will be net winners. Insurance companies will be net losers; providers of devices and pharmaceuticals will be modest losers due to higher tax burdens. Certain other issues will be factors: How many states will opt into the program? How many employers will stop providing medical coverage? What will people pay for government-provided insurance? How soon will payment-reform models gain traction? The PPACA will certainly be implemented, Taylor says, and there will inevitably be incremental reimbursement cuts in 2013, as part of a debt-reduction bill. We’ll see change in the health-care–delivery model, with movement toward integrated delivery systems and with more money invested in care coordination. There will be more consolidation of payors—but consolidation won’t fix the basic economic failing, which is that health insurance is no longer a hedge against catastrophe. “Going to a physician and getting a prescription: That’s routine care, not catastrophic loss,” Taylor says, “and when you cover that, you create inefficiencies that result from excess utilization.” Taylor remarks that in 1960, average US patients had to pay about 50% of their own health-care expenses; today, they pay 11%. The average annual out-of-pocket cost for health care in the United States, he says, is about 2.6% of average per-household disposable income, or about what that same household spends on televisions and other audiovisual equipment—and only about 40% of what it spends in restaurants. “There’s very little skin in the game, for the consumer,” he says. “If copayments rise, that’s more money that the provider has to collect.” Moreover, Taylor adds, more and more small employers are dropping insurance coverage, leaving their employees temporarily uncovered. Again, that leaves more for the health-care provider to collect from the patient. The Missing Link What’s missing from health-care reform, Taylor explains, is anything that addresses the disintermediation among consumer, consumption, and delivery. Price transparency isn’t addressed, either. “Imagine,” Taylor says, “going to the grocery store and seeing no prices on any item; you’re paying out of pocket for only 10% of whatever you take. Will you walk out with steak or hamburger?” Another problem is that no sustainable mechanism exists to fund per-beneficiary Medicare spending. Capitation will become a priority. Inflation of health-care prices continues to run ahead of consumer-price inflation, overall. By 2030, taxes will be funding 25% of Medicare expenditures, and some sort of reform will be necessary. Cutting provider payments by 75%, over the next 17 years; reducing benefits; pushing back the eligibility age; and means testing all will have to be on the table, Taylor says. With regard to the current balance of power between payors and providers, Taylor notes that hospitals have regained some negotiating power and have been able to raise their prices above inflation, but this is not true of physicians, physician groups, or outpatient providers. Insurance exchanges continue to move pricing power into the payor’s hands. Insurance exchanges also provide more transparency, in terms of premiums, and that will hurt the marginal insurance companies. “Price transparency doesn’t exist, for providers,” Taylor says, “but when it comes, it will weaken providers.” The next material movement on price is more likely to be up, Taylor says, so insurance companies are more than happy to use capitation with any provider, if they can. Accountable-care organizations are moving toward a fully capitated model, although it’s unclear how quickly that will be realized. Consolidation of hospitals is inevitable, too: Hospitals need to have good shares of their markets, to negotiate commercial reimbursement rates, and to achieve economies of scale. “Uncertainty makes these organizations want to band together,” Taylor says. “They have to be in a position to lose less if the pace of reform accelerates.”

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Joseph Dobrian is a contributing writer for Health CXO.