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Healthcare Reform - Is the Infection Spreading?

(Guest Commentary by Rick Konrad – April 23, 2010)

Dear Subscribers and Readers,

For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will discuss the impact of the healthcare reform on the healthcare industry (focusing on biotechs), and how much of the benefits won't come into play until 2014 or later.  Rick will then discuss his stock screening process – both on the long and the short side.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see "Let's Be Careful Out There – Sentiment in Secondaries" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

The market continues to confound many of us who look at sentiment figures and conclude that many stocks are somewhat overbought, if not extremely overbought. The news of this earnings season has generally been quite positive with many decent earnings surprises. Yet, it seems in many cases, especially in healthcare stocks, the earnings guidance has started to come down for the rest of 2010 as analysts reconsider the impact of healthcare reform. A great example of this was Amgen's (AMGN) conference call where earnings rose by 20% on a 9% revenue increase. Amgen's Q110 EPS of $1.30 beat street estimates of $1.25 primarily due to lower-than-expected R&D and SG&A expenses. But of much greater importance in the call was updated guidance for the impact of healthcare reform, resulting in a $200-$250 million shortfall in 2010 revenues. For 2011, the impact will likely be even larger.

I think it is quite worthwhile for readers to go through the Amgen earnings transcript to better understand the impact of reform on pharmaceutical and biotech companies with actual production and revenues. Though healthcare reform will certainly broaden the market as a larger population will participate in healthcare, the positive effects of this legislation will be felt in 2014. Prior to that, the impact will be negative as far as revenues and earnings on many companies, and analysts are just beginning to make the adjustments in their estimates. It is particularly interest to note the difference in performance between the large biotechs and the small wannabes. Check out the reactions of Amgen (AMGN), Gilead Sciences (GILD), and Genzyme (GENZ), then look at the smaller names, Dendreon (DNDN), or Human Genome Sciences (HGSI).

The reaction to changing healthcare reform has become quite evident recently (chart courtesy of

S&P Health Care (XLV) Participation Index

Excuse the pun, but it does appear that the infection is spreading. Here are some of the pertinent comments from the Amgen conference call regarding the impact of healthcare reform:

“I'll take a few minutes now to provide some insights on how healthcare reform will impact Amgen. This is intended along with the comments on guidance to give you a way to assess the overall impact healthcare reform might have as we move forward. First, it's important to recognize that although the new law begins to impose costs in the pharmaceutical sector in 2010, it does not begin providing appreciable increases in coverage until 2014. As a result, costs of the industry will be recognized for several years before appreciable revenue is recognized from coverage expansion”

“Aside from a potential revenue lift from the insurance mandate within the legislation, there are seven additional components to healthcare legislation that may have a meaningful impact on our financial performance over time and I'll briefly touch on each one of these. Note that there are a wide range of effective dates for these elements, and that must be considered in estimating the evolution of financial impact to Amgen. The first item shown here is the increase in the statutory base Medicaid rebate from 15.1% to 23.1% on the current Medicaid book of business. This rate is applied to the statutorily defined average manufacturers price or AMP, to establish the minimum dollar value of rebate that Amgen pays to the states. Note that an increase in Medicaid rebates also reduces public health service or PHS pricing. The effective date for this item is January 1, 2010 also, so we have already booked a quarter one accrual for the estimated cost of this item.”

“The second item on the list is a definitional change in the calculation of average manufacture of price. In the healthcare reform bill, this price definition was refined to exclude clinics and hospitals, effectively making it a measure of retail pricing, historically our lowest discount segment. The effect of this is to raise AMP, thus raising the dollar values Medicaid rebates and reducing PHS pricing to certain products. This item has an effective date of October 1, 2010, so it did not impact our quarter one accrual.”

“The third item here is the extension of rebates to the Medicaid reimbursed business and Managed Care organizations. The Medicaid rebates will be extended to 15 million to 20 million additional Medicaid beneficiaries now in Managed Care organizations that do not receive statutory rebates. This one is effective as of March 23, 2010, so it had a small increment to our healthcare reform accrual for quarter one. The annualized impact to this item may be double that of the increase noted in Item 1.”

“The fourth item on the list is the expansion of Medicaid eligibility to include those below 133% of the federal poverty level from the prior cutoff that in general was about 100% of FPL or lower. When affected, this will increase the Medicaid beneficiary base by an estimated 16 million people. Because this provision is not effective until 2014, there is no 2010 financial impact.”

“The fifth item on the list is the mandate for manufacturers to provide a 50% discount to Medicare patients who reach the Part D shared coverage limit. and enter the so-called doughnut hole. For Amgen, this impact is limited to our two current products that are reimbursed in pharmacies, Enbrel and Sensipar and eventually will have some impact on Prolia. There should be some benefit offsetting the cost due to more patients successfully getting through the doughnut hole into catastrophic coverage but this is very difficult to project at this time. It has the January 1, 2011 effective date so no accrual will be taken this year”

“Item six is an expansion of the public health service or PHS eligible hospitals. Additional children's hospitals, freestanding cancer centers, critical access hospitals, and rural referral centers will now be eligible for PHS pricing for their outpatient perfects. The PHS price approximates the Medicaid price. This item is one of the more modest factors on the list and the effective dates is January 1, 2010, so our quarter one accrual contains a full quarter's impact of this one.”

“Finally, the last item is the annual pharmaceutical industry fee. This is one of the more straightforward items conceptually. There is no legislation in annual dollar amount that must be assessed across the large companies in our industry. This amount is a apportioned to each individual Company based upon the calculation of that entity's share of total public planned sales. This item is also one of the largest on the list and additionally is not tax deductible. It has an effective date of January 1, 2011, so we will not be accruing for this in 2010. On an individual product basis, it's important to consider the highly variable difference in exposure to these seven items. The key driver of these differences is each product's exposure to the affected public program.”

Here is Amgen's Q1 presentation which provides an outline of some of these issues.

Moving to broader topics, I am frequently asked about how investors should screen for ideas. Much has been written on this topic. Years ago, James O'Shaughnessy wrote a book “What Works on Wall Street,” essentially a compendium of various methods that concluded with a number of value oriented metrics as the best way to beat the market. Originally published in 1994 and updated in 2009, the much heralded value shop, Tweedy Browne published “What Has Worked in Investing,” another strong endorsement of the value approach. A modern interpretation of value investing has come from behavioral finance, again a reasonable interpretation of some basic concepts can be found in another Tweedy Browne review, “Exploiting Investor Irrationality

Though there is much to defend the power of such factors as P/E, Price to Book, Price to Cash Flow, and Price to Sales, as academic research has discovered post Efficient Markets Hypothesis, there are many other factors which can and should be considered. Though we will explore some of these in greater depth in subsequent posts both here and in my blog, I would like to introduce a number of these concepts here.

Value investors generally dismiss momentum, yet there is decent evidence supporting this as a decent screening factor to select stocks. For example, some research has demonstrated that there is an underreaction to earnings news and a general price drift associated with the gradual incorporation of new information. Price “drift” is higher for firms with fewer analysts. High volume stocks frequently behave more like “glamour” stocks whereas low volume stocks tend to behave more like “value” stocks, hence, it is often useful to look for stocks that are “generic,” that draw less attention than their higher volume, and highly followed counterparts.

Analysts tend to have positive recommendations on stocks with high growth, high accruals (hence low accounting quality,) high price to book ratios and other value metrics all of which have a negative association with future returns.

I am surprised at times by the incredible aversion that investors, and occasionally governments have to short sellers (investors who sell stock before they own it hoping for lower prices.) Theory suggests that since shorting stock is relatively expensive, and may drive out less informed investors, open short positions reflect trades by more informed investors. There is reasonable academic evidence to suggest that more heavily shorted stocks tend to perform poorly. By extension, a reduction in short interest indicates less bearishness and perhaps some positive potential.

What I find particularly interesting about following short positions is that they are ‘real,” that is short sellers actually have their own capital at risk and hence have the strongest incentives to fully utilize as much fundamental information as they can garner. Analysts on the other hand live in a virtual world, certainly having a role in conveying information, but nonetheless somewhat conflicted in terms of generating commissions, trading, and ongoing investment banking business. I apologize to my friends in the Wall Street and Bay Street communities who live in the public fishbowl of publishing research and deal with these pressures. Been there, done that.

Recent academic work has suggested that short sellers as some of the most sophisticated investors around, incorporate most of the value and momentum factors that we have mentioned. By using the evidence provided by the behavior of short sellers in combination with the information (or dis-information) of analyst recommendations provides a fairly potent predictive combination. Stocks with high short interest but conversely rank highly with the analyst community, can represent superb shorts. Conversely, those with little or falling short interest but having little Wall Street support can be great longs.

Some recent work by an investment class at Stanford (apologies to Henry and his colleagues at the Anderson School of Management for even mentioning the name) has developed a screen which combines some of these factors, placing the heaviest weights on value and momentum factors. I have utilized this to begin screening under these factors but hope to refine it as time allows. A few names that look good as longs, based on my initial screening of these factors: Sears Holdings (SHLD), Raytheon (RTN), Advanced Micro Devices (AMD), JM Smucker (SJM), and Telus (TU), There are other defense names among the highest ranks in this screen, reminding me of a previous post in Marketthoughts, “Getting Defensive in Defense Stocks.”.Among smaller cap names, have a look at Insight Enterprises (NSIT), Kapstone Paper (KS), and Graphic Packaging (GPK).

I look forward to providing additional research into the power of some of these factors in subsequent posts.

Disclaimer: I, my family or clients currently have positions in the following securities mentioned in this post: Amgen, Genzyme, Sears Holdings, Raytheon, Kapstone Paper.

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