Special to CNBC.com/halftime by Tony Roth, Chief Investment Officer, Wilmington Trust
Four months into 2019 and the is up 15% yet health care appears to be on life support.
This is in part because of the defensive nature of health care, which has not been helpful in a rally dominated by highly cyclical names (those like consumer discretionary and technology that tend to do best in a growing economy). It is also due to policy risk, which has ramped up dramatically as the 2020 U.S. presidential election is brought into focus.
This policy risk is considerable — and contributes to our decision to be neutral health care in our sector strategy — but it is important to look beneath the surface. We tend to think of technology companies as being the biggest disruptors, but the innovation occurring within health care is arguably greater than any other area of the economy and is leading us to find some attractive investment opportunities in a beaten down sector.
It seems that no matter who we listen to on the 2020 campaign trail, their policy vision poses a direct threat to some area of the health care sector, but also greater opportunity as many seek in some way to broaden the base of health care consumption and/or the level of federal subsidization of that usage.
The Trump Factor
The Trump administration has backed continued legal challenge of the Affordable Care Act, which could be revisited by the U.S. Supreme Court, and is also contemplating a post-2020 return to Affordable Care Act repeal and replace efforts. Repeal of the Affordable Care Act would increase hospitals' "bad debts" as fewer insured means less demand for health care services, and more people entering hospital emergency rooms without the means to pay the subsequent bills.
The Bernie Effect
Among 2020 Democratic hopefuls is a building chorus of "Medicare for all," and Bernie Sanders is one of the loudest voices. Obviously private insurance companies would feel pain from a move to a public insurance program and other health care providers could also see a cut to payments relative to private insurance rates. But certain providers could receive a lot more federal dollars from an increased base. With details scant, there is the potential for ramifications on the entire sector.
The Common Ground
While hard to believe, there is also one area of the health care space where Democrats and Republicans share common ground: cracking down on drug pricing. As an example of what political pressure can do to pharmaceutical stocks, in September 2015, the S&P 500 Pharmaceutical Industry Index fell 24% in a matter of days following a tweet from Hillary Clinton about the exorbitant price increase of a drug called Daraprim. The index has still not recovered.
While the road to legislative action on any of these issues is at best incredibly long, winding, and covered by fog, it is prudent to proceed with caution. The veil of political uncertainty could weigh on the overall health care sector until or even beyond the 2020 election.
That said, it would be unwise for the long-term investor to write off all health care stocks, as this also happens to be one of the sectors experiencing the most rapid pace of innovation. While politicians are understandably focusing on policy-based solutions to the problem of rising health costs, we expect innovation to be transformational for the industry and drive efficiencies going forward. We highlight three innovation themes that we expect to increase health care productivity, reduce costs, and offer potential investment opportunity:
1) Treating Sickness → Preventing Sickness
One of the most obvious ways to reduce health care costs is to take preventative steps to avoid the expensive treatment of illnesses once they have reached a critical stage. Emergency rooms are notoriously overburdened and understaffed, and they are the most expensive entry point into the health system, but several technologies aim to get ahead of the ambulance ride. Companies like Teladoc enable on-demand, remote medical care through a patient's phone or internet-connected device, removing the often costly and inconvenient physical trip to the doctor (or multiple doctors). As other examples, there is Apple's Series 4 Watch, which offers electrocardiogram (ECG) readings, and the Rochester Institute of Technology's cloud-connected seat containing biometric sensors to measure a person's ECG, blood oxygen levels, and body weight. These technologies come with the intention of solving a major problem in early diagnosis and preventative care: adherence to frequent and regular testing of vitals. And in many cases, these efforts represent early advances that we expect to evolve into critical tools for the overall health care ecosystem.
2) Doctor in Control → Patient in Control
Anyone who has switched doctors knows the "existential crisis" that is typical when transferring your medical records and often includes a fax—yes, fax—of reams of paper, sometimes at a per-page cost to the patient. In 2016, Google acquired Apigee, a company specializing in open but secure application programming interfaces that could transform the traditional closed ecosystem of electronic health records and allow the patient to "own" their records, driving efficiency up and costs down.
3) Treating the Ailment → Treating the Person
The traditional medical diagnosis process involves conveying symptoms to a physician who prescribes a treatment for the ailment or disease they believe to be causing those symptoms. But not everyone reacts to the same treatment in the same way, forcing multiple costly rounds of trial and error until the physician and patient find something that works. Now envision a world where a treatment was prescribed not only based on the ailment but also that patient's genetic markers, more quickly zeroing in on what treatment could be most effective for that specific person. That is being made possible through the partnership of 23andMe, the company that sells home DNA kits, with pharmaceutical companies to develop more "personalized" treatment plans through the use of genetic data culled from millions of customers.
Going forward, it will be increasingly important for investors to balance the political risks with innovation opportunities, all with an eye toward reasonable valuations. In general, where the political risks are higher—in managed care, hospitals, and pharmaceuticals—the valuations based on forward-looking earnings estimates are more reasonable. Those areas seeing innovation but skirting the political spotlight, like medical devices and life sciences, tend to trade at higher valuations relative to their own history. At this time we are sticking with our neutral allocation to health care, but we think it would be a mistake to shun all health care stocks. Instead, we would advise taking a more surgical approach to investing in a sector that has become deeply out of favor yet presents numerous attractive opportunities.
Disclosure: Wilmington Trust maintains a neutral position in the health care sector.