Low-Cost Care Threatens High-Quality Health Stocks

The health-care industry may have finally met its match.

There have been many efforts to reform the U.S. health-care system over the years, but the one announced on Tuesday by the triumvirate of Amazon.com Inc., Berkshire Hathaway Inc. and JPMorgan Chase & Co. may be the most ambitious yet.

The announcement was light on detail, but it hinted at big plans. JPMorgan CEO Jamie Dimon said the “goal is to create solutions” that deliver “transparency, knowledge and control” to the three companies’ employees “when it comes to managing their health care.” Those qualities are conspicuously missing from the U.S. health-care system.

As my Bloomberg Gadfly colleague Max Nisen pointed out, a key line in the release is that the new venture will be “free from profit-making incentives.” That’s a big deal. Just ask low-cost investing pioneer Vanguard Group what’s possible when profits aren’t a consideration.

The obvious question for investors is what impact the effort will have on the health-care industry. Amazon is a formidable foe, as every industry that competes against it will attest. But health-care companies are no pushovers. Or, as factor investing aficionados might put it, health-care companies are high-quality businesses.

The numbers are astonishing. Health-care firms have been far more profitable than the broader market. The return on equity for the S&P 500 Health Care Index has averaged 20.6 percent since 1990, the longest period for which numbers are available, while the S&P 500 has averaged 13 percent. Its return on capital has averaged 15.3 percent, compared with 5.8 percent for the S&P 500. And its return on assets has averaged 8.7 percent, compared with 2.4 percent for the broad market.

The growth of those profits has also been more reliable than the broader market. The standard deviation of the health-care index’s annual earnings growth has been 8 percent since 1991, while that of the S&P 500 has been 17 percent, or more than twice as volatile.

And the coup de grace: Health-care firms have used far less leverage to generate their higher profitability. The health-care index’s debt-to-equity ratio has averaged 48 percent since 1990, while the S&P 500’s ratio has averaged 163 percent.

The high quality of health-care companies has translated into higher returns for investors. The health-care index has returned 10.1 percent annually since October 1989 through Tuesday, while the S&P 500 has returned 7.7 percent.

In fact, health-care stocks easily shook off the two biggest threats to their profits in recent memory. From September 1993, when President Bill Clinton proposed his health-care plan to Congress, to September 1994, when the plan was abandoned, the health care index was up 16.6 percent. And from July 2009, when House Democrats introduced their health-care reform bill, to March 2010, when Barack Obama signed the Affordable Care Act into law, the health-care index rose 21.6 percent.

Still, the quality premium that health-care investors have come to expect isn’t without risk. Even in a highly regulated industry such as health care, regulatory risk can always take a bigger bite of the profits. It happened most recently to the financial sector in the aftermath of the 2008 financial crisis.

There’s also the risk of disruption. Profits have a way of attracting scrutiny, either from competitors who want a piece of the bounty or reformers who want to share that bounty with consumers by lowering prices.

Health-care companies have dodged serious efforts to regulate them, but they now face the most disruptive force in business in Amazon’s Jeff Bezos. And if he and his co-venturers are serious about providing health care to their employees — and potentially all Americans — at cost, health-care investors may soon be reminded why the quality premium isn’t free.

Source: Bloomberg Gadfly, https://bloom.bg/2FubzIX