3 Issues That Every Healthcare Investor Should Consider

It's Interns Ask week on Industry Focus! In this week's healthcare episode, Kristine Harjes and Todd Campbell talk to a special guest, Foolish intern Amanda Way, about investing in the healthcare industry.

Listen in to find out how health insurers can determine a drug company's success and what insurers are looking for when they negotiate deals about potential drugs and treatments; how investors can keep their cool and make sound long-term investing decisions even during volatile election seasons like this one; and why the failure of the merger between Pfizer (PFE 0.67%) and Allergan (AGN) doesn't mean that the health sector will see a total cessation of M&A activity.

A full transcript follows the video.

This podcast was recorded on Jun. 22, 2016. 

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's June 22, a Wednesday. You've likely already heard that the theme of this week is Interns Ask. We've got some incredibly talented interns working in all different departments across The Fool this summer. We more or less bribe them into sending us their questions about the sectors that we cover on this show, as well as general investing questions. On the phone to help me answer some healthcare-related questions is our normal healthcare contributor, Todd Campbell. Welcome to the show, Todd!

Todd Campbell: Great to be here!

Harjes: In the studio with me to ask questions on behalf of both herself and her fellow interns is Amanda Way, who is working with our asset management team this summer. Amanda, what do they have you working on down there?

Amanda Way: I have a bunch of projects going on. I'm working with the marketing part of the asset management team. I'm working on creating maybe some stock pitches for the mutual fund. I've been having a great time down there.

Harjes: That's awesome. We're really glad to have you joining us a couple of floors up for the show today. Amanda came prepared with a list of questions, one from her and two from a couple of her peers. Todd, are you ready to answer them with me?

Campbell: Yeah. Let's dive right in!

Harjes: All right. Let's hear your question one!

Way: Great. All right. How do health insurance companies affect which companies succeed? How do you investors take this into account?

Harjes: This is a loaded question. I love this one. I think this one is probably my favorite question that got pitched to us in the healthcare sector because it really is super important. I think we got to take a step back before we go into the answer of how investors should think about this and just talk about how health insurance works. Todd?

Campbell: Right. The impact that health insurers may have across the industry really depends ... It stems from how they operate as a business. Most health insurance companies are for-profit entities. They're in business to make money. They make that money by charging premiums to people, to provide them with insurance, and then pocketing the difference between the premiums that they collect and the amount that they spend on healthcare. They're always actively negotiating deals with healthcare providers, specialists, hospitals, and of course, drug manufacturers, with the hope of collecting more in premiums than they spend providing healthcare services to those members.

Harjes: One of the really direct ways that health insurers can impact a drugmaker's earnings is the fact that they can pretty much decide the game for you. If they don't want to cover a drug or have it on their preferred list, as a drugmaker, you're kind of stuck.

Campbell: Right. It's not just drugmakers that are kind of stuck. You've got primary-care physicians that obviously always are arguing and debating on how much they should be compensated by these insurers. There is a cost crisis that's occurring in our country, if you will. The cost of healthcare is having a massive impact on us as a nation. That's in large part because there are so many of us that are getting older. There are 76 million baby boomers -- 10,000 of them turn 65 every day. The vast majority of healthcare costs are incurred from treating chronic conditions that oftentimes occur when we get older. There's a cost crisis. For healthcare insurers, it is so critical to try and walk that fine line between how much can I charge in premiums and how much am I going to pay out for care. That's where you get into the nitty-gritty of how insurers can make or break an investment in, say, a drugmaker or a medical device maker.

Harjes: You see examples of this all the time, where there are companies that have really, really promising new treatments or devices and then when you get to the actual "Let's see how many people we can get to use it and to pay for it," that's where you see these drugmakers and the medical device makers stumble.

Campbell: It really happens a lot when you can't draw the direct line between the medicine and, say, the outcome.

Harjes: That is extremely true. There has been a lot of talk of changing the way that the U.S. healthcare system works more toward a pay-for-value basis, but that's not how it works at the moment.

Campbell: Right. You've got drug companies individually having to go in and make negotiated deals with insurance companies. As a result, some insurers that are very large and have exposure to many members oftentimes can get a better deal and pay less for the drug than, say,  a smaller insurance company. Insurance companies will work in many different ways to control the costs that can limit the sales or the peak sales potential, for example, of a particular drug. We saw that in 2014 with the way that they responded to the new hepatitis C drugs that Gilead Sciences (GILD 0.43%) had rolled out. These were fantastic drugs. They changed the paradigm in treatment, but they were incredibly expensive. Insurers started by saying, "You know what, only the sickest patients are going to be allowed access to them."

Harjes: Yeah. The only way that you can really justify the cost is to look at the long term and say, "OK, what would happen if we didn't use this drug? If instead we use what's already on the market or if there's nothing on the market, what would happen if we didn't use anything at all?" Obviously, it is pretty impossible to assign a dollar value to somebody's life or somebody's quality of life. There are things that have a more obvious dollar amount attached to them. Todd, you mentioned the hepatitis C drugs from Gilead. You can talk about the cost of having to get a liver transplant. That's the sort of argument that you see. That, I think, is the best thing an investor can do to look at whether there is a good chance that the drug will be picked up by a lot of insurers or not, is if there is that sort of long-term cost savings argument.

Campbell: Right. If it doesn't exist or it's very hard to quantify, then it becomes a guessing game. Look what happened with MannKind in Afrezza. Here they have this inhaled insulin that theoretically, it makes it easier for patients to dose themselves prior to a meal. It does, inarguably, a better job at controlling blood sugar for those patients. Yet because reimbursement deals weren't able to be made with insurers, the sales never even came close to what the pre-launch expectations were.

Harjes: Yeah. I think we could probably fill an entire episode just with examples of drugs or devices that had a lot of promise and then stumbled when it came to reimbursement. I'm going to cut us off here. Hopefully, this scratches the surface at answering your question. What else do you have for us, Amanda?

Way: Kind of a follow-up by Emily Flippen, intern on the investing team. She asked: "With the current election cycle, I'm uneasy to invest in healthcare companies like Gilead Sciences and Celgene because of the potential impact of changes to Medicare and Medicaid. Is this fear justified? Will the election impact healthcare earnings?"

Harjes: Yeah. Regulatory risk has been a thorn in the side of all of healthcare, ever since the whole Martin Shkreli debacle, the most hated man in America. When people started to really look at just how much money these healthcare companies were making -- and some of them had a story behind them that was pretty hard to justify, this whole model of buying up other drugs that are forgotten about and then jacking up the prices, especially rare disease drugs. People got really, really upset about this and rightly so. This had this trickle-down effect to a lot of other drug-makers. I think this regulatory risk had made the entire sector pretty volatile lately.

Campbell: It always tends to ... Regulatory risk and the political discourse, everything tends to get really, really nerve-racking for healthcare investors around presidential election cycles. This reminds me a lot of where we were back in 2008, when we were debating massive potential changes to the healthcare industry that would be associated with what became Obamacare, the Affordable Care Act. You couldn't open up your computer, internet browser without stumbling upon an article saying how this was going to really, really change everything and can really, I guess, sink most for-profit healthcare companies.

Harjes: It was a lot of negative publicity and people were saying there's no way there's going to be any for-profit insurers left after this.

Campbell: Right. What ended up happening, interestingly enough, was that that turned out to be a phenomenal buy opportunity for healthcare investors. If you were able to step in and buy healthcare stocks into the teeth of all of that, then you were rewarded incredibly handsomely for taking on that risk. If you're going to be investing in healthcare stocks, you have to recognize that there is political risk, there is regulatory risk, but never underestimate a company's ability to change with the times and figure out a way to profit from whatever changes occur because of that risk.

Harjes: Yeah. That's what they do. They're for-profit companies. They will find way. And of course, we always say that the past can't predict the future. I mean, I don't want to say if so-and-so is elected and healthcare company stocks tank, it's definitely a great buying opportunity for every single one of them, but what I will say is that in the end, long-term trends trump everything ... That's an ironic word choice right there. That will trump these short term political swings which are totally unpredictable.

Campbell: Right. We are Foolish investors, right? So we want to look at the longer-term trend that supports owning healthcare stocks. We want to say, 76 million baby boomers getting older, requiring more care for longer periods of time -- that is really what should be driving interest in these companies.

Harjes: Amanda what is the last question of the day?

Way: Ben Estep, another investing team intern, points out that M&A -- which stands for mergers and acquisitions -- topped $4 trillion last year, and many of these deals seemed to be formed in odd ways just to lower taxes. He specifically noted the fall off through the Pfizer/Allergan deal, which I know you guys covered on this show in detail. His question specifically was, "Is the only way for a lot of big companies to continue generating earnings growth through M&A and creative deals to lower taxes, and should investors and companies heavily involved in M&A be concerned"?

Harjes: Todd, I'm going to let you take a swing at this one first.

Campbell: What we are talking about here are the tax inversions, right? Where you had a U.S. company that would then go out and acquire a company that had a headquarters somewhere else, such as Ireland, where the corporate tax rate was very low. That kind of M&A was financially rewarding to the acquirer because they were able to significantly reduce their costs without having to do much of anything. They could basically say, "Hey guess what, we're now headquartered over here in Ireland, and as a result if we've got $50 billion in sales, we're now paying a couple billion dollars less in taxes." Yes, mega-tax inversion deals are now DOA -- dead on arrival. I don't anticipate we'll see any more of these now that Allergan and Pfizer broke off their deal following some changes to tax inversion rules from the Treasury Department late last year.

Harjes: We can talk about regulatory risk, and that right there, that's a regulatory effect that healthcare industry had to deal with.

Campbell: Absolutely! They had to deal with that. Does that mean that you don't want to invest in Pfizer and Allergan anymore? Not necessarily. You've got two very different companies that have great, theoretically, great pipelines. That's what you should be focusing on. Is M&A, as a whole, dead now? No! There's ways to grow your company in your sales, in your profitability, by going back to the grassroots of M&A -- looking for promising new drugs that are coming through the pipeline that can either shore up your market share or expand you into new indications.

Harjes: So despite these tax inversions deals being pretty solidly less lucrative now, I agree with you, Todd, that we are not going to see as many companies going at M&A with this perspective, but it is still a humongous trend within the industry. I think it is something to be aware of. It's not necessarily a concern for investors that are invested in these companies that are very into M&A, but it depends on management's perspective on it. You get companies like Pfizer, for example, right after the Allergan deal fell through, not too long after it, they go out and they make a pretty splashy acquisition for $5.2 billion acquisition of Anacor, essentialy just for one drug that is competing in a pretty competitive market for a specific type of eczema.

Just recently on the show we were talking about AbbVie bought Stemcentrx for $5.8 billion. There are a lot of companies out there trying to grow by acquisition.

Campbell: Right, and if you were an investor and you were at one point looking and saying, "What Irish company is going to get bought next?", and trying to figure out that, stop doing that. Instead, let's take a look at de-risked clinical-stage companies -- and by de-risked, I mean maybe there are stage III or beyond or approaching regulatory approval. Those are probably the ones that are going to end up being the biggest targets from here.

Harjes: As opposed to the really early-stage ones. I'll also throw it out there that you never want to be buying any of these smaller companies simply because you think that they are going to be bought out, but it almost is one and the same to say "I think that this is a really attractive buy for a big pharma" and "I think this is a really attractive company on its own." Those two are very tightly intertwined, and so you want to be focused on the latter -- the "I think this is a great company " -- but if it's a great company then it's probably also a great buyout candidate.

Campbell: Yeah, it all depends on the evaluation. It's always going to come down to product, pipeline, and profitability. If you consider those three things, worst-case scenario, you end up buying a good stock for the long haul. Maybe not one that gets taken out right away, but you'll still end up being relatively happy with the purchase, hopefully.

Harjes: Exactly. I wouldn't be concerned about M&A as a big red flag unless that is the entire business model, in which case, that's the kind of company that is really coming under a lot of scrutiny, could potentially face more regulatory risk going forward, and then you want to watch out.

Campbell: Right, and the other thing to watch too, especially with these companies that have been "serial acquirers," is just this whole concept of how are they reporting their numbers, GAAP numbers versus non-GAAP numbers. Are they reporting clean numbers, or are they adjusted and include all sorts of kitchen-sink type stuff?

Harjes: Yes, I completely agree. I hope that these answers have been helpful to you Amanda and to the rest of the interns who asked these questions. Thank you so much for coming on the air today.

Way: Thank you so much for having me. This was great.

Harjes: Listeners, what questions do you have for us? Send then on in to [email protected]. As always, people on the program may have interest in the stocks that they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Amanda Way and Todd Campbell, I'm Kristine Harjes. Thanks for listening, and Fool on!