Hospitals: Investing Essentials

Find out what you need to know about investing in hospitals.

Aug 5, 2014 at 10:15AM

Source: Tenet Healthcare.

With the aging of the American population, health care has become big business, and hospitals play a major role in how Americans get their health care. Yet just a few decades ago, the idea of making profits from hospital services was largely unheard of, and even now, the industry is divided between for-profit hospital operators and non-profit entities competing against each other in an increasingly cutthroat environment. Let's take a look at hospitals and whether they make good investments in an era of major health care reform.

How should investors look at hospitals?

Hospitals provide inpatient services for those needing health care, including emergency treatment and procedures requiring extended recovery periods. Treatment of chronic diseases, helping women give birth, and handling laboratory work requests for local physicians are just a few of the things hospitals do.

From an investing standpoint, though, the first distinction you have to make is between for-profit and non-profit hospitals. Hospitals are allowed to file for tax-exempt status under the federal tax code, and as a result, non-profit hospitals are treated as charitable organizations, with donations qualifying for tax deductions in most cases. By contrast, for-profit hospitals get taxed on any profits, and they can't solicit donations that have tax-deductible status. That arguably puts for-profit hospitals at a disadvantage, but the trade-off is that for-profit entities have an incentive to focus on areas of medicine that tend to have higher profit margins.

What is the history of hospitals?

Hospitals date back to Greek times, when certain temples were dedicated to healing arts. Within the past 300 years or so, secular hospitals started to appear that more closely resembled today's institutions, with specialists trained in scientific techniques, giving treatment and with hospitals offering specialized equipment for use in treating disease and injury.

Source: Army Medicine, Flickr.

Much of the tension within the hospital industry stems from the changing role of hospitals over time. From one perspective, non-profit hospitals arguably have more of a civic responsibility for providing less profitable services to the general public in order to justify their tax-exempt status. Yet non-profit hospitals also are generally exempt from property taxes, which can put substantial burdens on the municipalities in which they operate. That has led to recent calls in some cases to eliminate the tax exemption for non-profit hospitals, so that they'll have to operate on an even playing field with for-profit entities. At the same time, some policymakers worry that eliminating the distinction will force all hospitals to focus on profitability and thereby potentially neglect some of the biggest needs in the communities they serve.

How many hospitals are there, and how many can you invest in?

The American Hospital Association puts the number of hospitals in the U.S. at over 5,700, with more than 920,000 beds. Just over 1,000 of those are for-profit community hospitals. To a large extent, a handful of companies have extensive networks of those for-profit hospitals, with big players Community Health Systems, HCA Holdings, and Tenet Healthcare accounting for a substantial portion of the total.

Moreover, consolidation in the industry has led to even larger networks coming into being, with the largest systems encompassing 200 or more hospitals. As health-care reform emphasizes greater efficiency, many expect further merger and acquisition activity to continue in the for-profit hospital realm.

Why invest in the hospital industry?

One thing investors can count on from hospitals is ongoing demand for their services. With an aging population, the need for health care is likely to increase dramatically over the next 20 years, and hospitals and other health-care providers have been positioning themselves to meet this increased demand for a long time.

At the same time, though, investors have discovered in recent years that even hospitals are susceptible to economic cycles. Due in part to weak economic conditions, increases in health care costs slowed considerably in recent years, which contributed to more favorable predictions about the sustainability of full benefits under the Medicare program. That's good news for consumers, but it puts hospitals under pressure, and other requirements of the Affordable Care Act and other reform legislation could make it even harder for hospitals to grow profits. As government programs expand, the reliance on reimbursement rates from Medicare, Medicaid, and similar payment sources increases, leaving hospitals more at the mercy of lawmakers.

Source: KOMUnews, Flickr.

Moreover, companies in other health care industry niches are working to replace hospitals for certain medical services. Neighborhood clinics from drugstore chains aim to provide simple yet convenient access to basic needs for which some patients would have used hospital emergency rooms. The impact of these and other moves on hospitals isn't certain at this point, but they'll have to refocus their efforts on protecting themselves from competition in lucrative business areas while minimizing the negative effects of greater regulation.

Hospitals are complex institutions that serve essential functions across the nation. As investments, hospitals require in-depth knowledge of the intricacies of the health-care system as well as the funding mechanisms by which patients get the care they need. Nevertheless, those investors who can analyze the industry well can pick out the companies most likely to take full advantage of the profit opportunities the hospital industry offers.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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