Janus Henderson: Can healthcare recover from 'Medicare for the masses'?

It’s been a tough few weeks for healthcare stocks. On April 10, Senator Bernie Sanders, a Democratic candidate in the 2020 US presidential race, introduced legislation for a Medicare-for-all health insurance scheme. Under the plan, private insurance in the US would be eliminated and Medicare, the federal health insurance programme for those aged 65 and older, would be expanded to all Americans.

Not surprisingly, managed care stocks plummeted, falling roughly 10% from 10 April to 18 April. The carnage also spread to other sub-sectors, including biotechnology and pharmaceuticals, which declined 7% and 4%, respectively, for the same period. All told, the healthcare sector was flat year to 18 April, compared with a more than 16% total return for the S&P 500 Index (Source: Bloomberg, as at 18 April 2019. Returns in US dollar terms).

Taking stock of the sell off

Understandably, investors may be worried about what’s next for healthcare. The Medicare-for-all proposal is not the first single-payer health plan ever put forth in the US, but Sanders is currently a front-runner for the Democratic nomination, and the bill was co-sponsored by other prominent Democratic candidates, including Senators Kirsten Gillibrand, Elizabeth Warren and Cory Booker, suggesting healthcare reform could remain a focal point for the next 12 to 18 months of the election cycle. In addition, UnitedHealth Group, one of the largest private insurers in the US, used April’s quarterly earnings call to address the proposal, which only seemed to spook investors more.

However, we believe the odds are low that Medicare-for-all could become a reality in the US, for a number of key reasons:

Lack of bipartisan support: Despite some candidates’ zeal for the proposal, key Democratic leaders in the House and Senate have been reluctant to back it, including House Speaker Nancy Pelosi, who has said she prefers trying to improve the Affordable Care Act. Meanwhile, managed care companies have significant lobbying power and deep pockets with which to fight the legislation.

Substantial costs: The cost of moving to a single-payer healthcare system in the US is unknown at this point. Some estimates suggest total healthcare spending as a percentage of GDP could potentially rise by trillions of dollars over the next 10 years, depending on how benefits are designed and payment rates to hospitals and other providers are determined. Other estimates suggest costs would actually fall.

Benefit design and payment rates are critical issues. Today, payments by private insurance plans to hospitals and other providers help subsidise lower rates negotiated by Medicare. If providers had to accept Medicare-level rates for all services, many practitioners might be forced to accept lower incomes or be laid off, and a number of hospitals – the vast majority of which are nonprofit – would likely shut overnight.

Meanwhile, although Medicare is a highly valued public scheme, it is not without its shortcomings. Notably, the trust fund covering inpatient hospital services for Medicare is projected to start running out of money in 2026. In order to replenish and expand the fund, payroll taxes would have to rise significantly or patient benefits be reduced.

Consumer unease: With the passage of the Affordable Care Act, we learned that most consumers do not want to jeopardise existing healthcare benefits or relationships with practitioners. More than eight in 10 Americans already receive coverage through either an employer, Medicaid or Medicare, according to the Kaiser Family Foundation. Upending that system would be highly disruptive and likely face substantial pushback.

What it means for investors

All said, we believe the odds of Medicare-for-all passing are extremely low (likely less than 5%). However, healthcare stocks initially reacted as though the probability was as high as 20% to 30% (The sector has since retraced some losses.) In our opinion, this discrepancy has made valuations for many stocks within the sector attractive. In fact, many firms that we view as high quality and that we think have significant growth potential now trade at substantial discounts to the market.

More importantly, we believe managed care fundamentals remain sound. In recent years, plan providers have been able to expand market share by building out integrated services with the help of technology, delivering value to patients while also reducing costs. Such initiatives have led to steady revenue growth for many insurance providers, which in turn has fuelled dividend growth, share repurchases and positive stock performance.

At the same time, we believe the healthcare sector as a whole is in a period of unprecedented innovation, driven by a greater understanding of the human genome and new modalities for treating human disease, from antibodies to gene-based therapies. Within medical technology, new devices can now repair faulty heart valves without the need for open-heart surgery and robots are increasingly enabling minimally invasive surgeries with more precision than ever before. Last year, the US Food and Drug Administration approved 59 novel therapies – the most ever in a calendar year – and we expect further exciting drug approvals in 2019.

Unfortunately, uncertainty around healthcare reform could, in the near term, do more to drive the sector’s performance than fundamentals. We think investors should prepare for heightened volatility. But we also believe there are ways to minimise the swings by focussing on companies developing innovative medicines that meet high, unmet medical needs. Therapies that markedly improve the current standard of care are likely to receive reimbursement regardless of the political backdrop. In addition, some companies fall outside the insurance debate, including those that generate significant revenues outside the US, firms that manufacture cash-pay products, such as contact lenses or cosmetic treatments, and those in the animal health industry.

Focus on the long term

We firmly believe that private insurance will not disappear in the US. However, we think some reforms are likely. Already, the Trump administration has unveiled regulation for Medicare that would require drug manufacturers to share rebates with seniors at the point of sale rather than the current system, in which savings are passed on to pharmacy benefit managers, distributors and other members of the drug supply chain. The administration is also considering a proposal that would require prices negotiated between hospitals and health plans to be made public. In the long run, we believe such initiatives could bring much-needed transparency to a system fraught with complexity and high costs and that rightly has drawn the ire of consumers. And against this backdrop, we believe companies levered to such reforms – whether by focusing on innovation, improving efficiencies, lowering costs or expanding access to medical care – could be well positioned.