Morningstar | Winners and Losers Emerging After Health-Care Reform
The biggest structural change in 45 years to the health-care sector is creating opportunities in pharmaceutical stocks while pressuring health-care providers, says Highland’s Michael Gregory.
Mallory Horejs: My name is Mallory Horejs. I’m an alternative investments analyst here at Morningstar.
Today, I have with me Michael Gregory, the Portfolio Manager of the Highland Long/Short Healthcare Fund, ticker HHCAX.
Michael, thanks for joining us today.
Michael Gregory: Thanks for having me.
Horejs: Sure thing. Well, Michael, first off, how would an investor want a sector-specific fund such as yours in their portfolio? Wouldn’t it be more prudent to diversify across sectors in terms of diversification and investment opportunities?
Gregory: Well, I think as an investor, you want to seek opportunity, and in this environment health care presents a very significant opportunity. Number one, the sector is large; it represents around 18.5% of our GDP, and because health-care prices inflate at higher rates than general prices, health care has grown as a percentage of our GDP every year since 1997, which is a pretty staggering statistic, but it represents and underscores the size and importance of the sector to our economy.
The second thing that’s important is that health care is going through a tremendous change. With the passage of the Affordable Care Act last March, we have entered into a period that I see as the biggest structural change to the health-care sector in 45 years, and that structural change is of such large magnitude that it does call up significant opportunity.
Then thirdly in health care due to dynamics specific to the space, I think we’re in the first few innings of a massive consolidation cycle, and therefore, the M&A environment and opportunity set is very robust.
Horejs: It’s interesting that there is only one other sector-specific long/short equity fund in this category, and it also focuses on health care. So what is it about health care that makes this space so attractive, and what are the opportunities that you see right now as well as in the long-term?
Gregory: Well, I think first you have to consider the setup. You have a sector that’s nearly a fifth of our GDP, that’s undergoing the biggest structural change in 45 years. Intuitively, what that is doing is causing an emergent set of winners and losers, and as policy evolves–and we know that any policy of this magnitude is going to be affected by popular sentiment, by budgetary limitations, and by whomever is in the House, Senate or White House–that organic legislative process will continuously reinvent that set of winners and losers, and so there’s a significant opportunity for a long and short fund to take advantage of the full playing field of opportunity.
The second opportunity is to consider the budgetary stress and balance sheet of the U.S. government. Now the U.S. government, as we all know, is under an excessive debt load. Debt represents around $14.3 trillion, we’re burning about $100 billion per month, and health care is one of the few areas in the economy that the government can actually tap as a source of savings. So, consider that as part of our debt ceiling debate and ongoing efforts to meet austerity, since the government represents $0.46 of every $1 spent in health care, health care is one of the few areas they can tap on the shoulder as a source of savings to address debt.
So we look for opportunities in a cost-contained environment. Certain businesses will thrive because they make health-care delivery more efficient, and certain businesses will suffer because they have products or services that have excessive price or excessive margin that don’t benefit the common good.
Finally, I think when you look at health care, it has brought to the fore very attractive portfolio features, and what I mean by that is, most equity long/short managers over the past few years have struggled with high correlation.
The sectors that folks invest in include industrials, or consumer or tech. Many of those sectors are tied to the pace of the global economic recovery or macroeconomic shock. Because of the intensive policy changes going on in the health-care sector, health-care stocks aren’t necessarily impacted by the pace of the macroeconomic recovery. They are impacted by the government’s tinkering in specific areas, and that creates an investment environment where we have lower correlation in health care, and we have a higher dispersion of ideas, which is a really attractive setup for a long and short strategy.
Horejs: OK. How do those three opportunities affect your current portfolio construction?
Gregory: Well, what we first do, being a long/short fund, is ascertain what net exposure we should have. So, if we’re fairly pessimistic as to the macro backdrop for equity market, then we’ll have a lower net exposure. And if we are fairly bullish and enthusiastic, we’ll have a higher net exposure. Then we’ll drop down and look at the five major subsectors in health care, and those include health-care services, medical devices, pharmaceuticals, biotechnology, and then life sciences and tools.
As I mentioned, there is such a high dispersion of business outcome for each of the subsectors that it’s prudent for us to look at each and look at the fundamentals and make a tactical bet on the prospect for each. So, for instance, we may see pharmaceuticals as an attractive area of investment. We think that the market may be in a bit of turmoil over the intermediate term. With a pharmaceutical company you can acquire a 4% to 6% dividend yield, the stocks trade at 7 to 8 times forward earnings expectations, and the Street, for the most part, has mis-modeled the ability of these companies to deploy cash. So we may have a positive net exposure in pharmaceuticals, and indeed we do currently.
Now conversely, if we’re of the opinion that the U.S. government is under an excessive level of debt and one of the areas that they are going to tap to raise funds, to address that debt, will be health care, we have figured out that facilities, and specifically health-care services, are the transmission mechanism for that policy shift. What that means is that whether you are a hospital practice or a physician group in Peoria, Ill., if you serve Medicare and Medicaid patients, the government will pay you less for what you do. So, we have a fairly bearish outlook on health-care services and would have a negative net exposure in that space.
So just to give you a sense of how that matches up with particular names, in the pharmaceutical example we favor Merck. It’s a name that has about a 4.84% dividend yield. It trades around 8 times next year’s earnings, and the company just implemented a cost-cutting initiative that we think can bolster margins over the foreseeable future.
But interestingly, the company generates a lot of cash per year and is sitting on a lot of cash, and the Street hasn’t adequately modeled the ability of that company to deploy the cash either in the form of an increased dividend, the form of accretive acquisitions, or in stock buyback. So that’s an area that tactically matches up with our top-down theme and represents a fundamental bottom-up name that we find attractive.
Go back to the health-care service example, an area that we do not favor are skilled nursing facilities. Case in point, these are businesses that have around a 15% operating margin. The government one month ago announced a flat 10% cut to the amount that they receive for treating government patients. Now, when you consider a business that can’t offset those cost cuts by reducing headcount or reducing their operating expenses, a 10% cut to the top line could translate to a 67% decrease in earnings. So, it’s an example of an area that we’re cautious over, but it’s also an example of the trauma that government reimbursement cuts can affect on certain businesses.
Horejs: So lastly, let’s just discuss how an investor could incorporate a sector-specific fund like yours into their portfolio.
Gregory: I think there are two real areas. Number one is that our fund has represented to advisors, a natural complement to their health-care exposure and their core long portfolios. Secondly, and perhaps more significantly, advisors have seen this strategy as an attractive alternative investment strategy, due to the low correlation, due to the high dispersion, due to the strong activity going on in the space from an M&A perspective, and due to this intensive structural change that we acutely focus on.
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