Profit from Health Reform's Flaws

10/13/2009 9:20 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Even as success looms for the proponents of reform, hidden costs are conspiring to torpedo any savings from health care legislation. Here are five stocks likely to benefit.

The Senate Finance Committee today approved a health care reform bill cobbled together by Montana Senator Max Baucus. And it's all but sure, thanks to a Congressional Budget Office report last week, that something like the bill—or a stronger version—will pass the full Senate and House by the year's end.

What you and I as investors now want to know is what stocks are going to make money from health care reform. I'll give you five ideas by the end of this column—one of which I'll add to my Jubak's Picks portfolio.

Let's start with what we're reasonably sure any bill is going to do, and then I'll explain how the economics of "externalities," a type of hidden cost caused by external factors (explained more fully in my October 6 post) are going to create some surprising winners by undermining the bill's efforts to control costs.

  • We know health care reform is expected to extend coverage to 94% of all Americans, up from 83% now. That's an extra 29 million Americans. But it's not everyone. According to the Congressional Budget Office's count, 25 million people who live in the United States, including 8 million illegal immigrants, still wouldn't have health insurance.
  • We know it's supposed to cost $829 billion over ten years.
  • We know the budget office said last week that the bill would actually reduce the budget deficit by $81 billion over the next ten years. Previously, the argument against the bill that most resonated with voters, if you believe the polls, was that it was so expensive that the country couldn't afford it. Republican senators opposed to the bill, which meant every Republican senator not from Maine had been so sure that the budget office would say this bill would add to the deficit that they had labeled the budget arm of Congress an honest scorekeeper. So when the agency said the bill would actually reduce the deficit, the Republicans' "costs too much" strategy was left in tatters.
  • And we know this bill would shift costs and profits around like crazy. At least that's what it's intended to do. The budget office's math assumes intentions are realities. Investors do that at their peril.

On paper, a whole lot of money would go to the insurance and health care industries. The government would spend $461 billion over ten years to give tax credits to people so they could afford insurance. It would also spend $345 billion to expand Medicaid insurance to cover more of the poor.

Giving with One Hand, Taking with the Other

But the bill—still on paper, mind you—also would take money away, sometimes from the same groups that it handed profits to just a subsection before. So the bill proposes wringing $404 billion in waste out of Medicare and other government insurance programs. That means the very drug companies, hospitals, doctors, and in some cases, insurance companies that benefit from having 29 million more Americans with health insurance. An additional $201 billion would come from taxes on what are being called Cadillac insurance policies. (Isn't it nice that Detroit's cars are still the symbol of luxury somewhere? The fight over what's a Cadillac and what's a Taurus is going to be especially vicious.)

Billions more will come from a grab bag of fees on insurance companies, medical device makers, and drug companies, and a change in the treatment of medical expenditures come tax time.

The battle over exactly how these pluses and minuses would be distributed is going to engage Washington's best lobbyists for thousands of very expensive billable hours. Already the hospital industry has said the bill wouldn't cover enough of the now uninsured to justify the deal it made to give up $155 billion in government payments.

Expect the haggling to reach epic proportions.

Costs That Aren't Immediately Apparent

But "externality economics" tells us to look at what's not on the table.

The external costs of the American diet aren't on the table, for example. Producing heavily refined foods that are high in fats and sugars results in a variety of external costs. Just to pick on one example, adult-onset (type 2) diabetes has a genetic and a dietary component, according to the American Diabetes Association. If you have a genetic predisposition to diabetes, eating what the association calls a Western diet is a great way to trigger it.

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No wonder, then, that diabetes is one of the fastest-growing diseases in the United States. From 1996 to 2003, the number of U.S. adults with diabetes climbed to 13.7 million from 9.9 million, according to the Department of Health and Human Services' Agency for Healthcare Research and Quality.

In those same years, the annual cost of treating a person with diabetes soared to $1,714 from $1,299. Do the math: The bill for this disease was $23.5 billion in 2003, up from $12.9 billion in 1996. That's an increase big enough to eat up health care reform's projected savings of $81 billion over ten years.

And the diabetes problem has gotten worse since 2003. The American Diabetes Association now estimates there are 17.9 million people in the United States with diagnosed diabetes. (An additional 5.7 million, the association says, are undiagnosed.)

That's just one example of the massive externalities affecting health care. You can, I'm sure, come up with others.

If Only We Had Thought About This Sooner…

I haven't yet mentioned the biggest externality: Aging. It's a good thing that we're living longer. I'm personally very much in favor of it. If there were an election, I'd try to stuff the ballot box in favor of living longer.

But there's a huge difference in cost between living a longer, healthy life and simply living longer. The second imposes huge costs on the health care system that are a result of decisions that we made decades earlier. We never cost out those decisions. There's no economic method for doing so. Yet deciding to smoke or drink or not to exercise or to eat more steaks and less broccoli all impose end-of-life costs.

I bring this all up not to lecture you on the need to eat your vegetables or on the evils of corn syrup.

I merely want to point out that these societal decisions impose huge external costs that have to be paid by someone. The bills before Congress would shift existing, well-measured costs around, but they don't even begin to address the need to take some of these externalities into the day-to-day or year-to-year cost of doing business or living.

And because these bills don't, they're doomed to long-run failure. The externalities that we can already see—and ones that aren't on the radar screen now—are going to eat these bills and their estimates of costs and cost savings alive.

So what does this mean for you as an investor? Three things:

  • These bills would set up a cost-containment strategy that would fail in the not-so-long run. The process of failing won't be quick or pretty. The government will keep attempting to maintain a lid on the ever-increasing bill for these externalities by putting more pressure on hospitals and doctors and drug companies and device makers. Margins in these industries, under pressure for a decade, are going to face even more pressure in the years ahead. If you buy these stocks on the health care bump, don't fall asleep with them in your portfolio.
  • Companies that are in the business of treating patients created by these externalities will face the same cost-cutting pressures, but the epidemic of disease in these areas will keep profits growing faster than bureaucrats and politicians can cut costs.
  • Companies that can deliver simple and easily understood cost-cutting products or strategies will prosper during this battle. They will be seen as the good guys by anybody trying to cut a cost.

Externality economics pushes me toward stocks such as generics giant Teva Pharmaceutical Industries (Nasdaq: TEVA), diabetes drug and hormone developer Novo Nordisk (OTC: NONOF), low-cost pharmacy and clinic operator CVS Caremark (NYSE: CVS), physician-to-patient information provider WebMD Health (Nasdaq: WBMD), and orthopedic replacement parts maker Zimmer Holdings (NYSE: ZMH).

I'm going to add Teva to Jubak's Picks with this column. I'll have a full write-up of the logic to that pick and my target price in an upcoming blog post.

At the time of publication, Jim did not own or control shares of any of the companies mentioned in this column.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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