A Crutch for Your Portfolio

08/27/2009 11:48 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns and John Gabriel of Morningstar ETFInvestor highlight a medical-devices ETF insulated from the vagaries of health-care reform.

Investors seeking exposure to health care but who are concerned about the uncertain regulatory environment and the potential impact that health-care reform might have on the sector could find iShares Dow Jones US Medical Devices (NYSE: IHI) to be a suitable pick. In our view, the medical-device industry should be pretty well insulated from many of the cost-cutting pressures likely to come about as a result of health-care reform.

Health-care needs aren’t tied to the economic cycle, so demand for medical equipment tends to be steady. Furthermore, an aging population and fast-growing markets abroad have spurred demand for cardiovascular and orthopedic devices as well as patient care and diagnostic instruments. This, coupled with continued product innovation, should ensure that holdings such as Medtronic (NYSE: MDT) and Stryker (NYSE: SYK) continue to churn out double-digit cash-flow growth and returns on capital.

According to Morningstar equity analysts, the potential ripples that health-care reform casts across the medical-device industry could be more bark than bite at this point. The single-payer system that has the health-care sector reeling is an issue that the device manufacturers have already been dealing with. Approximately two thirds of implants for total knee replacement and 80% of cardiac rhythm management devices are reimbursed by Medicare through the Part B program. However, manufacturers do not negotiate directly with Medicare. Thus, the single-payer effect is mediated through the provider network: hospitals and ambulatory surgical centers. Device makers negotiate with individual hospital chains or their group purchasing organizations, which often gives the manufacturers a bargaining advantage because there are only a limited number of device makers in the business and typically a more fragmented group of customers.

The weak customer buying power of hospitals is exacerbated by divisions between the administrators tasked with keeping hospitals out of the red and specialist physicians who operate as free agents. Device manufacturers have long exploited this division, and as long as certain specialists continue to generate profits for the hospitals, we expect physicians to win this game of chicken.

At this point, our equity analysts think that it is highly unlikely that the Centers for Medicare and Medicaid Services would insert itself and directly negotiate with the device manufacturers. This type of centralized approach would likely have physicians up in arms. It is more likely that Medicare would simply reduce its bundled reimbursement to hospitals and leave it up to the hospitals to figure out where to squeeze out the savings.

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