Investing in Health Care: The Threat & Opportunity of The Decade Ahead
If you invest in any health care related company today, you have to prepare for less and less money being spent in the sector in the years ahead. The United States economy faces a massive financial challenge to figure out how to provide for the health of our citizens and almost all potential paths to surmounting the challenge result in less revenue flowing to the health care sector.
This chart shows that far from a common problem, US spending on health care is out of control and an anomaly on the global stage.
What the chart shows is that the United States is a massive outlier compared to the rest of the world when it comes to the efficiency of our health care spending. While the US spends far more per capita on health care than any other country, the life expectancy of our citizens puts us solidly in the middle of the pack and on par with far less developed economies such as Chile.
To get a sense for the degree of inefficiency in our health care system, the arrows on the chart above show different ways that our health care system could return to the spending/life expectancy curve that characterizes the rest of the world. The green line shows that the US should be able to increase life expectancy from 78.5 years to a best in the world 84.5 years without any increase in our health care spending. The red line shows that alternately we could slash health care spending by 65% while still maintaining our current life expectancy. The orange line points to what many people would see as the optimal outcome; cutting health care spending by 30% while increasing life expectancy to 82.5 years, in line with Switzerland and Norway, two countries that lead the world in life expectancy.
Life expectancy isn’t the only metric to gauge the quality of health care. But the chart below shows that the US ranks poorly on a range of health outcomes measures. We feel confident that no matter how it is measured, the US is spending far more per capita than any other country while receiving lower quality care.
A reduction in health care spending seems almost unimaginable after years of runaway cost inflation, but the fact is that the high level of spending on health care in the US is a relatively new phenomenon. As recently as 1990, US health care spending as a percent of GDP was 30% lower than it is today, in line with the reduction described above that could be achieved consistent with delivering best in the world life expectancy levels.
Spending as a percent of GDP has increased around the world since the end of World War II. So increasing spending is not a U.S. only phenomenon. But during the last 25 years, the rate of growth in the US has far outstripped other developed economies, even while it has done little to increase the quality of care.
The impact of the inefficiency in our health care system is not limited to health. Government spending on health care is the #1 driver of the federal budget deficit and our growing debt load. So the inefficiency of the health care system is having a major negative impact on our economy. In fact, the issue is so large and urgent that it would not be an exaggeration to say that bringing the efficiency of the US health care system back in line with the rest of the world is the single most important thing our country could do to improve the long-term outlook for the US economy.
If you’re not convinced by the big picture data, check out this New York Times article from a couple of years ago detailing how in our health care system a single stitch can cost $500, Tylenol can cost $37 a pill and a bag of IV fluid can be marked up 13,600%. And see this article showing how if you go to the wrong hospital, you are three times more likely to die. There is little doubt that the US health care system is incredibly inefficient and exacting a huge cost without delivering commensurate value.
The problem for health care companies, as far as investors are concerned, is that the past 60 years have been characterized by the sector receiving a larger portion of GDP, with the last 25 years seeing US health care companies receiving a percentage of GDP that is far larger than in any other country. Should this trend be reversed, it means that for the next generation health care investors may well operate in an environment where health care spending contracts as a percentage of GDP, creating significant headwinds for health care stocks.
This chart shows the performance of the S&P 500 Health Care Sector vs the S&P 500 over the past twenty years. Investors who have enjoyed these market-beating returns need to realize that those returns were generated at least in part due to the American economy devoting an ever-growing share of total spending to the sector.
At Ensemble Capital, we don’t know exactly how the health care system will need to change to reign in cost inflation. But we do think that the decade ahead will be characterized by forces throughout the economy working to hold back health care spending creating a massive headwind for many health care companies. If solutions are put in place that bring health care spending back in line with a percent of GDP that falls along the curve in the chart at the top of this post, it will mean huge amounts of potential health care company revenue draining out of the sector.
But this does not mean that all health care companies will face tough times. Since the current inefficient system both costs too much and delivers inferior outcomes for patients, there is an enormous opportunity to both reduce health care spending while also improving the health care that Americans receive.
As we look at the health care sector for potential investment opportunities, we believe investors must apply a two-fold test to any company, 1) does this company’s products and services help reduce system-wide spending and 2) do these products and services improve patient outcomes?
This is not an easy test to pass. Many companies sell products and services that are helpful but do not deliver good value. Other companies might appear to reduce costs, but they do so by short changing patient health. But some companies deliver true value to the health care system. These are the companies that we believe will thrive in the years ahead.
While there are important political debates about the best way to structure our health care system, there is no constituency for continued increases in health care costs nor for reducing the quality of care. Consumers, employers, and the government are all under severe financial stress due to runaway health care costs while at the same time they receive inferior health care outcomes. Companies whose products and service perpetuate the current dysfunction are not likely to produce superior investment results for investors in the years ahead. But companies who can help fix the problem will be handsomely rewarded.
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