Investment Outlook - Third Quarter 2015

Second Quarter Review

Wedding Season for Health Care Companies

The fiery drama being played out in Greece has roiled Europe but not the cool heads leading corporations around the globe. Love is in the air in corporate boardrooms as evidenced by a record level of merger activity. Corporate marriages are occurring in virtually every industry from energy to telecommunications to semiconductors. But no sector has witnessed as much activity as the health care area.

Mergers are occurring in every nook and cranny of the sector. Publicly traded companies are buying both publicly traded and privately held companies. Most well-known health care companies like Merck are taking a measured approach to potential partners, but two less familiar names, Valeant and Actavis, are more aggressively wooing partners. Valeant has made over 60 acquisitions in the past 6 years. Their mates have included the likes of Bausch & Lomb, Medicis Pharmaceutical, and Salix Pharmaceuticals. Actavis has captured Allergan (actually the new name for Actavis), Forest Labs, and Warner Chilcott. The two serial acquirers have actually solicited the same target at times. The factors behind the consolidation wave are common across corporate America. Low interest rates, high stock prices, and excess cash have enabled buyers to successfully romance their targets. As long as these catalysts remain in place, the merger wave is likely to continue.

What is driving all this activity, particularly in health care? For starters, it covers a huge expanse of the U.S. economy. Health care remains a large, fragmented sector with only isolated segments of concentration. As a result, there are a lot of potential partners on the dance floor. And, most importantly, size matters more and more in the current health care environment. The major providers, namely hospitals and physicians, are consolidating in order to increase their ability to set prices. More and more doctor practices are being acquired by hospitals, and more and more hospitals are acquiring other hospitals

As the American population ages, the number of Medicare patients is rapidly increasing and Medicare rates are lower than the prices that privately insured patients pay to the providers. The so-called "affordable care act" has also increased the number of insured patients covered by Medicaid, where rates are also low. Providers feel the pressure and size enables them to fight back. One way providers protect themselves is to charge higher prices from patients with private insurance. The insurers and their customers -- corporations and employees -- do not like higher prices. Health insurers are responding by consolidating, which results in considerably larger patient bases -- the most powerful bargaining chip they have. The net result is providers are getting larger in order to better negotiate with large insurers and government agencies.

There is currently a flurry of activity in the health insurance group, where the four largest insurers are in various stages of courtship. In early July, Aetna announced a $33 billion acquisition of fellow competitor Humana. Not to be outdone, Anthem has reportedly offered $47 billion for Cigna. UnitedHealth, the largest of all health insurers, is rumored to be eyeing both Aetna and Cigna. Meanwhile, a smaller Medicaid insurer, Centene, just announced the acquisition of fellow Medicaid insurer HealthNet for $6 billion. Has Centene taken itself off the dance floor by acquiring HealthNet? Who knows in this heated environment? State insurance regulators are sure to question what the impact of these mergers will have on individual premiums, and the Justice Department could move to delay or break off these courtships. If not, the government may be giving tacit approval for insurers to add bulk in order to better bargain with hospitals and doctors -- the largest sources of healthcare spending.

Getting bigger and bargaining better are not the only reasons for the fevered activity. Most of the large health care companies, like all large companies, are struggling to find ways to grow revenues and earnings in such a subdued global economy. The creative financial managers within these companies have increased dividends, bought back stock and cut costs to increase earnings. Why not take the next step and acquire another revenue base and eliminate duplicative costs? Valeant and Actavis have both acquired companies in low cost tax regions and used these regions (e.g. Bermuda, Ireland, Canada) to improve the returns on acquired assets. In other cases, these acquisitions are driven by interest in an existing drug therapy that complements or broadens the acquirer's marketing effort. And finally, the acquisitions are driven by the search for new, early stage potentially breakthrough products that can be sold for high prices. Whatever the logic, the end goal is to increase earnings and stock prices.

The Health Care Sector Benefits from the Merger Wave

What are the investment implications, if any, of this health care merger wave? For one, it has been great for the performance of not only the acquired companies but also the acquirers -- Valeant and Actavis have been standout performers so far. The health care sector has been far and away the best sector in the market over the past three years. The S&P 500 health care category has advanced over 100% over the past three years compared to 70% for the broad market. By no means has the outperformance been driven solely by the merger wave. Some of the stock performance can be accounted for by the relative earnings strength in the sector compared to other sectors. Additionally, performance can be attributed to plain old animal spirits -- in the seventh year of a bull market; investors cannot resist sexy, new biotechnology stories. Biotechnology stocks, in fact, have actually benefitted from that wonderful investment twofer: new sexy product outlooks plus the possibility of being acquired. Celgene just announced the $7 billion acquisition of Receptos, which has two potential billion dollar drugs for multiple sclerosis and ulcerative colitis.

Similar to the broader market, the prices of stocks within the major health care sectors have advanced more than earnings. As a result, the valuations throughout much of the sector, just like the market, are considerably higher than a few years ago. At the current time, we do not see enough evidence that would cause investors to lose their enthusiasm for the sector, but there are a few developments that are worth monitoring. For one, the Federal Trade Commission has nixed several hospital deals based on the notion that they have become de facto monopolies in their respective geographies. The government has also begun to challenge the tax-advantaged takeovers made popular by Valeant and Actavis thereby putting up more hurdles for acquirers who are using tax driven strategies. At the grass roots level, both insurers and doctors are more openly challenging the high prices and effectiveness of many new, high cost drugs that have been key drivers for company earnings. This grass roots effort is sure to intensify as more and more expensive drugs hit the market. Finally, it would not be surprising if drug prices and higher insurance premiums and co-pays will become major issues in Presidential debates. Very few politicians can resist the urge to lambast drug companies and insurers.

We continue to monitor the health care sector closely and invest opportunistically in the area. It is a dynamic sector, critically important to consumers, businesses, and governments alike. Some of these companies have created breakthrough, life-saving products. Their science is world class. Their corporate missions are often unassailable. There is a whole new class of very effective oncology drugs on the horizon. The same is true for new cholesterol lowering drugs. And, there are many diseases, including Parkinson's and Alzheimer's, which are not currently effectively treated but are being aggressively researched in labs. These companies pour a lot of money into research and development activities with long periods of experimentation and trial. Many costly efforts prove fruitless. Acquisitions are just one part of their corporate plan, but it appears to becoming a more important part. Corporate history suggests that acquisition activity ebbs and flows. In health care and corporate America at large we look for the merger wave to continue to flow right through the end of this year.

Bob Milnamow
President and
Chief Investment Officer
July 2015