RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

Archive for February 2010

Adverse Selection and the Decision to Sell UNH Today

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It has long been my belief that government could not afford to reform healthcare without the support of health insurance, due to the size of the government debt and the high level of government obligations today (increased military operational tempo, the financial crisis, reduced tax receipts, etc.).  I did, therefore, hold UNH through the market crash of the last several years and bought from $53 down into the $20’s.  With the stock now selling in the low $30s, I was prepared to hold until the market realized its error in judgment — despite a moderate paper profit.

That started to change on the 16th with the Anthem WellPoint decision to increase rates to self-insured customers in California by as much as 39%.  While this move produced ire among state and federal government officials and the company reversed its decision, disgust with the insurance industry played no role in my decision to sell UNH today.  Instead, a small article in the Wall Street Journal indicating that the California state insurance commission had previously approved the hikes pushed me toward selling.  That article indicated that the insurance commission initially approved the requested rate hike due to “adverse selection.”

Adverse selection takes place when high cost customers are desperate to maintain their insurance, cost increases reduce the pool of profitable customers, and the reduction in profits due to this shift prompt subsequent premium increases due to the less favorable distribution of un-profitable-to-profitable customers in the less-diversified pool.  This increase in premiums prompts the next-most price sensitive tier of profitable-but-cost-adverse customers to leave the pool, a further increase in premiums and the “death spiral” continues.  Employers dropping coverage for workers and the young and healthy purchasing high-deductable plans support this scenario and, in fact, worsen the problem.

Candidly, adverse selection had been a concern of mine since teaching a third-party payers class as far back as 2005 (its in the PowerPoints and lecture notes), and, on the 16th, I mentioned this concern to my current students during a health policy discussion, but, despite these concerns, I held off selling the one healthcare insurer in my portfolio — UNH.  With the stock increasing in value, the trend is your friend for a stock which is undervalued based on nearly every backwards-looking measure, and the price held up well despite the Anthem news.  Then Paul Krugman (Nobel Prize winner in economics, Princeton Professor, NY Times columnist, and avowed liberal) published an Op-Ed describing the Anthem situation as the start of the Death Spiral of health insurance.  Since Krugman is politically unpopular among conservatives, I continued to hold the stock — believing the market would ignore the physics of adverse selection, and, indeed, the stock was up nearly 4% yesterday, even though President Obama announced administration desires to have the federal government take over the role of state insurance commissions and regulate premium increases.

For the record, it was the President’s announcement that pushed me over the edge, but not out of partisan political concerns.  Instead, I took the measure of the administration’s grasp of the healthcare market and came to the conclusion that not only are both parties clueless when it comes to healthcare, they are determined to execute the worst possible policies — targeting for cuts those areas of healthcare which government studies indicate contribute little to healthcare inflation while leaving unaddressed those areas constituting the most significant drivers of healthcare inflation, all under the guise of addressing cost inflation that threatens to bankrupt Medicare as soon as 2015.  This is akin to beating one child for the sins of his sibling, hoping the carnage will somehow reform the sinner.

Without going into great detail, patent-protected advances in medical technology is, according to Congressional Budget Office research, the leading driver of healthcare inflation — not doctors, hospitals, insurance, or patient lifestyle issues.  This is borne out by a review of current profit margins for the industry’s sub-sectors (you can find this in Yahoo! Finance).  So, pooling insurance across state borders, requiring every American to buy health insurance, cutting compensation to doctors, increasing taxes on alcohol and tobacco, and all of the other popular “solutions” offered by both parties miss the target if not addressing medical technology as the leading catalyst of healthcare inflation.

This means, as investors, you want to avoid the in-the-cross-hairs subsectors of healthcare (doctors, hospitals, insurance) and wager, instead, on Washington stupidity — which has been an abundant and reliable commodity since Will Rogers amused his depression-era audiences as the keynote act on Broadway in Zigfield’s Follies in the 1930s.  That stupidity includes Bush-administration orders that eliminated patent extensions for novel therapeutics coming out of the pharmaceutical industry, during 43’s first term.  This had the effect of shortening the period of product viability from 8 years down to less than 5 and increased the need to churn new products into the market at a faster pace.  This, in turn, pushed the industry to target blockbuster breakthroughs (rather that spend on research leading to incremental advances), and this strategic constraint promoted the product pipeline withering that now threatens Pfizer and others — leading to industry consolidation.  While I have a small position in PFE, I don’t recommend traditional big-pharma; again, due to bi-partisan ignorance.

So, which areas of healthcare are promising as investments?  Personally, I like generics (TEVA and FRX, with FRX continuing to represent a value play now that TEVA has appreciated in value), and research/efficiency-enhancing companies, such as PPDI and SLP (both continue to be value stocks, despite SLP’s 60% increase over the past year).  JNJ and PG, as anchor holdings, provide exposure to healthcare, quality management, and product and international diversification (Buffett’s recent reduction in JNJ and PG enabled his purchase of BNI and may not represent a loss of support for either stock).  And, with an assortment of patent-protected medications becoming generics over the next several years, CVS and WAG strike me as attractive — especially, WAG, now that CVS has had a nice increase.  Bio-med may be attractive for those who are able to leave the gaming tables of Las Vegas long enough to ante-up on this sector (sorry, but wagers based on phase I or phase II trial results is gambling to someone who seeks to invest based on more reliable measures of wealth generation).  Nevertheless, bio-med products, due to the newness of the sector, make subsequent, FDA-approved products less exposed to formulary constraints when patient and physician rub noses in clinic settings.  Finally, WMT, which sells car batteries, canned goods, and produce with its pharmaceuticals, is moderately undervalued and enjoys great economies of scale and heft — such as the scaly and hefty Sam’s Club worker who refused to let me create a mixed case of wine this past weekend and will, no doubt, be running for elective office in the near future (with an eye toward influencing national health policy).

I should mention that PPDI and SLP are smaller-cap companies and may not be covered by the Fool system.

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In a comment/note, SC asked about FCX, and I promised to post the stock price sensitivity tables.

ROC = Return on Capital

G= Growth

Percent chart assumes current price of $31.75.

Written by rcrawford

February 24, 2010 at 9:00 am

Posted in General, Investments

Investments Update — 2/18/2010

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On the 14th and 22nd of January, blog postings here asserted the market was at fair value (neither insanely cheap nor alarmingly expensive) and that this presented a shopping opportunity if inclined to believe the 11 of 13 leading economic indicators and conclude that we are in a sustainable (if not sluggish) recovery.  Having sold significant positions in FCX, PCU, BHP, and HANS for profits and having maintained around a 50% position in cash, I was, both, pleased and disgusted with my behavior during the market crash (buying on the way down, including a short ETF, making a few strategic buys near the bottom, and keeping way too much in cash during the rebound).  As indicated on the 14th and the 22nd, I was shopping, and, while time does not allow me to explain each (or the multiple purchases involved in building each position), to delay listing them any further would deprive regular readers of the opportunity to consider this group.

Before doing so, I should mention that my cash position is now down to 24%, which I’m maintaining due to the market’s uncertainty (soverign debt, roll-over of option-ARM and Alt-A morgages, etc.)  If, like 1933, the market experiences an encore crash (as it did after 1929), it will be easier to quickly throw on a hedge than to sell selectively and expect my wife to hide the sharp objects laying around the house.  Indeed, I am giving serious thought to taking some profits and selling some persistent laggards in order to increase that cash position moderately.

Additionally, I’m noting the amount each position has increased (on a weighted basis) since purchase.  While each new position strikes me as still under-valued, several have witnessed price appreciation that reduces the degree to which they are selling at discounts to intrinsic value.  Consequently, fellow deep-discount value-investors will want to give even greater scrutiny to those that are up significantly in the past several weeks.  This is especially important for the large-caps that are, either, new additions or increases to pre-existing positions, where the required margin-of-saftey is less significant than for the small-caps on the list.  The large-caps serve as stabilizing, core positions, which, due to the abundant analysis given them by the Wall Street professionals, suggests they are less likely to evidence dramatic volatility due to mis-pricing.

Lastly, I am aware that Warren Buffett has decreased positions in JNJ, XOM, and PG as I was adding to each and that we were both adding to DIS and WMT (actually, he was adding while I was starting positions), and I am aware of WMTs “disappointing” earnings announcement today.  Candidly, Warren didn’t consult me and, while I didn’t make the attempt, I doubt he would have taken my call if I had sought to consult him.  More importantly, for the life of me, I don’t understand why he (or the 20+ surrogates which invest on behalf of Berkshire subsidiaries) make many of their buy and sell decisions.  I considered the trash collections stocks recently (trash collection never goes out of style and they often enjoy monopoly status in many locals) and didn’t care for any on a valuation basis.  And then there is that Kraft (KFT) position.  Call me “clueless” because that is as accurate a description as any when it comes to making heads or tails of the Oracle’s decision.  I just don’t see the margin of safety there.

In any event, here is the portfolio (in two graphics).  On a weighted basis (since purchase of each), they are collectively up 7%.  Since the market top in 2007, the portfolio is up 37% (better than the indicies but unlikely to impress the best hedge fund managers).

And

[As always, consider the source when reviewing this history of my investing life.  It is designed to be a journal of my successes and failures as a non-professional — a candid assessment –, rather than an inducement for others to follow suit and contribute to my cause or enrichment.  This blog has fewer than 100 visitors per day, and many of those come for the articles related to subjects unrelated to investments.  So, there is nothing about this effort that stands a realistic chance of moving the market in my favor.  This blog, in other words, has no bandwaggon effect, unless considering Robert (me) playing a kazoo to constitute a symphony of one.  Equally, important, it is expected that any investment choice made by the reader represents an adult decision (whether consistent with my views or at odds with it), and that the reader is prepared to take responsibility for each when clicking the “execute” button to place a trade.]

Written by rcrawford

February 18, 2010 at 11:49 pm

Posted in General, Investments