Value Investing In HMOs


HMOs appear to be perfect stocks for today’s market. They have good balance sheets, terrific free cash flows and recurring, highly economics-insensitive revenues. The global macro stuff doesn’t really affect them. Greece could be abducted by aliens, Spain could go to war with Finland, and we’d all still be getting sick and buying health insurance. Rising unemployment and underemployment might put a small hole in my rosy thesis, but no worries: With 10,000 baby boomers signing up for Medicare every day and expected to do so for the next decade, that hole will patch easily.

What intrigues me the most about these companies is that they are misunderstood by investors. Though we call them health insurers, they are not really insurance companies, at least not in the true sense of the term. Yes, they take premiums up front and pay out medical costs over time, but they are actually health care logistics companies — they pass on health care costs to their customers. They are only insurance companies if an investor’s time horizon is a few quarters, because once in a while they’ll misprice the risk and their profitability will stutter. However, since they reprice their business every 12 months, the mispricing will be fixed at the next renewal. Even in their worst years, HMOs still make a lot of money.

During the 1990s, HMOs tried very hard to manage rising costs, even as their reputation was undermined (in John Grisham’s 1995 bestseller The Rainmaker, an insurance company played the villain). Since then the industry has gone through a transformational consolidation that has helped it to achieve significant economies of scale and more-rational (less competitive) pricing. HMOs stopped fighting rising health care costs and embraced them; they just pass them on, dollar for dollar, to the customer. In fact, they woke up to this little realization: Health care inflation is their friend ­— it drives revenues and thus profitability.

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It is also assumed that there is a constant political risk with HMOs. True, politicians love to hate HMOs, especially in their speeches and presidential debates. You pick up a lot more voters when you go after “evil” HMOs than when you embrace them as the most cost-effective alternative. Despite all the negative rhetoric being spit out by spineless politicians, HMOs are not going anywhere. They are deeply integrated into our health care system — they are our health care system.

And here is the most ironic part: Even if political rhetoric in the pursuit of cost savings spilled over into fierce action, and HMOs were euthanized and their profits were nationalized, the U.S. would save only about $13 billion a year (the total profitability of the HMO industry). Though it sounds like a fair chunk of change, that’s only 0.6 percent of our total $2.2 trillion in health care costs, or a few months of health care inflation. And to provide logistical health care services, the government would have to make a sizable investment (probably over $100 billion) and take over administration of health care. The $13 billion that HMOs currently earn would look like a promised land that the government would never reach.

Let’s face it, government is good at doing some things, like running courts and the military. But due to misaligned incentives and inherent bureaucracy, government will never be as efficient as for-profit enterprises. This is why the U.S. prospered and the Soviet Union disintegrated.

In the first two years of the Obama presidency, HMOs faced uncertainty as to whether Obamacare would even let them survive. Now that the impact of Obamacare on HMOs is for the most part known and uncertainty has turned into certainty, the companies will enjoy an influx of customers, courtesy of the U.S. taxpayer, but with them will come lower margins. Net-net, Obamacare should not have a significant impact on their business. But HMOs are priced as if the Obamacare outcome were still uncertain — they sport single-digit price-earnings ratios on earnings that are continuing to rise and that have grown into the mid-teens over the past decade.

Since I started this article without an introduction, I’ll finish without a conclusion — or at least without recommending any specific companies, as the entire HMO industry looks attractive.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

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I was born and raised in Murmansk, Russia (the home for Russia’s northern navy fleet, think Tom Clancy’s Red October). I immigrated to the US from Russia in 1991 with all my family – my three brothers, my father, and my stepmother. (Here is a link to a more detailed story of how my family emigrated from Russia.) My professional career is easily described in one sentence: I invest, I educate, I write, and I could not dream of doing anything else. Here is a slightly more detailed curriculum vitae: I am Chief Investment Officer at Investment Management Associates, Inc (IMA), a value investment firm based in Denver, Colorado. After I received my graduate and undergraduate degrees in finance (cum laude, but who cares) from the University of Colorado at Denver, and finished my CFA designation (three years of my life that are a vague recollection at this point), I wanted to keep learning. I figured the best way to learn is to teach. At first I taught an undergraduate class at the University of Colorado at Denver and later a graduate investment class at the same university that I designed based on my day job. Currently I am on sabbatical from teaching for a while. I found that the university classroom was not big enough for me, so I started writing and, let’s be honest, I needed to let my genetically embedded Russian sarcasm out. I’ve written articles for the Financial Times, Barron’s, BusinessWeek, Christian Science Monitor, New York Post, Institutional Investor … and the list goes on. I was profiled in Barron’s, and have been interviewed by Value Investor Insight, [email protected], BusinessWeek, BNN, CNBC, and countless radio shows. Finally, my biggest achievement – well actually second biggest; I count quitting smoking in 1992 as the biggest – I’ve authored the Little Book of Sideways Markets (Wiley, 2010) and Active Value Investing (Wiley, 2007).

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