A few weeks after Donald Trump was elected president of the United States, he was asked about pharmaceuticals prices. With typical rhetorical gusto, he declared, “Pharmaceutical companies are getting away with murder.” Well, my firm has been increasing our allocation to those “murderers,” and despite Mr. Trump’s comments, we are very comfortable with our positions in the long run (which lies beyond what may end up being a very volatile short run).
Pharmaceuticals companies check off a lot of boxes in our quality and growth dimensions. They are usually monopolies or oligopolies when it comes to their specific drugs; they have high recurrence of revenue; their business is not cyclic and thus marches to its own drummer; they have strong balance sheets and a high return on capital, and generate a lot of cash flow; they benefit from a significant growth tailwind as the global population ages (I aged just while writing this); and they enjoy pricing power (more on that later). Yet the pharmaceuticals sector as a whole has been decimated over the past eight months due to perceived political risk — first by pharma pricing critic Hillary Clinton’s “It’s in the bag” expectation of victory and then by Trump’s “They get away with murder” comments. We view the carnage created by the political risk as an opportunity to increase our exposure to this sector. Here is why.
President Trump mentioned that he wants the U.S. government — mainly, its Medicare program — to negotiate directly with drugmakers on price. His remark may create the impression that pharmaceuticals companies today charge the government whatever prices they want. That is not the case. Medicare covers prescription drug costs through a program known as Medicare Part D. Medicare basically outsources the negotiation of drug prices to pharmacy benefit management (PBM) companies such as CVS, Express Scripts, and UnitedHealth Group (a health insurance company that owns its own PBM). In fact, less than a handful of PBMs control this market and so exercise tremendous pricing power; thus the government is already negotiating with pharmaceuticals companies.
Here are some useful stats about this market: As of the end of 2015, 290 million Americans had health insurance. Among them, 214 million had private insurance and 52 million were insured by Medicare. Medicare insures a lot of people; however, UnitedHealth — a company whose business model relies on paying as little as possible for prescriptions — insures 70 million Americans and thus already has greater bargaining power than Medicare.
But let’s say President Trump gets his wish, the law is changed, and the government bypasses PBMs and starts bargaining with Gilead Sciences, Amgen, and Allergan directly — the Trump take-no-prisoners approach. Let’s even assume that President Trump’s ingenious negotiating techniques result in a 20 percent concession on price. Since Medicare represents only 18 percent of the total insured population, the net impact on pharmaceuticals companies’ revenue would be 3.6 percent. That’s a small pimple that they’d be able to cover up by raising prices 4 percent on the remaining 82 percent of payers.
The reality is that the reason Europeans and Canadians are paying much lower prices for their prescriptions is that they have a single-payer system, and thus pharmaceuticals companies are bargaining not with four or five entities but with one: the government. At this stage, however, it is very unlikely that a Republican president and Republican-controlled Congress will move this country to a single-payer system.
If the U.S. starts allowing reimportation of pharmaceuticals from Canada and Europe — another threat made by our president — then American companies will simply start raising prices outside of the United States.
Finally, let’s remember an important but often forgotten fact: Donald Trump is the president of the U.S.; he is not its king and doesn’t have the powers of one. Although we expect his tweets and other remarks to create additional volatility, they will not necessarily have a symmetrical impact on pharmaceuticals companies or whatever other businesses he tweets about.
We have taken advantage of price weakness and added to our positions in Amgen (analysis here), Allergan (analysis here), and Gilead (analysis here). We also bought some new positions. Stay tuned for next week, when I’ll reveal those names.
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Music note from MyFavoriteClassical.com
Today I wanted to share with you an incredible but forgotten gem: Concert Fantasia by Tchaikovsky. Tchaikovsky composed it in 1884, and it was very popular for about twenty years, then virtually disappeared from the public repertoire for a hundred years, until the late 20th Century. The reason for its disappearance escapes me – I’ll let you be the judge, but I think it is Tchaikovsky’s finest work.
Concert Fantasia is basically a concerto for piano and orchestra that doesn’t follow traditional concerto rules, as it has two movements instead of three. It seems to me that it’s the piano concerto that Tchaikovsky always wanted to compose. Tchaikovsky hated the sound of piano and orchestra together. About four minutes into this concerto the orchestra stops playing and the piano goes into a solo mode for more than nine minutes. Come to think of it, maybe this explains why this concerto disappeared for so long – conductors did not want to conduct it and musicians did not to play it. Concertos are usually a team sport of a solo instrument and orchestra – this one is not. I don’t know a single concerto where the conductor and whole orchestra sit on their hands and watch a solo piano go on an exploratory journey for almost a third of the concerto.
Previously I discussed Franz Liszt’s contribution to the modern piano – mainly his transformation of piano technique and creation of new, more technically demanding music for the much-improved piano. I argued that without Liszt the music of Grieg, Rachmaninoff, and Brahms would sound very different. I should add Tchaikovsky and especially this concerto to this list. Close your eyes and listen to the solo piano part – at times this instrument sounds like a complete orchestra (this is post-Liszt new music for new piano).
Article By Vitaliy Katsenelson, CFA – Originally written for Institutional Investor Magazine
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).