Monday, December 21, 2009

One for the Ages: Health Reform Will Take Years to Unravel

As the Senate readies final passage of its version of the health care bill, the country now focuses on the House, and alterations its members might propose in conference committee. Any material change could jeopardize agreements among Senate Democrats, and the bill itself.

Those odds appear quite low, however. Enactment is expected before the president's State of the Union address in January.

In the end, old-fashioned politicking will have enabled the largest health care overhaul in a generation. The Republican party, simply, had little ability to stall a filibuster-proof super majority, other than attempt to win over moderate Democrats and blunt some of the legislation's more pointed provisions.

Applying lessons learned from the past, including the first Clinton administration's attempt at health reform, the Obama administration established an aggressive agenda that centered on the House and Senate majority leaders' ability to shape the manifold details. The Democrats achieve not just a politically, but also an ideologically important victory.

Even with its majority, the party had to coalesce diverse positions on contentious issues. The end result is a substantial milestone in liberal philosophy, and the fundamental belief that health care should be a right just like freedom of speech or national defense. (Lawmakers and lawyers, though, are likely to challenge this notion in terms of the constitutionality of an individual mandate.)

The bill's final version will endure well over 2,000 pages of text, or more than 700,000 words. While lawmakers, congressional staffers, lobbyists and others have pored over its many details, no one has any idea what the total impact will be, or how its different features will intersect. Large sections simply have not yet faced the glare of public disclosure, beyond a coterie of Washington insiders.

As a result, it will take years to assess its full impact. Many of the bill's significant provisions, in fact, don't take effect until after the 2012 presidential election.

Even the independent Congressional Budget Office quantifies just measurable initiatives to existing programs such as Medicare and tax law. For other, more speculative, proposals such as payment reform or comparative effectiveness research, it ascribes less value—if any at all.

And perhaps the best quantifier of all, Wall Street, cannot fully implement its discounting mechanism because it simply does not trade the vast majority of the industry's value. Drugmakers, for example, make up half of health care market capitalization, but prescription drugs account for just 12 percent of $2.4 trillion industry. (Read "The Missing Stakeholder in Health Care Reform" in the Lyceum newsletter Perspectives, volume 5, issue 10.)

With so much uncertainty, folks will dedicate considerable time and effort over the coming months to analyzing and acting on its many consequences—in particular its unintended ones—in countless settings, from corporate water coolers to massive industry conferences. Smart minds will discover loopholes, from which new businesses will emerge as others diminish.

At the bill's heart—and no different than its debate throughout 2009—are fundamental questions of government intervention and consumer choice: How far should public policy extend into the care delivery process? What impact does this have on cost, quality and access? And does this process enable consumer choice? Should it? Its enactment further emphasizes government as the primary price setter (and, therefore, the primary influencer of care), while further diminishing market-based solutions.

However industry practitioners and observers measure its consequences, the public-private tradeoff will always feature as the central framework. One of the biggest tugs-of-war, for example, will be in the expanded number of covered lives: How much economic value do these additional lives create versus the cost of tighter regulation? Does this result in better health outcomes?

Expect the following topics to feature as examples of complex issues that are legislated but which could take months and years to develop and understand fully.
  • Accountable care organizations: the real-world and virtual integration of care delivery, involving local providers such as physician group practices and hospitals, and their patients
  • Comparative effectiveness research: the comparison and recommendation of different interventions in patient care.
  • Follow on biologics: the pathway enabling the manufacturing and distribution of large-molecule medications similar to proprietary predecessors.
  • Health insurance exchanges: the government regulated marketplace of insurance plans with different levels of coverage.
  • Independent cost-cutting commission: the expert body or institution exercising politically independent powers to reduce costs and inefficiencies across the health care system.
  • Payment reform: the shift away from a volume-based, fee-for-service model to something bundled or based on episodes of care.

Borrowing directly from The Wall Street Journal and Washington Post, we've reproduced below a side-by-side comparison of the Senate and House bills, many differences which the conference committee will have to reconcile.

Senate bill: Patient Protection Affordable Care Act
House bill: Affordable Health Care for America Act

Who is covered

Senate
  • The bill would ensure that 94 percent of legal residents have insurance coverage. The projected number of uninsured in 2019 is 23 million.
House
  • About 96 percent of legal residents under age 65—compared with 83 percent now. The projected number of uninsured in 2019 is 17 million.
Cost
Senate
  • The Congressional Budget Office estimates the bill to cost $871 billion and to reduce the federal budget deficit by $130 billion over 10 years
House
  • The CBO says the bill's cost is $1.05 trillion and reduces the deficit by $109 billion over 10 years
  • The net cost is $894 billion, factoring in penalties on individuals and employers who don't comply with new requirements. But after adding up a variety of new costs in the bill, including increased prescription drug coverage for seniors under Medicare, the cost is around $1.2 trillion
How it’s paid for
Senate
  • New excise tax on high-premium insurance plans, equal to 40 percent of premiums paid on plans costing more than $23,000 annually for families, $8,500 for an individual
  • $480 billion in cuts to Medicare over a decade
  • A fee on employers whose workers receive government subsidies to help them pay premiums; fines on people who fail to purchase coverage
  • An increase in the Medicare payroll tax by 0.9 percentage points to 2.35 percent on income over $200,000 a year for individuals, and $250,000 a year for couples.
  • Fees on insurance companies, drug makers and medical device manufacturers
House
  • $460 billion over the next decade from new income taxes on single people making more than $500,000 a year and couples making more than $1 million—the threshold was increased from $280,000 and $350,000, in response to lawmakers' concerns that the taxes would hit too many people and small businesses;
  • More than $400 billion in cuts to Medicare and Medicaid
  • A new $20 billion fee on medical device makers
  • $13 billion from limiting contributions to flexible spending accounts
  • Fines paid by individuals and employers who don't obtain coverage and a mix of other corporate taxes and fees
Requirements for individuals
Senate
  • Nearly every American would be required to obtain insurance, through either an employer, the exchange or other program
  • Individuals must purchase insurance or pay a penalty that would be the greater of $750 ($2,250 for a family) or 2 percent of income by 2016.
  • The maximum amount workers would be required to spend on premiums would be capped at 9.8 percent of income.
  • Exemptions for economic hardship
House
  • Individuals must have insurance
  • People who fail to purchase coverage would face a tax penalty of 2.5 percent of income.
  • People can apply for hardship waivers if coverage is unaffordable.
Requirements for employers
Senate
  • Companies with more than 200 employees are required to automatically enroll employees in plans.
  • Companies with more than 50 full-time workers that do not offer coverage would pay a fee as high as $750 multiplied by the total size of the work force if the government ends up subsidizing employees' coverage.
  • Tax credits for small employers.
House
  • Employers must pay 65 percent of family premiums or pay a penalty of 8 percent of payroll.
  • Companies with payrolls under $250,000 annually are exempt and the penalty is phased in for companies with payrolls between $500,000 and $750,000.
  • Businesses with 10 or fewer workers get tax credits to help them provide coverage.
Exchanges/subsidies
Senate
  • The bill would set up new insurance marketplaces—called exchanges—where people without access to affordable coverage through an employer could purchase comprehensive plans. Tax credits would be available on a sliding scale for individuals and families who earn up to 400 percent of the federal poverty level ($88,200 for a family of four).
House
  • Subsidies for individuals and families likely making up to 400 percent of the poverty level ($88,200 for a family of four). The subsidies would begin in 2013.
Insurance reforms
Senate
  • All plans sold to individuals and small businesses would have to cover basic benefits, including bans on lifetime limits, premium disparity based on health status and sex and coverage denials based on preexisting conditions. (Guaranteed issue, community rating, minimum insurance standards)
  • The government would set four levels of coverage: Under legislation passed by the Senate Finance Committee the least generous would pay an estimated 65 percent of health care costs per year; the most generous would cover an estimated 90 percent. Those numbers could change.
  • Establishes a national, voluntary insurance program for long-term care under which people would pay into the system while they're healthy and be eligible for cash payments if they need services for daily living needs.
House
  • A committee would recommend a so-called essential benefits package including preventive services.
  • Out-of-pocket costs would be capped.
  • The new benefits package would be the basic benefits package offered in the exchange
  • Includes bans on lifetime limits, premium disparity based on health status and sex and coverage denials based on preexisting conditions. The bill also would end a federal antitrust exemption that has for decades protected firms from federal investigations. (Guaranteed issue, community rating, minimum insurance standards)
Government-run plan
Senate
  • Democratic senators dropped a plan that would have had the government directly operate a health-insurance plan, while giving states the right to opt out
  • In place of that, the senators embraced a more limited proposal that would empower the government's Office of Personnel Management to put in place a new low-cost national health plan
  • The new national plan would be run by nonprofit entities set up by the private sector, and would be available to the public on the new insurance exchanges that would be created under the bill
House
  • A new public plan available through the insurance exchanges would be set up and run by the secretary of Health and Human Services
  • Democrats originally designed the plan to pay Medicare rates plus five percent to doctors. But the final version would let the HHS secretary negotiate rates with providers
How you choose your plan
Senate
  • Self-employed people and small businesses could pick a plan offered through new state-based purchasing pools
  • Employees would be generally allowed to keep their work-provided coverage
House
  • Beginning in 2013 through a new Health Insurance Exchange open to individuals and, initially, small employers
  • It could be expanded to large employers over time
  • States could opt to operate their own exchanges in place of the national exchange if they follow federal rules
Changes to Medicaid and Medicare
Senate
  • Senators dropped a plan to expand Medicare coverage to some people ages 55 to 64
  • For Medicaid, income eligibility levels likely to be standardized to 133 percent of poverty ($29,327 a year for a family of four)
  • States could negotiate with insurers to arrange coverage for people with incomes slightly higher than the cutoff for Medicaid
  • The federal government would pick up the full cost of the expansion for 2014 through 2016; thereafter financing will be shared through an increase in the federal medical assistance percentage ("FMAP")
House
  • For Medicaid, the federal-state insurance program for the poor would be expanded to cover all individuals under age 65 with incomes up to 150 percent of the federal poverty level ($33,075 per year for a family of four)
  • The federal government would pick up the full cost of the expansion in 2013 and 2014; thereafter the federal government would pay 90 percent and states would pay 10 percent
  • Exemptions for economic hardship
House
  • Individuals must have insurance
  • People who fail to purchase coverage would face a tax penalty of 2.5 percent of income.
  • People can apply for hardship waivers if coverage is unaffordable.
Requirements for employers
Senate
  • Companies with more than 200 employees are required to automatically enroll employees in plans.
  • Companies with more than 50 full-time workers that do not offer coverage would pay a fee as high as $750 multiplied by the total size of the work force if the government ends up subsidizing employees' coverage.
  • Tax credits for small employers.
House
  • Employers must pay 65 percent of family premiums or pay a penalty of 8 percent of payroll.
  • Companies with payrolls under $250,000 annually are exempt and the penalty is phased in for companies with payrolls between $500,000 and $750,000.
  • Businesses with 10 or fewer workers get tax credits to help them provide coverage.
Exchanges/subsidies
Senate
  • The bill would set up new insurance marketplaces—called exchanges—where people without access to affordable coverage through an employer could purchase comprehensive plans. Tax credits would be available on a sliding scale for individuals and families who earn up to 400 percent of the federal poverty level ($88,200 for a family of four).
House
  • Subsidies for individuals and families likely making up to 400 percent of the poverty level ($88,200 for a family of four). The subsidies would begin in 2013.
Insurance reforms
Senate
  • All plans sold to individuals and small businesses would have to cover basic benefits, including bans on lifetime limits, premium disparity based on health status and sex and coverage denials based on preexisting conditions. (Guaranteed issue, community rating, minimum insurance standards)
  • The government would set four levels of coverage: Under legislation passed by the Senate Finance Committee the least generous would pay an estimated 65 percent of health care costs per year; the most generous would cover an estimated 90 percent. Those numbers could change.
  • Establishes a national, voluntary insurance program for long-term care under which people would pay into the system while they're healthy and be eligible for cash payments if they need services for daily living needs.
House
  • A committee would recommend a so-called essential benefits package including preventive services.
  • Out-of-pocket costs would be capped.
  • The new benefits package would be the basic benefits package offered in the exchange
  • Includes bans on lifetime limits, premium disparity based on health status and sex and coverage denials based on preexisting conditions. The bill also would end a federal antitrust exemption that has for decades protected firms from federal investigations. (Guaranteed issue, community rating, minimum insurance standards)
Government-run plan
Senate
  • Democratic senators dropped a plan that would have had the government directly operate a health-insurance plan, while giving states the right to opt out
  • In place of that, the senators embraced a more limited proposal that would empower the government's Office of Personnel Management to put in place a new low-cost national health plan
  • The new national plan would be run by nonprofit entities set up by the private sector, and would be available to the public on the new insurance exchanges that would be created under the bill
House
  • A new public plan available through the insurance exchanges would be set up and run by the secretary of Health and Human Services
  • Democrats originally designed the plan to pay Medicare rates plus five percent to doctors. But the final version would let the HHS secretary negotiate rates with providers
How you choose your plan
Senate
  • Self-employed people and small businesses could pick a plan offered through new state-based purchasing pools
  • Employees would be generally allowed to keep their work-provided coverage
House
  • Beginning in 2013 through a new Health Insurance Exchange open to individuals and, initially, small employers
  • It could be expanded to large employers over time
  • States could opt to operate their own exchanges in place of the national exchange if they follow federal rules
Changes to Medicaid and Medicare
Senate
  • Senators dropped a plan to expand Medicare coverage to some people ages 55 to 64
  • For Medicaid, income eligibility levels likely to be standardized to 133 percent of poverty ($29,327 a year for a family of four)
  • States could negotiate with insurers to arrange coverage for people with incomes slightly higher than the cutoff for Medicaid
  • The federal government would pick up the full cost of the expansion for 2014 through 2016; thereafter financing will be shared through an increase in the federal medical assistance percentage ("FMAP")
House
  • For Medicaid, the federal-state insurance program for the poor would be expanded to cover all individuals under age 65 with incomes up to 150 percent of the federal poverty level ($33,075 per year for a family of four)
  • The federal government would pick up the full cost of the expansion in 2013 and 2014; thereafter the federal government would pay 90 percent and states would pay 10 percent

Saturday, December 12, 2009

Controlled Information Exchange

What's the point of information exchange, if you can't view it, analyze it or pass it along?

On Friday, December 11th, shares in the market research firm IMS Health tumbled on news of a proposed amendment to the Senate health bill that would ban drugmaker access to prescription data. Should this legislative action pass, it would force down the company's valuation just as IMS's management team finalizes the company's sale—the largest private equity transaction of 2009—to TPG and the Canada Pension Plan.

The federal rule's terms are not groundbreaking at the state level. They would mimic similar legislation enacted in New Hampshire, Maine and Vermont over the past four years. In fact, it was also IMS Health that lost a 2008 appeal against the state of New Hampshire and its law banning prescription drug data gathering. In June 2009, the US Supreme Court declined to review the appeal, opening the possibility for other states to legislate similar bans.

Important questions
And while the Senate amendment may not pass, it does raise important questions, none of which is likely to disappear anytime soon:

  • How important is free flowing information to the economic model of an industry and its value chain?
  • What are appropriate consumer protection mechanisms?
  • Do digital data require a different set of rules than analogue data?
  • What's the balance of power between states and the federal government in controlling information flow?

Because the debate over prescription drug information features—as its key issues—consumer privacy, data ownership and government intervention, its participants are likely to extend across and beyond the health care sector.

To put it simply, the implications of a national law are as vast as the economy itself. They impact not just the usefulness of health information exchange, but the effectiveness of the care delivery system, and—beyond health care—the general application of market analysis to consumer buying behavior.

Consider this just in terms of health care. As part of the March 2009 stimulus bill, lawmakers allocated nearly $20 billion in incentive money that the Department of Health and Human Services ("HHS") will pay out to providers adopting electronic health records in a meaningful way. The first payments are scheduled to begin in little more than a year.

Digital health information, the argument goes, leads to better patient outcomes because it allows for critical data exchange across the care delivery system, which includes not just providers, but also product manufacturers, service vendors, payers, consultants and others.

Already, that system is learning new HIPAA rules, which impose additional restrictions on information flow, and now include both civil and criminal penalties for non-compliance. If government hardens the flow even more, especially as the health industry transitions to a digital framework, it could, in effect, devalue taxpayer money to zero even before HHS doles out the incentives. (Read "Digital Health Records Biggest Obstacle" in the Lyceum newsletter Perspectives, volume 5, issue 10.)

HHS, as an aside, will pay this money through Medicare reimbursement, utilizing the current fee-for-service framework. Many industry people believe Congress missed an important opportunity to shift reimbursement to a value-based system.

The Health Insurance Portability and Accountability Act ("HIPAA") of 1996 established standards for electronic information exchange and the use and disclosure of patient information. Health professionals have complained about its burdensome requirements, often challenging patient care and medical research capabilities, and its added administrative costs. In March 2009, under the American Recovery and Reinvestment Act, Congress introduced the Health Information Technology for Economic and Clinical Health, or "HITECH", Act, which further tightens standards in the handling of patient data—for example, its tracking practices and notification of breaches. HITECH imposes more severe penalties and expands the number of liable parties, or covered entities, to include business associates.

Limited information
Even if providers can implement EHR systems that function appropriately as defined by "meaningful use"—and many industry people don't expect this to lead to substantially higher penetration rates among different provider groups than the single digits that currently exist—few of them would have much use for the patient information that the systems could navigate.

It would be no different than purchasing a fully-loaded, high-performance sports car, when onerous road rules limit its owner just to driving around the block.

While government should establish basic parameters, it risks derailing substantial progress in digital information exchange if it complicates a nascent system. Unintended consequences could have lasting impact.

Government would also establish a precedent that extends to other industries. Lawyers will likely challenge any effort aimed at packaging and selling consumer buying behavior, including highly sophisticated systems in the retail industry. Even companies relying on proprietary systems, such as Walmart and Amazon.com, could see direct challenges to their business models, if a national consumer protection law is aggressively pursued.

At the very least, we're learning how just one small amendment to a massive congressional bill could propagate an economic shock wave. Sorting through the bill's myriad details could take longer than its multi-year roll out.

Perhaps we'll discover that many of these details cancel the net economic impact. Then again, maybe they'll multiply the impact.

Either way, the market's reaction to IMS Health reveals deep-rooted uncertainty that won't soon go away.

Saturday, November 28, 2009

Risk Takers Take to Health Care

What motivates innovation and entrepreneurship? A good business plan, capital—and a propensity for risk taking. Although bright ideas are plentiful, market activity has hardened since the onset of the financial crisis. Capital flows, once voluminous, have eased to a trickle.

Risk taking comes from asking a simple question: "Should I, or shouldn't I?" Should I, or should I not, commit my own wealth to an uncertain venture?

For now the 'Shouldn't Is' fall into the majority. In fact, many economists expect risk aversion to linger for quite some time.

Yale economist Robert Shiller, in a January opinion piece to the Wall Street Jouranl, describes the 'Should I, or I shouldn't I' back-and-forth in terms of market trust, or "animal spirits" as Keynes put it:

[L]ost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place—for why the economy fluctuates as it does.

He argues that without market trust the economy cannot recover fully.

By holding back, industry suitors and investors (suppliers of capital) diminish future opportunities for themselves and their targets. This process perpetuates a vicious cycle of hand-sitting, and suppresses economic momentum.

As we know, the economy encompasses many different pieces, and while its composite may stagnate, certain pockets expand and absorb whatever excess capital exists.

Since the recession's start nearly two years ago, risk takers that exist have mostly targeted health care. Consider this, first, in terms of trends in venture-backed companies and mergers and acquisitions. Next, think of the potential catalyst this creates in altering health care's fundamental economic model.

Venture-backed companies
In the second quarter (2009), health care surpassed information technology as the largest industry in money raised for the first time in a decade. For every dollar health care companies collected in 2008, IT firms brought in $1.37. So far, in 2009, the levels are equal.

The table below illustrates the relative portion of funds raised between the two industries over the past seven quarters, and compares this to the dollar amount for all venture-backed companies. (Source: Dow Jones VentureSource)


2008




Period
Q1
Q2
Q3
Q4
Total
Health Care

26%

31%

28%

30%

29%

Information Technology

43%

38%

38%

39%

39%

Total Raised (million)
$8,559$8,347$8,170$6,086
$31,163

2009



PeriodQ1Q2Q3
Total
Health Care

34%

41%

34%


37%

Information Technology

40%

36%

37%


37%

Total Raised (million)$4,082$5,420$5,086
$14,588

While health care and technology accounted for about 70 percent of funds in each quarter, the mix shifted. Health care increased its portion by nearly 50 percent, from 26 to 37 percent of total.

Comparing the first three quarters of each year, total dollars shrank by 42 percent, from $26 billion to $16 billion. Money invested in IT narrowed by 45 percent, but decreased by a more modest 25 percent in health care, from $7.1 billion to a $5.3 billion.

Mergers and acquisitions
Though more quiet in recent months, the biopharmaceutical industry featured several large-scale, strategic transactions in the first half of 2009. This next table showcases the biggest deals.

Type
Acquirer
Target
Value
StrategicAbbott Labs
Advanced Medical Optics
$2.8 billion
StrategicJohnson & Johnson
Mentor Corp
$1 billion
StrategicPfizer
Wyeth
$67 billion
StrategicMerck
Schering-Plough
$41 billion
Pipeline
Johnson & Johnson
Cougar Biotechnology
$1 billion
PipelineRoche
Genentech
$47 billion
PipelineBristol-Myer Squibb
Medarex
$2.4 billion
PipelineSanofi-Aventis
Fovea Pharmaceuticals
$500 million

Through October, across all industries, bankers closed nearly 5,800 deals in the US worth $620 billion. Despite levels down considerably from 2008 and 2007, health care's share is a robust 21 percent, six percentage points higher than industrials (second rank) and seven points better than financials (third rank).

Debt placements totaling $58 billion have fueled buyout firms, making 2009 a peak year, surpassing 2007. Just in November, Goldman Sachs financed TPG Capital and Canada Pension Fund's $5.2 billion acquisition of medical data provider IMS Health—the largest private equity transaction so far in 2009.

Expect the following market dynamics to expand deal activity throughout 2010:
  • Portfolio pressure among private equity firms: Costlier financing and shareholder pressure are likely to force firms to realize exit strategies in the coming months. "2010 and 2011 will see a big explosion in dealmaking activity' as the debt deals that financed the buyouts begin to approach the end of their five-year term," commented Portfolio.com. "Until now, there has been little incentive for private equity owners to try to sell or otherwise capture any profits on their health care acquisitions; doing so would have required them to dismantle their existing cheap financing and replace it with more costly capital."
  • Drugmaker shortfalls: A reticent FDA and looming patent expiry are forcing big pharma to look to mergers and acquisitions for growth. Products totaling nearly $200 billion in sales are expected to go off-patent in the next five years. Proprietary drugmakers are now paying richly for products to add to pipelines "to offset the revenue they’re losing to lower-priced copies". (Source: Bloomberg News)
  • Unspent capital: Despite health care's relative buoyancy, private equity firms still boast over $400 billion in unallocated money, noted Bloomberg News. Cost cutting, demographics and the prospect for health care reform are creating new opportunities.
  • Dollar weakness: Foreign purchasers may take advantage of the greenback's tailspin. Against the euro, yen and other major currencies, the dollar has lost more than a third of its value since its 2002 peak.
  • Scarcity premium: The recession may have ended, but the recovery process has begun slowly. Health care growth—about 10 percent per annum—ensures a more stable outlook than other industries.
  • Expanded health care coverage: Both the senate and house reform bills expand coverage to over 30 million people, establishing a large revenue base for many different companies. Health insurance companies are facing margin contraction on more regulation, but many other players could see incremental growth.
Economic model
Health care's sheer economic weight guarantees that its innovators and entrepreneurs will access at least a disproportionate amount of capital relative to other industries. However, even in a dominant risk-taking environment, industry suitors and investors would still require adequate compensation.

In current conditions, suppliers of capital are much less forgiving. Strategic buyers are searching for acquisitions that are immediately accretive. Financial buyers, expecting capital costs to increase, are screening for lasting high returns on capital.

Less evolved companies, or companies confronting uncertain cash flow, will have a tougher time finding shareholders and suitors. Take, for example, private equity portfolios. The private equity universe holds about 100 companies valued in excess of $500 million (Source: Portfolio.com). About a quarter of these companies are publicly traded. The rest would need to demonstrate not just clear, but immediate returns to prospective buyers.

But it's not just a question of financial strength. Companies should also boast an innovative business model. This business model, moreover, needs to center on cost savings—or value—as its money-making mission. Those companies that demonstrate identifiable savings for their clients, no matter their industry segment, should enjoy the best prospects in attracting capital and doing deals.

Until capital constraints ease for the economy as a whole, risk-aversion will firmly control the 'Should I, or shouldn't I' debate. For now, risk takers, in the minority, favor health care, though the degree of their commitment could fluctuate widely depending on returns.

Whether it's the house or senate reform bill, or some combination of both, don't expect legislation to alter health care's fundamental economic framework. Supply and demand still won't transact with each other, and cost growth will only accelerate.

We can be sure that what we know health care to be today will continue indefinitely, at least until the system can no longer afford itself.

Give market dynamics a chance. If financial and strategic investors want to commit capital, then its their choice, and their choice alone—win or loose.

It would be the most effective, and least politicized, way to make health care more efficient.

One day, dealmaking and investing might even repair the economic model.


For observations on the public equity markets, read "The Missing Stakeholder in Health Reform".

Friday, October 30, 2009

Open Letter to the American CEO: Five Need-to-Know Facts About Health Care

Dear CEO of Any Company:

Want in on a little secret? Here's what health care's brightest business people think about reform: whatever lawmakers accomplish this fall, it won't alter how the system works or move the needle on costs.

Now—more than ever—you need to understand health care's fundamental underpinnings. As the corporate leader, you aren't just managing health care costs. Even if your business is in a non-health care industry, you are likely seeing new revenue opportunities emerge in health care as it expands across the economy.

Whether cost control or revenue growth, knowing how the system works is a crucial first step towards margin expansion.

Consider these five must-know facts.

1. Supply and demand do not transact with each other. At a recent Lyceum roundtable on health care reform, one entrepreneur noted: "Are we going to change a system where consumers don't pay and payers don't consume? I don't think so, unless Washington suddenly starts advocating market-based solutions."

It's ironic, and perhaps telling, that a section of the economy as large as health care doesn't perform as a normal industry. At ground level, physicians provide services, but payment is received not from customers but from commercial health plans and government. Because supply does not actually transact with demand—unlike any other industry—there can be no market-determined price or consistent measure of quality and value.

What's more, physician service reimbursement occurs under a volume-based framework, called fee-for-service, where doctors submit claims based on specific inputs, not total care.

Medicare, for example, applies a complex reimbursement formula called the resource-based relative value scale ("RBRVS") to non-hospital rendered physician services—about 25% of total health care expenses. A 29-member committee, determines exactly how much Medicare will pay for these individualized services. Critically, it also serves, de facto, as the basis for commercial health plan reimbursement. This single committee, therefore, controls nearly $600 billion dollars in industry pricing.

Transparency is non-existent. And the medical value chain is left with cost control as its only profit lever.

2. Market forces also don't shape the drug supply chain.
While in-patient and out-patient services exist outside standard economic practices, the other 20% of health care—the drug supply chain—does not follow the same framework, except for products that providers directly administer, such as infused and injected biologics. Commercial health plans and pharmacy benefit managers, instead, apply formularies to steer beneficiaries to more effective medication usage.

At least that's the intent. In reality, drug benefit managers also operate in their own opaque system, just not one controlled by a single committee. To optimize business margins, they negotiate directly with drugmakers on behalf of employers, their clients. Volume-driven rebates, pharmacy network spreads and mail service margins all affect formulary placement. Large margins, in particular, characterize generic drugs.

Drug manufacturers, meanwhile, have targeted physicians, directly and indirectly through consumer-directed advertising for branded products. Doctors, however, don't pay for the products. And those eagerly-courted erectile-dysfunctional consumers, happily forking out $30 co-pays, have no conception of actual prices.

Still, Caterpillar's recent effort with Walmart (and now Walgreens) attempts to alter this system by introducing a new competitive force: the retail channel. And unlike the medical side, the entire drug supply chain is publicly-traded, exposing it to shareholder demands and expectations.

The net effect of all this is that prescriptions are prescribed, purchased and paid for outside of anything resembling a normal supply/demand market framework.

3. Information is the most important commodity.
In a system as complex as health care, knowing what someone else doesn't know can make all the difference in the world.

Here, there's an important parallel with the financial service industry. Broker-dealers, Wall Street's middlemen, have traditionally operated at the confluence of market data streams. Whether it's corporate news flow or clients orders, no other entity processes as much information. While so-called Chinese walls presumably deter misuse of this information, neither corporations nor institutions possess even a fraction of this information wedge.

In the late 1990s, things changed, as broadband Internet democratized information access. Suddenly, new tools allowed counterparties to know as much—or more than—the broker-dealer. At the same time, electronic share trading networks emerged, allowing institutions to transact directly with each other.

As a result, margins in traditional advisory services shrank, and broker-dealers began turning to high-margin proprietary trading and investment services.

Health records are still 90% paper-based. On the medical side, information is so fragmented that no one entity has a distinct advantage over another. Claims processing, for example, often takes weeks or months to adjudicate, as provider and payer bicker over codes, procedures and contract pricing.

On the pharmacy side, the pharmacy benefit manager functions similarly to the broker-dealer. No other entity controls as much information about manufacturers, payers, providers and consumers.

Just as the Internet revolution recast the financial services landscape, it could likewise upend the traditional flow of information in health care. For medical benefits, it could create new power centers as information is digitized. For the pharmacy side, it threatens to disintermediate existing channels.

4. New revenue opportunities exist across industries.
So what if health care is 17% or 30% of GDP? If it's efficient, then it's creating jobs and contributing to economic growth.

Many different opportunities exist for non-health care companies to take advantage of the industry's growth. Take the affordability problem, for example. Why shouldn't bankers explore new lending channels to help consumers reduce the monthly premium burden? And what about information technology? Washington has already passed legislation that will provide incentives for electronic health record adoption. Like Sarbanes-Oxley, myriad rules will apply, a complex intertwining which creates opportunities for sophisticated software and service vendors.

Health care is first and foremost a service industry. Because supply is finite, economic rules apply as in any other industry. The problem with health care is an inability to define value on a consistent basis. If a company is smart in how it navigates the industry's nuances, then plenty of revenue opportunities will exist.

Retail-centered strategies such as convenient care clinics are challenging traditional delivery of care. Emergent, cash-based business models in the primary care profession are challenging traditional reimbursement practices.

As much as regulatory constraints may burden the system, there's no shortage of innovative strategies. It's just a question of matching resolve with the appropriate resources.

5. The CEO needs to be in control. The health care dollar begins with the employer. It just doesn't necessarily end there. Health benefits is a cost center, and typically reports up through the human resource department to the CFO. In most cases, CEOs never engage in this business unit other than to monitor trend growth. And while the direct cost exposure could be 5% or more of the cost base, the indirect opportunity cost in employee efficiency is much greater.

The problem, though, is that concepts such as presenteeism and workforce productivity are difficult to quantity, and particularly difficult to justify committing big dollars to when shareholders are assessing quarterly performance.

But how much are changes in market conditions now affecting expectations placed on CEOs? We may be emerging from recession, but few people expect economic growth to sustain an accelerated pace. With trend growth lower than in the previous economic cycle—corresponding to reduced revenue expectations—CEOs have little choice but to re-examine cost structures to preserve margins.

Just as health care may present new revenue opportunities, it also creates opportunities for chief executives to drive internal efficiency, simply because only a handful of companies have taken advantage of this, and so much low-hanging fruit exists.

The CEO needs to drive this process. Whether Caterpillar, General Mills, Pitney Bowes, Safeway or Whole Foods, examples exist of CEOs forcing efficiency. But these are just a handful of companies against the thousands out there that could be doing likewise.

Health care may be complex, but knowing its basic workings puts the corporate leader at an immediate advantage. Whether cost control or revenue growth, this is no time for herd mentality.

Be proactive. How smartly you manage health care's various risks and opportunities will determine your company's success.

Friday, September 18, 2009

Capturing the Employer's Voice: A New Twist in the Health Reform Debate

Every now and then some data point comes along that completely disrupts the flow of a debate. In health care, this occurred in June, when the Congressional Budget Office (CBO) scored the first two health reform bills to emerge from the 111th Congress.

Then, the CBO starkly reminded us that large reductions in spending cannot occur without fundamental changes in the financing and delivery of care. And dollar savings attributed to comparative effectiveness, health IT and other "soft" initiatives vanished, as simple speculation.

With its scoring, the CBO established the ten year/ trillion dollar benchmark as a deciding legislative factor. Immediately, the debate shifted from concepts and theory to economic reality. This drew in the electorate, which arcane medical and insurance language and plain-old inertia had sidelined previously. (Remember, consumerism only factors into the health value chain on a limited basis.)

Now, a just-published survey could similarly disrupt the debate. It reveals just how the biggest payer of health care is thinking. And it's not positive.

This summer, the consultancy Towers Perrin surveyed 433 employers on health reform. Here are excerpts from its press release (published September 17th):

"Employers say they will not absorb any additional costs that result from reform and plan to take actions to avoid doing so, including reducing benefits, raising prices for customers and/or reducing head count"

"Nearly one in four companies (23%) in the survey are currently rethinking benefit changes in light of possible reforms, and nearly all (89%) plan to reexamine their health benefit strategies for active employees in response to the passage of health care reform legislation. And while talent management considerations such as productivity, workforce health, and recruiting and retention remain important even in a tough economy, cost issues will dominate employers’ decision making in a post-reform world, according to the survey."

"In addition, employers do not expect that reform as currently proposed will address some of the fundamental drivers of health care costs. For example, nearly two-thirds of employers (65%) believe that health care reform will have little or no impact on consumer behaviors, an area many leading employers have begun to target as one of their key cost-containment opportunities"

"Towers Perrin’s Health Care Reform Pulse Survey also examined the experience of employers based in Massachusetts, a state that has imposed a pay-or-play mandate on employers and a coverage mandate on individuals similar to those currently proposed in Congress. Among those employers, most are not sure what, if any, impact the three-year-old Massachusetts mandates have had. Most respondents have seen little or no change in employee or employer health care costs or access to or quality of care. Notably, however, more than two-thirds of these employers report that their administrative burdens have increased."

Pretty glum. What's important, though, is that the survey unifies the employer's voice. While different trade associations exist to represent them, politics distort opinion, which too often collides, diminishing what amounts to a potent and relevant stakeholder.

Recently, we've seen political dissonance muffle certain large employers sharing individual experience—Safeway, Walmart and Whole Foods. Rather than focusing on one company, however relevant its message, this survey reflects a cross-section of experience and opinion.

Towers Perrin, a consultancy, grinds no political ax. It makes a living advising employers on managing health benefits, which includes surveys and data collection.

This survey—its timing—provides as clear a window as we're likely to get into how 60% of the health care dollar is thinking.

And if employers are planning for higher capital costs and reduced head counts, then the bill we pay could be much higher than the CBO's current scoring, which measures direct tax revenue and government spending, not indirect economic consequences.

Anyway you cut it, the survey's results present a new twist and a new reality, not likely to disappear anytime soon.

Although it doesn't carry the same headline effect of the CBO suddenly grounding congress in financial responsibility, it does forecast an economic response we could feel for some time to come.

Tuesday, September 15, 2009

The Capital Markets and Common-Sense Rules

Private enterprise is taking a beating. Whether in health care or the financial services industry, policy debates rarely feature the economics of supply and demand—much less self-correcting mechanisms. Instead policymakers have re-conceived market dynamics as a web of casual relationships.

Take, for example, these common lines of argument that advocate government intervention in the capital markets. Big Wall Street bonuses lead to excessive risk taking, which forces "bad behavior" in the capital markets. Likewise, improperly incentivized ratings agencies inflate the quality of securities, which bloats leverage ratios. Or, inconsistent regulation fails to curb market excess, which contributes to a moral hazard.

The fix, then, should be simple, right? Legislate—or mandate—bonus limits, new business models for ratings agencies and more comprehensive regulation.

Okay. Let's say we accomplish this and call it common-sense rules. (Read the text of President Obama's Wall Street speech here.) Will it achieve the desired effect? Well, that depends what we mean by "desired effect" or "common-sense".

And here's the rub. The capital markets work as they do exactly because countless thousands (millions) of people interact with them daily, a few directly and many more indirectly, for many different purposes: investing, funding, speculation, arbitrage, price information, short-term needs, long-term needs, and more. Like Facebook or MySpace, the markets are a social network, except much bigger, much broader and much more unifying.

If it's control lawmakers want, then whatever they establish today risks obsolescence tomorrow—or, worse, some significant unintended consequence. Just look at the fallout from the short sale ban last fall. Market volatility elevated and the price discovery process deteriorated: the exact opposite of what the SEC and market participants intended, and needed, to take place.

Rules and regulation designed for control can never keep pace with market innovation. Nor would we necessarily ever want them to keep pace. Because if they ever were to match innovation, innovation could never occur, by definition.

Rules and regulation should, instead, support market innovation. Consider this in terms of Lehman's demise. Whether the Feds were correct in allowing the bank to shutter is secondary to the fact that the business model—Wall Street's business model—failed.

And let's not confuse the markets with Wall Street. The markets themselves didn't err. They got it right, punishing those who got it wrong. And we know government and regulators were far behind, having little clue that the Wall Street business model was failing as badly as it was.

Fast forward one year, and we're at the same place we were before the crisis. Nothing has really changed in terms of a new model taking root. The bulge bracket features new name plates, and one or two old ones. But if we view the landscape as a continuum of capital flows, then money is just as—or more—concentrated among these big guys as it was in September 2008.

In the name of 'Too Big to Fail', taxpayer money is effectively buttressing a broken model, and postponing its inevitable replacement.

The question should be: What's the opportunity cost of not allowing this transition process to take place? Weak economic growth, high unemployment, a diminished dollar, market uncertainty? Likely all four and more, as Wall Street fails to expand money flows between corporations and institutions.

Here are four expectations for the next Wall Street business model, in sequence.

A return to the partnership model. It should be no surprise that Goldman emerged on top because it embraces a model closest to a partnership than any of its competitors. In contrast to a shareholder controlled firm, a partnership ties the firm's capital directly to its manager, so that risk capital is their money, not other people's money.

A breakdown of concentrated capital. Empire building may be instinctive, but emperors will always define themselves by personal gain. It would be naive to expect that market participants would ever curtail their pursuit of personal fortune. That pursuit, though, could be much more lucrative in a different business model, even if the ultimate scale of the business is much smaller than, for example, Sandy Weill's Citigroup at its peak.

A greater sense of firm identity. An important byproduct of the partnership model is less employee turnover. The compensation format ties individuals to a firm. Wall Street had become a battlefield of mercenaries: analysts and bankers, for example, benchmarking themselves against external polls, instead of their own contribution to the firm's bottom line. Firms became faceless and amorphous, as employees sold themselves to the highest bidder.

A shift to longer-term planning. Goldman demonstrates that a partnership-like model can function within a publicly traded company. Other firms, however, may opt to proceed as private businesses. Either way, this shift will allow managers to plan longer-term and respond less to "best practices", which can often standardize quality. Firms may become more cautious, but they will likely become more specialized.

So, who's to say what's right and what's wrong? Definitely not government or regulators, or really anyone but the market itself. That's not to say there is no place for oversight or rules, just not the kind that impose control.

Capital is finite. It's an economic good. If there's one lesson we should take from the health care reform debate it's that we should never depend completely on the expectation that somebody will do something for us. The sooner that policymakers can trust markets, the better off we become, and the faster our economy will recover.

After all, the last thing we can afford is the restriction by non-market forces of a natural market transition.

Monday, September 7, 2009

The Missing Stakeholder in Health Reform

Pop quiz: who's missing at the health care reform discussion table? Is it: (a) government (b) patients (c) doctors (d) employers or (e) owners of health care companies?

Guess what? Of all the stakeholders in the health care universe, it's the corporate shareholders—the very owners of those health care companies, large and small—who are left out in the cold.

Why is this? Like every other industry, health care depends on Wall Street for much of its capital needs. Growth requires investment, investment requires capital, and the financial markets are the spigot from which capital flows. So why don't shareholders have a voice in the reform debate?

At $2.4 trillion, the total annual spend on health care is well-publicized. Few of us, however, realize that this expenditure translates into a market capitalization just under $2 trillion. Within the S&P 500, only information technology and financials boast higher total values. The 52 companies that comprise health care equal 13.5% of the index's total value.

S&P 500 Health Care Constituents
And while docs, drugmakers and drugstores may come first to mind when we think of health care, shareholders represent a critical stakeholder. Without their money and collective judgment, there is no research and development, no new plant facilities and no incentive for clever business strategies.

Individually, a shareholder might be any other stakeholder: a physician, corporate executive or consumer. No lawmaker, though, is weighing the sum total of these individuals.

Out of sync
Despite the stock market size of the health care industry, it lacks breadth, and does not adequately represent the entire universe. Drugmakers, for example, make up 60% of the listed market capitalization. Hospitals, on the other hand, constitute less than 1%. (Of 5,000 hospitals across the country, just eleven hospital groups are publicly listed.) In terms of total spend, prescription drugs and hospital care represent 12% and 37%, respectively.

National Health Care Expenditures
Source: Centers for Medicare and Medicaid Services


Health Care Industries
Source: Yahoo! Finance

The market, moreover, values commercial health plans—36% of the source of funds spent on health care—at just 4% of the total health care universe. (We wonder: How much does head-to-head competition with government programs contribute to this under-representation?)

If we break down spend between private and public money, majority public- (Medicare/Medicaid-) funded services feature substantially less in the investment universe, and private-funded services substantially more. Of course, the two questions that naturally follow this are: one, what's the impact of market forces? And, two, to what extent do these forces drive efficiency?

While most folks would probably argue that drug manufacturers underachieve in operating efficiency, no one would dispute the fact that the pharmacy "value chain" (the dollar flow from manufacturer to consumer) is inherently more efficient than the public spending-led medical side. The best example for this is claims processing—a major source of administrative inefficiency across health care (more than a half according to one study). Pharmacy systems adjudicate claims instantaneously, whereas the medical system can take several weeks or months.

The table below breaks down types of service by funding source.

Source: Centers for Medicare and Medicaid Services

We can only speculate, unfortunately, whether market forces would drive efficiency the same way in hospital care.

The disconnect between the market and the industry extends to the way Wall Street pros analyze health care. Sell-siders and buy-siders, for instance, still segment drugmakers into biotechnology and non-biotechnology companies, even though all manufacturers—even the generics—now target biological products.

Rarely do these same "drug analysts" also cover pharmacy benefit managers ("PBMs"), even though these companies directly affect pricing and market share. In fact, Standard & Poors doesn't even categorize CVS Caremark and Walgreen as health care stocks, despite their obvious focus, which includes major PBM franchises. Broader indices also don't include the smaller capitalized health information service companies such as Allscripts-Misys Healthcare and Cerner Corp., and instead add them to the technology sector.

As a result, information does not flow as seamlessly as it could across the marketplace. Compounding this problem, coverage teams on either side of the Street don't normally exist across health care, as, for example, they do in technology between software and hardware.

And what about employers? The employer-based insurance market provides coverage to two-thirds of the US population under the age of 65. A large company with 50,000 employees, for example, likely exceeds $500 million per year in total health care spend, including dependents and retirees. As with Starbucks, this level often surpasses investment in core products and services.

Assuming $500 million of spend on average for the largest 100 companies, we can estimate a total annual budget of $50 billion. How management allocates this money directly affects a company's cash flow. Are shareholders prepared to ask the right questions? Are they asking questions at all?

Still relevant
What if lawmakers did include shareholders as a stakeholder? At a minimum, shareholders would urge more efficiency. They would also articulate viewpoints based on return on investment, and frame health care as an economic good—rather than as a right or privilege.

In a recent Wall Street Journal opinion piece, Greg Karpel describes health care as a value-creating industry: "The $2.4 trillion Americans spend each year for health care doesn't go up in smoke. It's paid to other Americans." Mr. Karpel refers to job growth and medical innovation as two examples, and addresses health care as a "significant, perhaps a principal, driver of the economy".

Shareholders could be advocating this uncommon position in precise fashion—except for dislocations across market participants. Still, the market can provide critical and dispassionate information and assessment, which the health reform debate desperately needs.

Even though the shareholder stakeholder may have far to go in developing his own voice, what he can contribute to the reform discussion would be relevant enough.

Sunday, August 30, 2009

We're All "Meaningful" Now: Expect a Busy Fall for Electronic Health Records

Get ready for lots of news flow on "meaningful use" this fall. The government has set an ambitious yearend deadline for establishing a formal definition, a critical step in its effort to spur electronic health record (EHR) adoption.

"Meaningful use" refers to the way in which the government will expect providers to use electronic health record systems — whether in an appropriate manner or not.

At stake for the provider community are billions of dollars in incentive payments. Starting in 2015, the government expects providers to have adopted and be actively utilizing an EHR in compliance with the meaningful use definition or it will subject them to financial penalties under Medicare.

To defray the cost of EHRs — often tens of thousands of dollars — the government has promised big subsidies ($44,000 per physician), though not without strings attached. It will pay the first incentives in 2011 based on prior performance. A provider not following meaningful use of a certified EHR could risk not receiving any government funding. The American Recovery and Reinvestment Act of 2009 provides a minimum of $19 billion in funds to kick start EHR adoption. Media sources now report a funding level nearly twice the size at $36 billion.

According to the government's website, "The focus on meaningful use is a recognition that better health care does not come solely from the adoption of technology itself, but through the exchange and use of health information to best inform clinical decisions at the point of care." Broadly, meaningful use will encompass different parameters, including patient communication, diagnosis, device usage, patient encounters, specific patient information, laboratory tests, medication usage, physical exam findings, and procedures.

Just recently, the Obama administration announced it would provide $1.2 billion in grants to create 70 HIT centers around the country. David Blumenthal, the president's HIT czar and head of the national EHR effort for the Department of Health and Human Services, meanwhile, has stated that he expects a formal definition of meaningful use by the end of the year. The process began in June.

To put the cost savings opportunity in perspective, about half of health care expenditures constitute waste, whether dollars spent on preventable conditions, redundant tests or back office processing. About half of this waste relates to poor patient behavior: obesity, smoking, non-adherence. A quarter represents clinical inefficiency: readmissions, poorly managed care, medical errors, treatment variance, unnecessary ER visits — the primary target for EHRs.

The remaining quarter reflects operations, or the back office. Of this, claims processing accounts for about half, and ineffective IT a third, staff turnover and paper-based prescriptions the rest. (Note: We have sourced these estimates from a 2008 report by the consultancy PriceWaterhouseCoopers. Click here to view.)


If we exclude from this waste calculation patient behavior, the practice of defensive medicine (more a payment issue than an IT issue) and claims processing (not directly a clinical issue), then we would assume that EHRs would impact about a third of all wasted dollars spent.

In a $2.4 trillion dollar industry, where $1.2 trillion is waste, EHRs could theoretically address about $400 billion of this. A substantial number, it would roughly equal the entire prescription drug market at half this level.

Let’s not forget, too, that each of these numbers is growing at 10% per year. In seven years, $400 billion becomes $800 billion, although — presumably — effectively deployed EHRs would slow this growth rate.

With such a substantial business opportunity at hand, it's no wonder many different organizations are now targeting health IT, and EHRs specifically — including not just traditional technology vendors such as Intel, IBM and Microsoft, but also managed care organizations, plan sponsors, and dozens of venture-backed firms.

Despite this, many problems exist, ranging from cost to lack of a common standard. Even though, for example, several different EHR systems may operate within a single provider setting, one system does not necessarily communicate with another. And for small practices, implementation costs can be prohibitive.

While nearly 40% of physicians report using a full or partial EHR system, only 4% indicate they use a certified, fully functional system, according to a survey by the Centers for Disease Control and Prevention.

Enter the government, and Dr. Blumenthal's mandate to make everything work together. But for EHRs to recoup even the expenditure the federal government is prepared to make, all the different stakeholders must first agree on a definition of meaningful use.

No one anticipates an easy process.

What happens, for instance, if the government defines meaningful use too narrowly — or too broadly? How does the government change the definition? And when?

Providers will also need to submit data that qualifies them for incentives. What does this process entail? How much of a time burden does it create? Also, to what extent will provider inertia drag down future returns?

And none of this includes issues pertaining to the certification process and privacy concerns. Who, for example, owns the data?

In its scoring, the Congressional Budget Office has not allowed significant savings for EHRs simply because the opportunity, while massive, remains highly speculative. Even if the government adheres to its aggressive timeline, EHR savings on a national scale would not occur until well after 2015.

Stay tuned for a busy fall.

Sunday, August 23, 2009

Nearing a Market Top

Nobody wants a good thing to end, especially an historic run in the equity markets. Precedence, though, suggests that we're nearing a conclusion.

From its March 9th low through August 21st, the S&P 500 has rallied 51.7%, the index's best 117-trading-day performance since before 1950. In fact, five of the ten best continuous 117-day periods between June 1950 and August 2009 occurred this month, as the table below illustrates.


January 1983 featured three of these periods, and the end of May/beginning of June 1975 the remaining two. (Both of these periods come closest in showcasing the same type of performance.)

The market has been so strong that of the 14,890 continuous 117-day periods over this six decade time frame, just three periods posted gains over 45%: those ending August 19th, 20th and 21st.

And on only 89 occasions did the market gain more than 30%. That's less than 1% of total. The market, moreover, only managed a 15%-or-more advance during less than 14% of this period.

82% of the time it ranged between -15% and +15%.


Clearly, the current race upwards marks a distinct reversal from the market's nosedive in the first days of March and in November last year. Too far, too fast? Statistically, at least, we've sprinted deep into outlier territory. If we go by our table above, then the more "normal" trend line for the S&P would be the 0% to 15% range.

Let's assume a flat market. It would take 39 trading days at the current 1026 level for the market to mean revert back into the sub 15% range. Under a correction, this could happen more quickly.

On the other hand, for the market to sustain its record-setting 45%+ pace until yearend (for example), it would have to average daily gains of between 0.4% and 0.5%. That would equal a closing level above 1500. Improbable, if not impossible.

While August 2009 showcases trading patterns similar to June 1975 and January 1983, it also features a much different backdrop. These two preceding months actually resemble each other much more closely than either one does August.

In both months, the economy was three months into recovery, after severe, protracted downturns. In both cases, cyclical unemployment peaked exactly one month prior: in May 1975 at 9.0%, and in December 1982 at 10.8%. 10-year Treasurys were yielding 7.86% and 10.46%, respectively, while inflation soared at 8.5% and 6%.

Politically, the Democrats held both the house and senate in 1975, but not the White House. The Republicans under Reagan controlled the White House in 1983 and the senate, but not the house. Unlike today, free trade and capitalism energized a small minority of the world's population.

Tax policy varied, however. Rates sharply declined throughout the 80s. Gasoline prices also varied. In 1975, they were rising, and, in 1983, falling.

Market direction tracked differently, too. The S&P 500 after June 1975 closed the year 5% lower, and would not sustain higher levels for another three years. After January 1983, the market finished the year 14% higher, but had also gained 15% over the subsequent six-month period, equal to the same period-to-end-of-year time frame as 1975. Also, the nearly two-decade long bull run had just begun.

August 2009 is unique in many aspects: the global landscape, the point of time in the economic cycle, the credit and banking systems, the regulatory and legislative outlooks, to name a few.

Whether we're facing a lengthy flat market or a sharp pullback, don't expect the historic resurgence to continue.

Sunday, August 16, 2009

Listen to the Market: "Health Reform Won't Distort the Insurance Business Model"

When it comes to health care reform, it seems the more likely that government will pass legislation, the more sanguine Wall Street gets that nothing will occur. Government-run health care? Won't happen. An evisceration of the private insurance business model? No way.

Consider this. From its March 9th low to August 14th, the S&P 500 surged 48%. Over the same period, four of the five largest commercial health plans (by lives and market capitalization) outperformed the major index.

In fact, during this stretch of 111 trading days – that's five and a half calendar months – Cigna never underperformed the market. Humana did so once, way back on March 11th. And WellPoint dipped below the market on seven occasions, the last time on April 3rd.

UnitedHealth Group stumbled 19 times, mostly during a bad stretch in late March and early April. Now, its shares stand ten percentage points higher than the market average. Even Aetna, which consistently underperformed, is 38% higher on an absolute basis.

See the chart below covering this trading period. The red line is the S&P 500.

Click to enlarge.


The comparison also extends to other components of the health value chain. The maligned health plans have outperformed each of the major stakeholders. The S&P 500 is higher (marginally) than the major pharmacy benefit mangers – Medco, CVS Caremark and Walgreen – and trouncing the drug manufacturers by more than 20 percentage points.

To be fair, it's FDA uncertainty, not congressional power-broking, that's weighing heavily on the drugmakers. And depending on its structure, a pathway enabling follow-on biological products could improve prospects dramatically. Both house and senate bills feature it, and traditional foes seem closer to finding some sort of resolution than ever before.

So, what's the health reform fuss all about anyway? Well, if you're an investor, it's making for good entertainment.

Indeed, the market's great discounting mechanism reveals prospects so strikingly different than the constant news media coverage that it can't be right, right?

Well, no one can ever be sure. But let's just say this. Not since 1994 have lawmakers threatened major overhaul to this extent. With the party seeking to upend private insurance holding majority control, passage would have seemed inevitable – if not a full-on government option, then something damaging, at least, to the current business model.

That, to several high-minded folks, seemed the intent.

Despite this, and except for company-specific issues, investors never marked down the industry's prospects, even during the worst of the mudslinging and the darkest days of apparent unity among the ruling party.

And let's not lose sight of the fact that this is turning into one fine example of market rationality, while total hysteria grips the Hill and many corners of Main Street.

Maybe Wall Street isn't so villainous after all.

Maybe lawmakers should take care in turning their reform plans to that potent discounting mechanism.

It could be the only thing that keeps us sane.

Wednesday, July 29, 2009

Rise of the Machines

In the Terminator series, machines rise up to replace humans. On Wall Street, fiction now appears to be reality, as complex algorithms and super-fast computers conspire to wrest control of market liquidity.

Recently, the New York Times brought attention to the ins-and-outs of high frequency trading, or HFT. (Read here.) And with Goldman Sachs producing eye-popping trading results, many observers – looking to identify the next weapon of mass destruction – are crying foul. (Read here, Goldman's profits in HFT.)

Sen. Charles Schumer (D-NY), pushing to ban components of HFT, is increasing visibility even more.

HFT, basically, is rapid-fire buying and selling of securities, in milliseconds. Proprietary trading desks and hedge funds orchestrate it for own-account gains, trading for pennies or less literally in the blink of an eye. By constantly churning, these funds' trading activity often constitutes the market for many different securities. (Read explanatory diagram here.)

Here's where problems arise. When a mutual fund submits a buy order with a limit price, HFT funds can buy-and-sell the difference between the current price and the limit price. If, for example, a dealer looks to execute a buy-order with a $25 limit and the price is $24.90, HFT funds could theoretically profit from the entire 10c difference.

As the mutual fund portfolio manager, you worry that your best price should have been something less than $25. You know that pennies on millions of shares represent a material cost, and that your shareholders bear this.

In this case, the market isn't achieving true price discovery for the security in relation to its liquidity. A substantial amount of liquidity is addressing price movement alone (irrespective of the security), while only a portion is takng into account the security's actual value.

HFT is controversial because it potentially creates information asymmetry and false liquidity. Its proponents argue, however, that barriers to entry are low (once you get past the set up costs), so pricing is actually transparent; and some liquidity (albeit low quality) is better than no liquidity.

As with derivatives, the problem – if we want to call it that – in HFT isn't the product itself, but the typical inefficiencies of a marketplace that can never be completely uniform. Some folks are just really clever at exploiting those inefficiencies, and market functions take time to keep pace.

Whatever response lawmakers and regulators take, as long as there's money to be made, the folks who brought you CDOs and HFT will spawn something new and different.

That is, until the machines actually do rise up, and all humanity is finally gone.

Related reading:

Hurrying Into the Next Panic? (NYT)

How to Understand High Frequency Trading (Atlantic Online)

High-frequency Trading (Marginal Revolution)