Contributor: David Friend, WG’84, MD
To learn more about David, click here
With all due respect to Warren Buffett and Yogi Berra,
"When it comes to healthcare ....pricing is what you pay....value is what you don't get."
One of the most important factors in investing in healthcare going forward is truly understanding and accurately forecasting the potential earnings power of new products and services. The ability of investors to accurately determine the future prices of new products and services is absolutely critical to accurately modeling the EBITDA, ROI, EPS, CAPEX and NPV of the companies they are targeting. The rewards of correctly calculating these factors over time can create outstanding investment returns. The cost of miscalculating these factors over time can be equally as devastating to your portfolio.
We at the BDO Center for Healthcare Excellence & Innovation expect the coming decade to produce more than $10 trillion in wealth as investors are drawn to new, innovative healthcare products and services. Innovation in healthcare has blossomed, in particular, with the scientific revolution in genomics and information technology and the realization that many human illnesses, particularly cancer, are analogous to software defects. Precision medicine and other new forms of treatment based on discoveries in molecular biology and computer science promise to revolutionize the way we care for patients.
However, as rosy as this outlook appears, we also expect that more than $4 trillion will be destroyed during the same time period. This will be the result of current medical products and services made obsolete by new disruptive discoveries at a pace never before seen. I believe we will look back in twenty years and realize that medical practice in 2015 was in the stone age relative to our future potential.
To state the obvious, in order to create Alpha,* investors will need to put their money on the winners and short or avoid the losers. A key determinant to generating investment outperformance will be the mastery of pricing and understanding how it translates into investment returns. In the United States, the process by which the pricing of new products and services in healthcare occurs is a function of the regulatory environment that controls the pace of innovation and competition -- both of which are a by-product of complex state and federal political processes that regulate the healthcare industry. In the past, predicting pricing on future products and services was relatively easy because there was no requirement to take into account the “clinical value” of the product or service produced. If the product was new or competition could be held to a minimum, forecasting pricing for investors could be rather straightforward with fairly predictable and steady results and cash flows.
Over the last year or so, an increasing number of critical headlines have appeared regarding the way drug prices are established in the United States. This is not really surprising, as many business models are dependent on some form of price and quality opacity for a significant portion of their profits. The only real surprise to this observer is that it's taken so long for this issue to appear on the front burner.
As a healthcare investor, one cannot have failed to notice the almost daily stories regarding the pricing of innovative new medicines such as drugs to treat hepatitis C as well as stories about companies purchasing older medications and raising their prices dramatically. The former discussion really is about how society wants to reward the risks and cost of innovation going forward. The latter is about how much society wants to permit competition and the information transparency required to enable it.
Understanding the Future of Innovation and Competition…the Keys to Pricing and Investment Success
There is a disruptive revolution going on in the areas of innovation and competition. The disruption caused by innovation is being driven by the scientific discoveries we previously mentioned. The disruption occurring in competition is being caused by legislation, the unsustainable increase in healthcare spending as a percentage of GDP, and the revolution in technology that is empowering consumers.
As a result, it is critical for investors to have a point of view on both of these factors. The days when new drugs can simply be priced without limitation is coming to an end. Emerging discussions focused on pricing new innovations by simply using “cost accounting” to develop new drugs ignores the extraordinary risks that financial capital is required to endure to produce them. Current estimates are that nine out of ten drugs fail to reach the marketplace.
While it is often mentioned that it can cost more than $1 billion to get a new drug to market, what investors often to fail to realize is that the costs often refers to nine drugs that failed at $100 million each as well as the one drug that succeeded for $100 million. Simply pricing the new drug based on its $100 million cost of development while ignoring the losses investors suffered will dramatically reduce the incentives for innovation. While I expect these cost-based discussions will receive a lot of attention and will need to be closely monitored to see if they get real traction, I don’t believe they will be enacted. Having personally experienced the failure of wage and price controls in the early 1970s, I don't believe that our society will go in that direction.
If we are to motivate investors who are expected to endure nine total investment failures for every success, society will need to balance the enormous investments required to produce new drugs with their attendant risk of failure against the potential value that new inventions bring to society. The nascent move towards pricing new medications based on the value they bring to patients and society is one I believe every investor is going to need to come to grips with because slowly, but inevitably, I believe it will become the coin of the realm.
At the same time, the use of competition to help moderate and establish drug prices will increasingly come to fruition as a policy tool and as an outcome of the consumer revolution. As consumers become responsible for paying for a larger percentage of their drug costs out of the their own wallets through a combination of increasing co-payments, deductibles, tiered pricing arrangements, and indication-specific pricing, we can expect consumers and those entities which negotiate for them, such as pharmacy benefit managers, health plans, and consumer-focused e-commerce websites, to continue to revolutionize the purchasing process in the same way that consumer empowerment has revolutionized the travel, retail, and transportation industries.
It should be no surprise that the healthcare industry will push back on competitive forces where it can, through mergers and acquisitions, advertising, and intense lobbying, to help move the political process in its favor. Just look at the way Airbnb and Uber have mobilized its customers to act in the political arena to defeat political actions designed to limit their business. I believe the healthcare industry will continue to raise prices on older products as it can, albeit more discreetly, both to boost cash flow for investors, as well as to fund development of new innovations. I also expect the government to apply more scrutiny to transactions that reduce competition. The Federal Trade Commission already appears to be taking a more active stance with respect to mergers in the healthcare provider space.
As these forces of innovation and competition continue to disrupt the healthcare system, it will be more important than ever to understand how these forces will impact the pricing of the new products or services being considered for capital allocation. This is because the major driver of future wealth creation will be both the creation of new products and services AND the ability to set a price for them that rewards investment.
While stories about order-of-magnitude price increases for older drugs may make for interesting headlines in the short run, the days of unbridled price increases for drugs and services that are unrelated to the clinical value being created are clearly coming to an end. Business models built on this strategy of “buy and raise” are no longer as attractive to investors as they once were.
In the future, investors will create Alpha through their focus on competition and innovation and understanding their impact on pricing. This focus will likely lead to three types of investment situations:
- Products and services that are truly innovative and can produce superb clinical outcomes and have no meaningful clinical competition. These companies will command well-deserved premium pricing that will result in outstanding returns for shareholders.
- Products and services that are made obsolete by innovation. These companies will rapidly lose pricing power with dismal returns for their shareholders.
- Products and services that have traditionally relied on quality and information opacity or reduced competition. Without a truly innovative competitor, these companies will slowly lose pricing power until they are either made obsolete by an eventual innovator or find a stable price point that provides reasonable value for the clinical outcomes obtained. Such a scenario, which will likely be the most common of the three, will yield slightly below market matching returns for their shareholders.
In order to create Alpha, your healthcare portfolio will need to find and invest in the winners that emerge from Category 1 while attempting to avoid or shorting the losers in Category 2.
The health investing game is clearly becoming more difficult, potentially more lucrative and a lot more risky. An understanding of the forces that shape pricing will be required for all who wish to play going forward.
Contact David at: [email protected]
* Apha:
1. a measure of performance on a risk-adjusted basis
2. the desirable/outsized return on investment derived from skill