Morningstar Advisor - October/November 2012 - (Page 31)

majority in the Senate. Right now, that looks like a long shot. Without gaining the presidency or an overwhelming majority in the Senate, Republicans could still find ways to tie up parts of Obamacare using budget maneuvers, but it’s a potential landmine for Republicans. Even though right now the public is split on Obamacare, many of its provisions have already been put into place. Once the public starts realizing the benefit of some of these provisions, restricting them is going to prove to be very challenging for Republicans. So, at this point, we’re assuming that Obamacare will stand regardless, and what the individual mandate does for the health-care sector is that it allows companies to capture the upside of Obamacare. More than 30 million newly insured people will enter the health-care system. Damien Conover: Another aspect of the November election is that no matter which party wins we expect a return of Washington’s focus on cutting the federal deficit. measures are passed, the National Institutes of Health could face 7% to 9% cuts in its budget. Funding for new research would be slashed, which would be a major blow to life-science firms. Guziec: If Obamacare is here to stay, give us a blow-by-blow of what health-care reform and 30 million newly insured people mean for the major health-care sectors? Morozov: For medical technology and Guziec: Alex, what about the excise tax that medical-device companies will have to pay? Morozov: At 2.3%, it’s a meaningful headwind, devices, Obamacare’s effect will not be that significant, because a lot of recipients of medical devices are already on Medicare. Also, these newly insured folks will be younger; they’re not the medical-device industry’s customer base. That said, Obamacare is a big plus for diagnostic companies, health-services companies, and hospitals. Hospitals are probably the biggest winners. The individual mandate will allow them to finally limit the charity care that they’ve been providing for years for underinsured or uninsured patients. Conover: In the pharmaceutical sector, we see reform as a net neutral. But it’s important to dissect that a little bit. The negatives of Obamacare for the pharmaceutical industry are front-end loaded, and then the positives kick in on the back-end. What I mean by that is that during the first couple of years of Obamacare, the big pharmaceutical companies are paying fees that are going to weigh on earnings in the range of 2% to 4%. but it’s not as punitive to the industry as one may think. If, on average, the medicaldevice companies carry margins somewhere from the high teens to mid-20s, it’s a sizable hit. But we do need to remember that most of the device companies are multinational, so that alone is a sizable offsetting factor to the tax. For companies like Becton Dickinson BDX, the tax is going to be less than $100 million, which ends up being somewhere in the 1% to 1.5% range, as opposed to 2.3%. Also, a lot of medical-device companies have been restructuring their operations; they’ve been getting leaner ahead of the tax, because really the tax is just one of the many secular headwinds that the industry is facing. Pricing pressure is one; economic utilization is another. So, the excise tax, for many companies, is just yet another hurdle that they have to overcome. How do they do it? Mainly through focusing on emerging markets—on areas where they can leverage their technology and get new demand. Guziec: Has the market priced in these lower expectations? Morozov: Yes. Medical technology is one of few remaining undervalued sectors in health care. The market is seeing next year’s depressed earnings because utilization is still fairly weak and the excise tax is going to provide a decent hit to a lot of those companies’ earnings. But the market is dismissing very strong demographic trends and good growth prospects for a lot of these med-tech firms. It’s a sector we’re bullish on. Several firms have 4 and 5 stars. We’re bullish on Covidien COV, St. Jude STJ, Medtronic MDT, and Stryker SYK. Guziec: Another big uncertainty is the economy. What do we see going forward with macro conditions and health care? One element that is very likely to happen, because both parties agree on it, is something that will have an impact on big pharmaceutical firms: coordinating the costs of dual-eligible patients. Currently, if a patient is eligible for both Medicare and Medicaid, he gets reimbursed at Medicare levels, which are about 30% higher than Medicaid prices. There is a lot of support to eliminate this difference. If it goes through, big pharmaceutical companies would take a 2% to 4% hit. Dual-eligibles is just one area where the government will look as it returns its focus to cost-cutting initiatives. And again, this will probably happen no matter who wins in November. Morozov: Another one of those areas that could see cuts is funding for government and academic projects. If the most-draconian By 2014, however, we get this inflow of millions of people who weren’t insured. An insured person spends about 30% more on drugs than does an uninsured person. So, there’s this tailwind that comes in the latter part of the decade as Obamacare gets instituted. We think that this tailwind hasn’t been fully appreciated by the market. Hence, we still think the pharmaceutical industry is undervalued, even with their recent run-up. MorningstarAdvisor.com 31 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Contents
Contributors
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012