The Market Appears to Misprice Risks to Healthcare Earnings from the Budget Control Act

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Since details of the Budget Control Act were made public, Hospitals have meaningfully underperformed the broader Healthcare industry; Large-Cap Pharmaceuticals, Specialty Pharmaceuticals, Biotech and Medical Devices have performed in-line

This implies that the Act’s committee fails to produce legislation, which results in automatic cuts. In turn, this results in as much as a 2 percent reduction to Medicare, which presumably translates into a 2 percent reduction in Medicare payment rates. In such a (we believe relatively unlikely) scenario Hospitals are directly affected, and sellers of innovative products are not directly affected

The market appears to believe the committee will fail completely, i.e. that the members can find nothing to agree on. We suspect the market misreads the mechanics of the automatic cuts – if the committee fails to produce law resulting in $1.2T in deficit reduction, the automatic cuts kick in as an addition to whatever savings were produced by the committee’s law in order to reach a $1.2T total; the automatic cuts do not replace the cuts in a < $1.2T committee law

Because the automatic cuts contain significant political pain for both parties, both parties have a vested interest in avoiding as much of the automatic cuts as they can, even if the cuts cannot be avoided entirely. This means the question of whether the committee legislates new rebates and/or discounts for drugs and devices is not a broad / binary question of whether the committee can find $1.2T in deficit reduction; it is a very simple question of whether the committee (and ultimately the Congress) prefers ‘X’ dollars in (politically safe) new discounts and/or rebates on drugs and devices to ‘X’ dollars of (politically dangerous) automatic cuts

Accordingly we see a very real risk of new discounts and/or rebates for drugs and devices sold to Medicare and Medicaid, though this risk appears not to be reflected in share prices for the corresponding sub-sectors. Ignoring for a moment our longer-term investment views of each sub-sector; we believe that Hospitals have been oversold in the immediate reaction to the Budget Control Act, and that Large-Cap Pharmaceuticals, Specialty Pharmaceuticals, Biotech, and Medical Devices have been ‘undersold’ in the immediate reaction

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