Practical analysis for investment professionals
11 July 2012

The Economics of Obamacare (Part 1): The Implications for Health Care Investing

Now that the U.S. Supreme Court has upheld the Patient Protection and Affordable Care Act (PPACA) — known simply as the Affordable Care Act and more popularly as “Obamacare” by conservatives and, yes, liberals alike — it is a good time to explore what the legislation really means. The architects of PPACA emphasize three main goals: to provide access to health care to all; to improve the quality of care; and to find ways to slow or reduce the cost of care. Can the law meet these lofty goals? And what are the implications for investors in hospital and insurance stocks?

It’s impossible to answer these questions without understanding the deeply complex historical background of health care in the United States, so I’m breaking my analysis into three posts. In this first post, I’ll cut to the chase and lay out my investment thesis in brief. In a second post, I’ll delve into the history of health care insurance, working through the lens of American economist Milton Friedman and British physician Max Gammon, so that those interested in the deeper context can better understand my rationale. And in my third post, I’ll assess what the central lessons of Medicare can teach us about the economic impact of the new health care law.

The centerpiece of PPACA — and the core of the controversy over the law — centers on the mandate that most Americans obtain insurance, either from private insurers or new government-run plans, or face a penalty. As I see it, though, the analysis must really begin on the other side of the pond. About 30 years ago, Gammon embarked on a journey to understand the cause of Great Britain’s explosion in health care costs. He began by studying the creation and role of the National Health Service (NHS) in the United Kingdom in 1948, which is that country’s government-run health care program. Gammon ultimately concluded that the NHS created a bureaucratic black hole in which input costs rose and displaced the quality of care. This theory of “bureaucratic displacement” became known as Gammon’s Law and is visible just about anywhere the government has a large influence.

In 1991, Milton Friedman updated the famous Gammon’s Law study by applying it to the U.S. health-care system:

Progress in medical science may well explain most of the decline in output [e.g., occupied beds]; it does not explain much, if any, of the rise in input per unit of output. True, medical machines have become more complex. However, in other areas where there has been great technical progress — whether it be agriculture or telephones or steel or automobiles or aviation or, most recently, computers and the Internet — progress has led to a reduction, not an increase, in cost per unit of output. Why is medicine an exception? Gammon’s law, not medical miracles, is clearly at work.”

Now that the Affordable Care Act is the law of the land, new price mandates and cost shifting will drive ever more people of all age groups to migrate into government insurance plans. We have seen this before: it is a central lesson from the government-run health insurance plan for people over age 65, known as Medicare, which came into effect in 1966 and subsequently drove a dramatic increase in both the cost and bureaucracy associated with U.S. health care.

Future of U.S. Health Care To Unfold in Three Phases

In my view, the future of U.S. health care will have three phases, each with important implications for investors:

  • Phase I: In this phase, the number of people added to the insurance rolls will grow by about 30 million. Of course, this new enrollment of mostly younger, healthier people will boost the premiums and profitability of private insurers in the short run. This phase may last two to three years. In this phase, hospitals such as HCA Holdings (HCA), Tenet Healthcare (THC), and Lifepoint Hospitals (LPNT) will be helped by getting fewer uninsured people and hence lower bad debts.
  • Phase II: The government will create exchanges to sell government-run policies in competition with the private market. Because it is the U.S. federal government, it has the power to negotiate prices below the private market and thereby force additional costs onto private insurers, just like Medicare. Over time, this will erode the competitiveness and solvency of the private insurance plans. As they struggle for growth and then survival, they will be forced to steadily raise prices, leaving them vulnerable to political attack as the “bad guys.” This will likely occur as “death by water torture” with a steady drip, drip, drip rather than one dramatic event. This phenomenon will take about ten years to fully play out. Nevertheless, in phases II and III, the economics of the private health-care business will be dramatically changed and the franchise values of United Health Group (UNH), WellPoint (WLP), and Aetna (AET) will be harmed substantially, and likely fatally, as they will for most private insurers. Phase II clearly paves the way for a single-payer system. In addition, in phase II (and phase III — see below), hospitals will succumb to an ever-increasing bureaucratic wall in which access to care is restricted and the needs of the bureaucracy outweigh their ability to provide care.
  • Phase III: This phase will begin after phase II is entrenched but well before it is complete, in about five years, maybe sooner. This is when the growing cost pressures become too onerous on all insurers. Consequently, the bureaucracy of the system takes over and restricts access to medical services as a means to control costs. This is where such medical technology companies as General Electric (GE), Medtronic (MDT), Zimmer Holdings (ZMH), and major pharmaceutical companies like Merck & Co. (MRK), Pfizer (PFE), and Johnson & Johnson (JNJ) are confronted with a wave of restrictions on reimbursements for their products, particularly for expensive therapies. Somewhere before or when phase III begins, the market will focus on the difficulties these companies will have in achieving adequate returns on capital. Steadily, capital investment in research and development will slow and health innovation will slow as well.

At present, Medicare covers only 13% of the population who themselves spend about 30% of all health care dollars. The remaining 70% is spent on those below age 65. Until now. Going forward, the Affordable Care Act will immediately cover another 30 million people that are not directly in the system, and due to the mechanics at work in the various phases described above, the remaining 70% of health care dollars will increasingly flow through the government — meaning the government will have to supersize its bureaucracy, in my view likely tripling its size in the next ten years. Look for bureaucracy to grow and centralized decision-making to become paramount. More importantly, look for the system to become a swirling vortex of taxpayer dollars . . . in other words, a black hole.

More articles from the “Economics of Obamacare” series:

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.


About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

4 thoughts on “The Economics of Obamacare (Part 1): The Implications for Health Care Investing”

  1. srikanth says:

    how far will be the government policies be effective if compared to the private market in terms of insurance schemes and premium payments?

  2. Biz says:

    What are your STATs and computations to support Phase II and III? Couldn’t the opposite also be true?

    1. Hi Biz, I’m afraid I can’t answer your question unless it’s a little more specific on what you mean by opposite. I think if you read Part 2 and Part 3, it will become more clear that the PPACA will cause government bureaucracy to escalate dramatically. This will cause the cost of health care to shift into overdrive. The roll-out of the various aspects of the PPACA will of course affect timing – as will future decisions not yet made. But, in general, the adoption of 30mm new participants will be the “easy” part for the government, adjusting the size of the bureaucracy comes next. Then comes cost shifting and cost controls. The timing and duration of the phases I highlight in Part 1 reflect my best guess at how long these aspects take to play out. But under no circumstances will the legislation be able to achieve its stated goals: providing access to all, improving quality of care, and reducing cost of care. It’s kind of like saying I’m trying to lose weight by eating more twinkies…

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