Healthcare has traditionally been a defensive sector with spending that is less sensitive to overall growth than other parts of the economy. As a result, healthcare stocks have tended to produce more consistent returns than the broader market. But disruption on multiple fronts is challenging the status quo and undermining the sector’s defensive qualities.
Something’s Got to Give
Americans spent an estimated $3.5 trillion on healthcare in 2018—about 18% of total GDP. This compares to an average of just over 12% of GDP for other developed economies (Display). Spending per person in the US is almost twice that in comparably wealthy countries. While the use of most services is no higher in the US, physician services, administration costs, and prescription drugs cost twice as much. Yet, despite significantly higher spending, health outcomes in the US lag the rest of the world.
Disruption on Four Fronts
Bloated costs and relatively poor outcomes highlight a healthcare system that is ripe for disruption, innovation, and consolidation. There are four forces that we believe are poised to disrupt the status quo: regulatory change, rising consumerism, the digital revolution, and the Amazon effect. The combination of these forces will have varying impacts on the subsectors within healthcare, increasing the importance of fundamental bottom-up research.
While the passage of the Affordable Care Act (ACA) in 2010 and its implementation were marked by controversy, few can argue with the law’s dual mandates of improving quality of care and reducing costs. But most Americans agree that more needs to be done. Surveys show that healthcare was the top issue for voters in 2018 and early indications point to it remaining high on the list in 2020. So more regulatory change seems inevitable.
Whether the next step is “Medicare for All” or modifying and improving the ACA, the shift away from the traditional fee-for-service business model to value-based care is likely to continue. In the traditional model, increased volumes equate to more revenues and there is little financial incentive for providers to focus on preventative care or shift toward lower-cost settings. In contrast, value-based care, which is focused on efficacy and quality of care, provides better financial incentives for preventative care, early detection, and monitoring of chronic conditions. As a result, reimbursement risk is growing for high-fixed-cost incumbents like hospitals, while those providers and services that help produce better patient outcomes and control costs will likely benefit.
Consumer engagement in healthcare is different than in most other sectors, in part due to the traditional disconnect between the users of care and the payers. But today, as patients are bearing more of the costs, with high deductible plans and increasing co-pays, they’re demanding greater price transparency and greater choice in how and where they receive care.
Rising awareness of the wide range of prices charged—often for the same procedure or service from the same service provider—is reinforcing the importance of comparison shopping. Websites designed to increase price transparency may help bring price alignment over time, much as online shopping has driven prices down for many other consumer goods. Insurers are also encouraging patients to move to lower-cost care sites by highlighting potential cost savings. Cost-effective alternatives to unnecessary emergency room visits range from 24/7 nurse lines and telemedicine visits, to retail-based convenience clinics and urgent care (Display).
Rising consumer engagement is likely to contribute to additional pressure on high-fixed-cost incumbents. We expect hospitals to continue to lose share to specialty care providers, and managed care companies to benefit from consumer engagement that contributes to lower costs.
Surveys of industry insiders frequently cite technology as the biggest potential disrupter in healthcare. And indeed, advances in technology are contributing to precision health tools that were unimaginable a decade ago.
Precision health tools include an explosion of devices that help keep people well, smooth rehabilitation, or reduce hospital readmittance rates. Direct-to-consumer medical technology companies have developed an array of apps and wearable sensors—from simple activity trackers to continuous blood sugar and blood pressure monitors. These pervasive-sensing devices, which help monitor both chronic and acute conditions, can significantly improve patient outcomes and reduce the need for expensive care.
Big Data and advances in artificial intelligence also have the potential to revolutionize medical research and healthcare. It took the Human Genome Project 13 years and about $1 billion to sequence the first genome. Today, rapid and relatively inexpensive DNA sequencing provides researchers with almost endless possibilities for predictive analytics and personalized medicine. The UK Biobank, for example, contains the genetic material for 500,000 volunteer participants that is helping researchers study the respective contributions of genetic predisposition and environmental exposure to the development of disease.
DNA sequencing has also provided insights into the genetic mutations present in some tumors and has led to highly effective, targeted treatments for some cancers. Beyond oncology, however, the promise of Big Data and AI in drug development has taken longer to materialize than industry insiders had hoped. But medical researchers and pharma industry executives are still banking on Big Data and artificial intelligence to reverse the dramatic decline in returns on investment in drug research and development over the last decade.
Beyond more traditional medical technology companies, many tech giants are making a push into healthcare. Microsoft and IBM, for example, are focused on health information systems. Apple, Google, and Facebook have dedicated healthcare “skunkworks” and are actively buying or backing external start-ups. These so-called tech insurgents are likely to both introduce new competition into a healthcare delivery system that is highly resistant to change, and partner with existing players as they adapt to shifting competitive dynamics.
There are early signs that Amazon is targeting the healthcare sector as well. In early 2018, the company formed a joint venture, Haven, with JP Morgan and Berkshire Hathaway designed to lower costs and improve care for the one million employees of the three companies. While formed as a nonprofit, the market is watching carefully for signs that this venture will expand to compete for profit with managed care.
Amazon also acquired PillPack, an online pharmacy start-up. While relatively small, PillPack’s pharmacy licenses in 50 states give Amazon a leg up on entering the pharmacy market, which many believe is ripe for e-commerce disruption. As online penetration of the prescription market increases, we estimate that Amazon’s share of total retail pharmacy will grow to 12%, or around 900 million prescriptions per year by 2027. While this may not be a game changer for Amazon, the threat to brick-and-mortar retail pharmacies and other parts of the drug distribution channel is clear.
Threats and Opportunities
Outsized profits and inefficiencies increase healthcare’s vulnerability to disruptive forces. Regulatory change, rising consumerism, the digital revolution, and the Amazon effect will impact different subsectors—and, importantly, individual companies—within healthcare by varying degrees. Ultimately, investment decisions will be driven by our view on how these potentially disruptive forces will influence a company’s earning potential over time. We expect that these disruptive forces will erode the sector’s traditional defensiveness and that we will see increasingly divergent fortunes as some companies adapt and innovate, while others fail to embrace the changing dynamics.
An information edge can mean the difference between getting ahead—or being left behind. That’s why many of our entrepreneurial clients look to us as a source of intellectual capital. For more insights on disruption, check out the related blogs here.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.