With the election over and the Affordable Care Act (a/k/a Obamacare) now the law of the land, I've decided to revisit my healthcare picks from last summer. (My dead-on election predictions can be found here.)
The hospital stocks have been on a tear as investors figured another 35 million customers are ready to check in. The largest hospital chain in the country, Hospital Corp of America (HCA), is up over 45% year to date. But, with a few analysts publishing price targets as high as $40, it's worth asking: Are hospitals really a new growth story?
In his recent book The Cost Disease, economist William Baumol explores the reasons why computers get cheaper and healthcare costs never seem to decline -- and his basic argument is that some industries outpace the economy's average productivity. For example, in 1913 Ford (F) introduced assembly lines to move cars between workstations. This allowed workers and their tools to stay in one place, which cut the time to build a Model T from 12 hours to 2 hours. As output per worker grew in these types of industries, employers could afford to increase wages.
But in other industries -- ones Baumol calls "stagnant" -- productivity gains are much harder to come by, if not impossible. Employers in those stagnant sectors are forced to raise wages no matter what, because otherwise it will lose workers to the more productive sectors of the economy. As the cost of production rises, firms are forced to raise prices.
As Baumol points out, performing Mozart in 2012 takes the same number of musicians as it did in the late 18th century. In the performing arts, standardization and automation are very difficult -- and industries with goods that are tailored to meet customer specific demands fall into this "cost disease" sector.
For example, it would be hard for a barber to cut the hair of 10 times more heads today, right? A pilot can't fly 10 times more flights. In that vein, it would be difficult for a surgeon to do 10 times more surgeries today -- wouldn't it? In order to add capacity, you'd have to hire more barbers, more pilots and more surgeons. Any industry that depends on human interaction usually falls into this cost-disease category. You can only get so much productivity out of a human being. Of course, cutting human input -- which makes these products valuable -- would be self-defeating.
Baumol argues that industries infected with this cost disease, such as education and healthcare, never see their costs decline. In fact, since the 1980s the cost of a college education has risen by 440%, and the cost of medical care has risen 250%. During that time, average wage and price increases have only grown 110%.
If you follow Baumol's line of reasoning, you'll see he is on to something. For example, in the last five years HCA's sales per employee has grown 3.3%, from $144,398 to $149,156. But its enterprise value has skyrocketed as investors have chased the stock. From fiscal 2007 to the latest reported quarter, investors have driven up HCA's enterprise value from $27.8 billion to $43.0 billion, a 54.5% increase. In the last three years, HCA's operating margins have bounced between 13% and 14.4%.
In contrast, take a look at Intuitive Surgical (ISRG). This company's sales per employee have gone from $786,424 at the end of fiscal 2007 to $1,073,960 in the latest quarter, a 36.5% climb. During this time, operating margin has grown 573 basis points to 40.14%. As with HCA, Intuitive Survival's enterprise value has increased 57%.
According to Baumol's theory, Intuitive Surgical is the superior investment in the healthcare sector over the long term. After all, it can increase its profits by adding automation and productivity, just like Ford did in 1913.
HCA, on the other hand, is overvalued according to Baumol's theory, because it is very difficult for the company to dramatically improve productivity. HCA can add capacity by buying more hospitals, cutting money spent on bandages and eliminating a few employees at the margin, but it will never see the dramatic increases in productivity over the long term that it needs to support its high valuation. Cutting human input to increase productivity (and profits) would greatly diminish HCA's end product.
So, as you begin to hearing the hospital industry is suddenly the new hot growth area, this is just something to think about.