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Valuation: Why Health Insurer Anthem Is Worth Investing In

November 19, 2019, 2:00 PM UTC
Michael Nagle—Bloomberg

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” — Warren Buffett, Fortune, 1999

In a column about Alphabet this past summer, I discussed the concept of “headline risk,” a shorthand term investors use to capture the state of play when a stock isn’t performing well because of a drumbeat of bad news.  Often, the negative headlines misrepresent a company’s issues, either by grossly exaggerating them or by ascribing permanence to a problem that’s merely passing.  Charlie Munger, always one for a colorful image, says that he and his partner, Warren Buffett, love investing in businesses that have “localized cancer”—not systemic or terminal, in other words, but transient and therefore easily dealt with. 

Localized cancer, headline risk—call it what you will, these episodes create wrinkles in the investment time-space continuum that long-term investors can use to arbitrage between perception and reality.  Such is the case right now with Anthem, one of the nation’s leading health insurers, which I own for my clients and have been adding to recently.  Caught up in the political rhetoric of the 2020 election, Anthem is an above-average business selling for a below-average price— below-average, as in cheap.

A long-shot ‘Doomsday’

Let’s address Anthem’s Doomsday Scenario straightaway. Should the United States of America adopt a single-payer health-insurance system, Anthem will definitely turn out to be a bad investment.

Anthem and the other “Big 5” health insurers—UnitedHealth Group, Aetna, Cigna and Humana—are middlemen that connect the complicated ecosystem of healthcare providers, consumers and payors.  When one big customer—the government—sets rates and deals with the parties involved, there is little use for such intermediaries.  You’ll get no argument from me that under such a scenario Anthem will lose considerable value. But I will argue that a.) Anthem and other health insurers play a vital, misunderstood role in the current system; b.) the probability is remote that this role will be vitiated by socialized insurance in the short- to medium-term; and c.) Anthem has attributes unique among its managed-care peers that make it especially attractive.

As to the probability of the Doomsday Scenario, three things need to happen at once for it to transpire.  The American people need to elect a Democrat from the left wing of the party, like Sen. Bernie Sanders of Vermont or Sen. Elizabeth Warren of Massachusetts; the Democrats need to retain their majority in the House of Representatives; and they need to pick up three seats in the Senate to win a majority there. Pace Warren Buffett and probability theory, we can assign a numerical likelihood to each event and thereby assess the chances of a radical healthcare overall.  

Personally, I give a Sanders or Warren presidency a 25% chance, the Democrats retaining the House a 95% probability, and their odds of recapturing the Senate 1 in 3.  Probability theory dictates that the chances of three things happening simultaneously is calculated by multiplying together the odds of each individual event occurring. So a 25% chance of a far left-wing president, times a 95% chance of a House majority, times 33% odds of reclaiming the Senate equals an 8% probability that the Democrats will be able to enact some form of universal government healthcare.  

Let’s call it a 5% to 10% chance—i.e., not very likely, even before considering the fourth thing that needs to happen: actually getting the legislation passed.  

In 1992, Bill Clinton came into office with Democratic majorities in both houses of Congress and an electoral mandate to do something about healthcare.  But his proposal, which would have ensured universal coverage through a combination of employer mandates and government funding, failed amidst criticism from both conservatives and liberals.  Present-day proponents of government healthcare appear to have learned from such battles, and they are already cautioning against optimism. Last month, liberal columnist Paul Krugman wrote in The New York Times: “Even if Democrats win in a landslide in 2020, taking control of the Senate as well as the White House, it’s very unlikely that they will have the votes to eliminate private insurance.”  

Everyone agrees that costs are out of control:  Our per capita healthcare spend is roughly two times that of other Western nations.  Moreover, despite the spending our outcomes are often worse than those of our international peers, especially among poorer Americans.  The problem, as Krugman intimates, is that nobody wants to make the sacrifices required to fix the situation.  Doctors and hospitals, which together account for more than half of all outlays, aren’t raising their hands to lower prices.  Corporations and government desperately want cost discipline, but their constituents, be they employee or voter, will oppose any remedy that involves lower benefits or higher taxes.  The critical fact is that one in two Americans get their health insurance through their employer, and despite rising deductibles the system works pretty well for these people.  Americans don’t pay anywhere near the lion’s share of the cost of care, making healthcare one of the few marketplaces in which Americans, the ultimate consumers, are indifferent to price.  With someone else footing the bill, the average American will continue to resist change.

Thus the most likely healthcare outcome after next year’s election is going to be some sort of tweak to the existing system.  And any tweak will almost certainly favor Anthem and its peers. This was the case after Obamacare, which gave managed-care companies millions more lives to insure. [Editor’s note: On Friday, Anthem stock rose 6.5% and other managed-care providers also saw share-price gains after Warren announced that she would not attempt to immediately enact Medicare for All if elected president.]

Invaluable infrastructure

The healthcare question engenders such passionate feelings from both right and left that relatively few people stop to ask, “Exactly what do health insurers do?”  The answer is quite easy:  They are not price-gougers or any of the other epithets liberals like to tar them with. They are simply intermediaries, middlemen that splice together the spaghetti-like tangle of doctors, hospitals, drug companies, patients and the corporations and government entities that pay the bills. 

In both their function and their economic characteristics, health insurers resemble nothing so much as power utilities. Like an electrical-transmission company or a gas pipeline, health-insurance networks are boring but essential pieces of the American economic infrastructure. Their economics reflect this reality:  In exchange for connecting the many parties involved, health insurers make a small profit margin— generally less than 5%—and a decent but not obscene return on their investment.  Anthem’s return on equity is roughly 15%, similar to an electrical utility’s return and far below those of other, more powerful economic-franchise businesses. Paint-maker Sherwin-Williams, which I wrote about last month, earns nearly 50% on equity, and Alphabet earns 60% if you back out its cash stockpile.

Also lost in the political rhetoric is the fact that for the last generation, health insurers have been the principal and perhaps the nation’s only private entities to have bent the healthcare cost-curve downwards. Since the advent of HMOs a generation ago, annual healthcare cost inflation has decelerated from the low teens to the mid-single digits today, according to data from the Bureau of Labor Statistics.  This is because corporations and both state and federal governments use the major health insurers as bullying enforcers that keep doctor and hospital bills in check.  

Anthem has an average of 30% market share in the states where it sells insurance; as a result, any doctor’s group or hospital system must either make a deal with Anthem or miss out on 1 out of every 3 patients in their region. This gives the company bargaining power and is in fact the source of Anthem’s competitive advantage.  Anthem’s large local market share allows them to extract doctor and hospital discounts for its corporate and government clients, which makes Anthem a low-cost provider of insurance.  This in turn makes them more attractive as the enforcer of choice for both government and corporate purchasers of insurance, allowing them to gain even more market share.  It’s a classic self-enforcing competitive advantage and one that will continue to grow as Anthem continues to add share and scale.

Blue Cross roots

Besides this inherent edge that it shares with the other Big 5, Anthem has other, unique advantages.  As the only major publicly traded company with permission to sell Blue Cross Blue Shield insurance (it licenses the name from the nonprofit Blue Cross Blue Shield Association for use in 14 states) it has the most trusted brand in the nation.  Anthem is also in very early stages of a major overhaul of its basic operations, and as such is a classic turnaround stock. 

Gail Boudreaux, president and chief executive officer of Anthem, speaks during Fortune’s Most Powerful Women conference on Oct 1, 2018.
Patrick T. Fallon—Bloomberg via Getty Images

Anthem’s two prior CEOs came from the nonprofit side of healthcare, which was in keeping with Anthem’s Blue Cross roots.  Because of this, though dominant in its markets, Anthem was a sleepy and one might even say a lazy company.  More innovative health insurers like UnitedHealth Group have pushed aggressively into adjacent businesses like dental and vision insurance, pharmacy-benefit management and even healthcare data analytics, but Anthem has spent the last ten years doing little more than buying back its own stock. Several years ago, its investor-relations director told me with a straight face, “We do one big initiative a decade.”  

Thankfully, in late 2017 Anthem’s board of directors fired its CEO after a botched merger attempt with Cigna and hired the ideal replacement: Gail Boudreaux, who has roots in the non-profit Blues system but also was a high-ranking executive at UnitedHealth.  Under Boudreaux’s leadership, Anthem suddenly looks like a 21stcentury enterprise.  The company is updating its antiquated IT systems, has exited a foolish and highly unprofitable pharmacy-benefits contract with Express Scripts and has begun to grow  its core insurance product—the most lucrative part of Anthem’s business—for the first time in more than a decade.

Rarely have I seen such a rapid corporate transformation.  It’s obvious from Boudreaux’s first 24 months that the business was so mismanaged that she found more than just low-hanging fruit awaiting her—the fruit was sitting right there on the ground. After her initial fixups, Boudreaux is now pushing into data analytics, Medicare Advantage and other profitable lines of business that her predecessors had neglected.  The opportunity is huge:  UnitedHealth Group, the leading managed-care company, insures only 25% more lives than Anthem but has a market capitalization that’s 3.5 times bigger.  The only reason for this is that Anthem has failed to push into new, promising areas the way UnitedHealth has—but that’s changing under Boudreaux.  Relatively speaking, the transformation won’t be difficult: Before she came to Anthem, Boudreaux was president of UnitedHealth’s core health-insurance division.  She has UnitedHealth’s playbook, in other words.  

Driven by Boudreaux’s initiatives, earnings, which were a mere $12 per share in 2017, should by my estimate nearly triple to $30 per share by 2023—a growth rate of 17%. One doesn’t have to look even that far out to see that Anthem is a cheap stock:  It will earn roughly $22.50 per share next year and thus trades for 12 times 2019 earnings.  The average stock in the healthcare industry, which is generally under the cloud of headline risk, is trading for 15 times 2020 earnings, and the average company in the broader S&P 500 trades for nearly 20 times next year’s estimates.  This means that Anthem is trading as if it were well below-average as a business—but as we’ve seen above, Anthem’s position as an essential part of the nation’s healthcare infrastructure makes it an above-average business.   

Longer-term, perhaps the nation will devise a wholesale healthcare reform plan that attacks high costs, mediocre outcomes and non-universal coverage, one that’s palatable to all stakeholders.  If that happens, there’s a good chance that Anthem and the other managed-care companies will be designed out of the system.  But that reckoning is beyond our investment time horizon, I think, so the perceived risk to Anthem is just that—perceived, or headline, risk.  When this risk recedes, the reality of Anthem’s critical role will shine through, and the pricing arbitrage will resolve in favor of those who own Anthem today. 

Adam Seessel is founder and CEO of Gravity Capital Management. He owns Anthem stock in funds that he manages for clients. His column, “Valuation,” appears monthly on Fortune.com.

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