In this newsletter we are going to talk about two related yet unrelated topics: health care and smoking.
The FDA and Nicotine
On Friday July 28, the FDA announced that they are going to explore a new requirement for tobacco companies to reduce the level of nicotine in cigarettes below addictive levels. In a carrot and stick approach, however, the agency also announced they were going to relax some of the rules around “reduced risk products,” such as e-cigarettes and vaping products. Nevertheless, tobacco stocks dropped as much as 10% between Friday and the next Monday.
There is not a lot of scientific evidence regarding reduced nicotine levels in cigarettes. To the best of my knowledge, in the last two decades there have been only two, six-week studies conducted. One study examined the effectiveness of reduced nicotine levels to assist smokers who wanted to quit (it was effective). Another study examined what effect reduced nicotine levels had on smokers’ habits. Contrary to what many people speculate, reduced nicotine levels did not make smokers consume more cigarettes to get the same level of nicotine. At the same time, the study didn’t seem to offer any conclusive results about whether smokers were better able to quit. Whatever the FDA does, if anything, it is likely to be implemented slowly. You can’t force a nation of smokers to quit cold turkey by drastically dropping the nicotine levels of cigarettes. The future of tobacco companies is not in cigarettes; however, it’s in flameless and smokeless reduced risk products, such as vaping and e-cigarettes. Philip Morris and Altria arguably are best positioned to take advantage of this trend over the next decade.
In our opinion, the biggest news is that the FDA is again looking at banning menthol in cigarettes. When I first went into business, the FDA was also considering banning menthol. As a precaution then, we never included Lorillard, the maker of Newport Menthols, in our portfolio. Later, Lorillard merged with Reynolds American, which we owned. About that time, the FDA decided against banning menthol. Last year, British American agreed to buy out the rest of Reynolds American. As a result, British American is now the tobacco company with the most exposure to a menthol ban. British American gets 38% of its sales from the US and about half of those sales (19% of the company’s total) are menthols.
Because of the renewed risk over a menthol ban, we decided to sell British American. We kept our investment in Philip Morris International because the company has no exposure to the US cigarette market. We kept our investment in Altria because of the company’s strength in reduced risk products and low exposure to menthol cigarettes. We kept our investment in Imperial Brands Group because the company gets only 21% of its revenue from the US and has minimal menthol exposure within that 21%.
Health Care in the US
Health care stocks have typically been a great investment. Over time, the health care sector has outperformed the market. In addition, health care stocks usually offer generous dividends and tend to fall less than the market during times of panic. What’s not to like?
Well, we recently reduced our exposure to the health care sector because we see some trouble on the horizon.
In 1960, the US spent approximately 5% of GDP on health care. Today the country spends 20%. This is why health care stocks have outperformed the market. Consumers and businesses have basically quadrupled the amount of money they spend on health care! We don’t think that kind of growth is sustainable.
Right now, the US spends about 2 to 4 times as much per capita as every other developed country on health care. The average per capita cost of health care amounts to one-third to one-fourth of the average person’s income (depending on which data set you use and how you define income).
In our opinion, we’ve reached the limit on how much consumers can spend on health care. Health care is by far the number one issue among voters. Indeed, health care issues have largely dominated the political climate since 2010.
A health care system that spends four times as much per person as other developed countries is a system with a lot of issues everywhere. I have many friends and clients that work in the health care industry and they have stories they could tell about various inefficiencies in the system. And you may have experience with some of those inefficiencies from a patient’s perspective.
Instead of looking at the intricacies system, I’m going to focus at a higher level. We don’t know when or how health care reform will happen in the US, but we do know it’s at the top of voters’ minds and they’ll likely continue to vote people into Washington to fix health care. The only way to fix health care is to reduce spending. Reduced spending could take many forms. It could add a public option to ObamaCare (e.g., Medicare for all). It might be small steps like allowing Medicare to negotiate lower drug prices. It could come in the form of stricter regulations about the profits insurance companies can earn. Another option could be to remove middlemen, like pharmacy benefits managers, from the system. The problem is we just don’t know what it will be.
Less money spent on health care means lower profits for health care companies. The flip side is that it frees up money that can be spent elsewhere and other sectors of the economy can benefit. Let’s say a friend currently pays $1000 a month for an expensive prescription drug. Then let’s say we finally have some type of health care reform that includes a regulation reducing drug costs to the levels the rest of the world pays. As a result, our friend now only pays $100 a month for that same prescription. What will our friend do with the other $900? Maybe they can save up to buy a house. Maybe they buy a new car. Maybe they go out to eat more often.
It doesn’t matter if we have small incremental improvements in health care (letting Medicare negotiate lower drug prices) or major reform (like a single payer option). The point is voters have clearly said they want less money going into the health care sector and they have said that is a major issue. We think the health care sector is going to change fundamentally. We don’t know when, or how quickly, but we believe change is coming. Our goal is for clients’ investments to be well prepared for that change.
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