Source: Valuation by Tim Koller.
I have been reading for a few weeks the book called “The five rules for successful stock investing”. For those who do not know it, the author is Pat Dorsey. Former Director of Stock Analysis at Morningstar. Right now Pat is working in his own company called Dorsey Asset Management.
From my point of view, the book is simply for begginers, clear and well-written. The classic book that you can re-read every year. I found the last 13 chapters as a reference guide or 101 XXX industry. Here are my notes from the chapter called “Health Care”. Highlight:
- Health care is one of the few areas of the economy that’s directly linked to human survival.
- Vital importance of health care gives this sector the potential for above-average financial returns.
- Many areas in the health care sector are dominated by a few big player.
- The health care sector includes drug companies, biotechs, medical device firms, and health care service organizations.
Economic moats in Health Care:
- High start-up costs, patent protection, significant product differentiation, and economies of scale. Patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records.
- Patent protection often prevents direct competition, so firms charge the highest price the market will bear for prescription drugs.
- Higher prices + economies of scale = gross margins ofter > 75% to 85%
- Barrier to entry: develop a drugs will take > 15 years, research, development and regulatory process and can cost hunderds of millions over that time frame.
- Pricing is often opaque to health care consumers and irrelevant to physicians helping make the decisions.
- Branded pharmaceutical companies generally boast top-notch profit margins.
- Most global pharmaceutical companies have returns on invested capital (ROICs) in the mid-20s.
- Gross margins often near 80%
- Operating margins between 25% and 35%.
- But innovation isn’t cheap. It takes money to make money, and the average cost of taking a drug from discovery to the pharmacy shelf is $800 million.
- The clinical testing phase (trials in humans) alone can take a decade.
- Drugs are discovered in many different ways.
- Drug development timeline: Preclinical Testing > Human Clinical Trials (Phase I) > Human Clinical Trials (Phase II) > Human Clinical Trials (Phase III) > FDA > To Market
- Generic drugs have the same chemical composition as brand name drugs but cost significantly less (40% to 60% less). They do not need to recoup the $800 million in per drug research and development costs.
- Drugs have been known to loss as much as 80% of their sales in the first six months after going off patent.
- Companies to provide stellar performance: blockbuster drugs, patent protection, full pipeline of drugs in clinical trials, strong sales and marketing capabilities, big market potential
Generic Drug Companies:
- Gross margins 40%- 50%
- Operating margins around 15% to 20%
- ROIC depending on the company’s exposure to branded drugs.
- Some competitive barries such as: 180-day of exclusivity marketing, which allows the generic company to cash in before others join the party.
- They seel to discover new drug therapies using biologic – cellular and molecular- processes rather than the chemical processes used used by big pharma.
- Categories: established, up and coming, and speculative
- Established: large number of drugs in late-stage clinical trials, plenty of cash on hand, plus cash flow to cover several years of research and development expenditures, salesforce of their own, a stock price that provides a margin of safety of around 30% to 40% to its fair value.
- Up and coming:
Medical Device Companies:
- These are the companies that make the hardware for medical procedures. There are two main types of device firms: cardiovascular and orthopedic.
- Barries to entry: economies of scale, high switching costs, and long-term clinical histories all serve as high barriers to new entrants.
- Patent protection on devices and instrumentation used for installation also provides a measure of protection.
- Each company makes its own proprietary set of tools that work exclusively with its own joint replacements, a surgeon who decides to use a different company’s artificial hip must squeeze in time to receive training on how to use the new instrumentation system.
- Finally, some device firms face less risk than pharmaceutical firms because product improvements tend to be evolutionary rather than revolutionary.
- Key factors we look for in a device firm:
- Salesforce penetration
- Product diversification
- Product innovation
Health Insurance/Managed Card:
- Less atractive because are subject to intense regulatory pressure and widespread litigation.
- How to find good companies:
- Effective medical cost management and underwriting
- Minimal dual-option business
- Large mix of fee-based business
- Minimal exposure to government accounts