Healthcare stocks took it on the chin last week following Obama’s budget submission.  The new budget calls for a National Health Insurance Program and sweeping changes to the current Medicare process.

While the entire budget will likely be cut up, twisted, reformatted and then put back together by congress, the uncertainty had a profound effect on the markets.  Drug makers, managed care providers, medical technology companies and insurance firms all fell in lock step.  Investors obviously fear that a widespread change in government reimbursements and other programs could severely crimp future profits.

In particular, Obama plans to establish a $630 billion dollar “reserve fund” which will be used to fund the national health insurance program.  This program would likely require much more capital to be “fully operational,” but the move is still groundbreaking and has the potential to significantly change how Americans receive medical care.

This year I have actually been quite active in the healthcare sector.  In the publication Taipan’s New Growth Investor that I write for, we have two long positions (A diagnostic company as well as a managed care firm).  At the same time, my trading service Death Cross Trader has benefited from shorting or buying puts on a few over hyped, high multiple medical technology companies.  The new budget has certainly had a profound effect on all of these positions.

Efficiency as the Goal

It’s a bit ironic coming from the government, but the big push for this budget centers around efficiency.  I say ironic, because it is pretty rare that you actually see the government operating efficiently.  But with a new Universal Healthcare system beginning to take form, the government wants to keep a lid on medical costs.

Looking at “for-profit” companies in the industry, this can be pretty bad news.  If regulators look in and see companies accepting medicare payments and making wide profit margins, the payments will likely be reduced.  That’s why we are seeing stocks of profitable healthcare companies trading sharply lower.  For instance, Gilead Sciences, Inc. (GILD) dropped 9.6% in just 2 days following the release of the budget.  The company develops treatments for many viral diseases.

Most of Gilead’s products have very high profit margins because they own the patent on vaccines and medicines.  We’ve been short GILD in Death Cross Trader because investors got too confident that these profits would continue to grow.  Now, investors begin to question whether these wide profit margins will stick around.  After all, what if the government requires Gilead to offer treatments at substantially lower prices?  I don’t think this is an impossibility anymore.

This is a pretty sobering event for free-markets.  Part of the reason Gilead’s products are so expensive is because of the huge research expense to develop a product.  Typical drug companies may spend tens or hundreds of millions to develop, test, and get products approved.

Once the process is complete, the actual cost to manufacture each pill can be very low.  But companies charge a high price to make up for the development expenses along the way.  If medical companies can’t charge enough to make a profit on top of these costs, there is a pretty good argument that the advances in medical technology could be pressured.

Aside from the social and moral concerns, we as investors and traders have to do the best we can to protect our capital in this environment.  And that means even profiting from declines like we’re seeing in the medical stocks right now.  For instance, last week I suggested DCT traders buy puts on Immucor, Inc. (BLUD).  The stock had broken sharply below a support level and was vulnerable due to a high earnings multiple (among other things).

Today, just over a week later, those puts are more than 200% higher.  The movement in stocks like Gilead and Immucor goes to show that healthcare is a recession resistant sector, but certainly not recession proof.

Attractive Opportunities Still Exist

While investors quickly sold every healthcare company that had a pulse (pardon the pun), there are a few key areas that still appear to be good investments.  To be quite honest, the healthcare sector can actually be quite bi-polar when it comes to the profitability of individual companies.  So from and investing standpoint, there are several sub-sectors to consider when looking at healthcare stocks.

Some of my most recent recommendations have been for home healthcare companies with relatively attractive profit margins.  These firms usually have a significant reliance on Medicare which reimburses the company for much of the care given.

On the surface, this may sound like a losing combination.  After all, if Medicare payments are going to be reduced to firms making strong profits, doesn’t that mean home healthcare companies will be in the crosshairs for Medicare cuts?

But looking deeper into the dynamics, I believe home healthcare solutions will actually be PART of the plan to increase efficiency.  You see, when a patient gets discharged from the hospital, or needs to have watchful care, home health companies step in and provide care at a much lower cost than if the patient were hospitalized.  So in actuality, these firms ALLOW Medicare to be MORE efficient and cost conscious.

Obama has stated the goal of reducing re-admission to hospitals.  They simply don’t want to see patients released and then have these same patients returning to the hospital.  That’s more costly for everyone.  But since many home care firms specialize in taking care of acute patients, there should be even more business coming their way.

So I expect while profits per patient may decrease a bit, companies in this sub-sector will get more than enough new business to make up for it.

FD: Author does not have a position in stocks mentioned
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Additional Reading:
Forbes: What Obama’s Healthcare Budget Means For You
Big Picture: Time For A New Deal