Investors Rush to Place Bets on Medicare Reform - TheStreet

Health care companies -- and their investors -- are drooling at the promise of a bigger piece of the Medicare pie.

Granted, current Medicare proposals are still half-baked and subject to major recipe changes before they become final law. And past Medicare opportunities have left many health care players with a bitter taste in their mouths. But health care stocks, gobbled up by eager investors, are clearly sizzling as Medicare reform heats up.

Both houses of Congress have already passed bills that call for a sweeping overhaul of the current Medicare system. Now lawmakers are hammering out the final details of a $400 billion plan to provide seniors with affordable health care coverage -- including prescription drug benefits -- by opening new doors in the private sector. Managed care and drug-related companies, in particular, could see new opportunities to profit.

In a recent report, UBS analyst William McKeever pointed out that managed care stocks rocketed 30% in the second quarter -- doubling the broader market's gains -- and still recommended buying many of them anyway. McKeever sees huge opportunities for current Medicare players and newcomers alike.

"If the federal government allows the health plans to generate adequate returns, the Medicare market could become a viable growth opportunity," McKeever wrote last month. "The development would be a huge positive for the group."

The Right Ingredients

Arne Alsin, an Oregon fund manager and

RealMoney.com

contributor, likes health care stocks in general. He says Americans are willing to spend more on health care than on any other "discretionary" item. And he predicts that America's appetite for health services will only grow as the population ages over the next two decades.

Betting on solid long-term returns, Alsin has built an investment portfolio with "fairly heavy exposure" to many health care businesses. He likes health maintenance organizations, health care service providers and pharmaceutical plays -- and always looks to buy more when the price is right. He recently singled out

Humana

(HUM) - Get Report

, the nation's second-largest Medicare HMO, as a strong pick in his

Turnaround Report

for

RealMoney

.

Indeed, Alsin dislikes only one health care specialty -- medical-products distributors like

Cardinal Health

(CAH) - Get Report

-- right now.

"They have extremely thin margins," explained Alsin, who has no positions in that sector. "I don't like the fundamental business model at all."

Peter Cohan, a Massachusetts author and investment strategist, has some misgivings about the distributors, as well. Cohan is particularly troubled by the so-called pharmaceutical benefits managers, or PBMs, like

Express Scripts

(ESRX)

and the Medco division of

Merck

(MRK) - Get Report

, which have been plagued by accounting questions and government investigations.

"There just seems to be a lot of funny business in this area," said Cohan, who has no position in PBM stocks.

And Medicare reform may fall short of helping this particular group. Some experts question whether PBMs -- already struggling with low profit margins -- could even participate in a Medicare program aimed at providing seniors with more affordable drug coverage. But the market is in no mood to discriminate. Bullish investors, enjoying their strongest run in recent history, have already placed huge bets on companies just hoping to profit from the biggest Medicare changes ever.

Still, Alsin isn't pinning his own investments on Medicare reform. Having seen Medicare programs backfire in the private sector already, he warns that future reforms are just as vulnerable to the "law of unintended circumstances." Cohan expresses similar caution about current Medicare proposals.

"How that money will get distributed -- and how much is involved -- is hard to figure out right now," Cohan said. "From an investor's standpoint, it's still too early to feel confident about the impact on

health care companies."

McKeever nevertheless recommends buying a whole slew of managed care stocks -- including some hurt by Medicare before -- as the current debate pounds on.

The Medicare Flop

Investors have thrown the biggest gains at a current Medicare champ.

By now,

PacifiCare

(PHS)

has proven itself in a tough Medicare business littered with casualties. While other players have withdrawn from Medicare in defeat, PacifiCare has somehow managed to stay afloat -- and even thrive -- while operating the largest Medicare health maintenance organization in the country. The company now stands to profit handsomely from its staying power.

Under proposed legislation, the government would immediately sweeten the pot for so-called "Medicare + Choice" operators like PacifiCare that already insure Medicare recipients.

"If the government fixes the M+C program, PacifiCare would have a significant boost to its profit outlook," McKeever wrote last month. "We view PacifiCare as the Medicare play with by far the largest exposure."

For years, PacifiCare has struggled with the same Medicare caps that have devastated competing HMOs. In 1997 -- when Medicare HMOs were still booming -- Congress passed a balanced budget law limiting Medicare + Choice premium hikes to 2% annually. But actual medical costs, covered by the HMOs, were soaring by at least five times that amount. So Medicare HMOs began fleeing difficult markets.

By 1998, some of the industry's biggest names were reeling.

UnitedHealth Group

(UNH) - Get Report

scaled back Medicare drug benefits and made plans to exit markets after weathering a $900 million hit.

Aetna

(AET)

shut down Medicare programs in more than half a dozen states.

Oxford Health Plans

(OHP)

set its own caps, limiting reimbursements to doctors and hospitals, before weighing benefit cuts, as well. Even PacifiCare conceded defeat in particularly tough areas.

All told, nearly 100 Medicare + Choice plans disappeared in 1998 alone. And another wave of exits -- led by

Cigna

(CI) - Get Report

and Humana -- followed in 1999.

"Eventually, you get to the point where you cannot offer a valuable product," explained Susan Rawlings, head of retiree markets for Aetna. "The math just didn't work."

Today, Aetna offers Medicare coverage in just a handful of states. But the company remains optimistic that new Medicare laws -- influenced by its own CEO -- will create better opportunities in the future.

"If the bill passes in a manner that's fiscally responsible -- and we're very optimistic that it will -- we think the opportunities ... will be significant," Rawlings said.

Still, even Rawlings admits that "the devil always lives in the details" of a law. And other industry players are still holding their breath, as well.

"Humana says it's not sure how beneficial" the reform package will be," Cohan said. "And I suspect that's a fairly honest statement."