A model portfolio of large cap stocks

I’ve started an experiment where I’m keeping a public portfolio of large cap stocks via the Motley Fool CAPS system- you can view it here.  I would like to see if I can generate value on the long side… something that I find much, much more difficult than shorting.

My criteria are:

  1. Pick only the quality businesses in a particular sector.  For example, Dollarama is the clear leader among discounters.
  2. Not overpriced.  For that reason, Amazon and Netflix don’t make the cut (just look at what happened to Amazon during the Dot-Com Bubble).
  3. I avoid industries where there are no clear industry superstars.  Oil and mining stocks simply don’t make the cut as none of them are quality businesses.
  4. Lastly, I avoid dying or shrinking industries.  Profits ultimately don’t grow in dying industries and therefore those stocks almost never do well.

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Healthcare inflation is driven by bad medicine

According to the Commonwealth Fund (an endowment-supported US foundation), US healthcare spending has increased to 16.6% of GDP in 2014.  Other countries have seen less rapid increases in healthcare spending.  For the most part, inflation is being driven by doctors with a vested interest in pushing medical services, expensive treatments, and pharmaceutical drugs.  To my surprise, what I’ve found is that many aspects of modern medicine aren’t supported by rigorous scientific evidence.  While the FDA drug approval process superficially appears to be scientific, it often isn’t.  One way that pharma companies game the system is to prove that a drug (e.g. statins) affects a dubious biomarker (e.g. cholesterol) rather than prove that the drug causes more good than harm (e.g. lower mortality).

Unfortunately, mainstream views on science and medicine are quite ignorant of what goes on.  We are taught to only trust medical advice from “trained and licensed professionals”.  Much of society worships technology and has blind faith in the claims made by medical authorities.  I would argue that this environment is a fertile ground for the trend in healthcare inflation to continue going forward.  And if that trend continues, it is likely that American health insurance stocks will continue to do quite well.

Pharmaceutical companies researching active placebos may also do quite well.

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US health insurers

US health insurance stocks have performed extremely well.  Even if you had bought the worst ones, performance would have been similar to the S&P 500.  Why?

While the overall US healthcare system is dysfunctional relative to those in other developed countries, a broken healthcare system doesn’t explain why insurance stocks have done better than hospital stocks.  While hospitals engage in abusive practices such as surprise out-of-network medical bills (balance billing), hospital stocks have been mediocre investments.  A better supported explanation is scale.  One manifestation of scale is in dialysis treatment, a unique market where Medicare is the biggest negotiator with at least 90% of patients.  Commercial payers, with their lack of scale in this situation, are charged many times what Medicare pays.  SIRF’s analysis puts it at roughly $1,050 per treatment versus $250.  Of course, no health insurer enjoys 90%+ market share so their scale advantages are smaller.

Here’s a look at how market cap (a proxy for size) correlates with return on assets:

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