Rising Health Care Costs Could Direct Resources Back to the United States

The U.S. Federal Reserve is reasonably confident that "core inflation" is under control. But maybe the Fed should take a field trip to a hospital-any hospital-and re-evaluate its conclusions. We know that rising health care costs in the United States may not be the most critical item on the agenda of Australian investors. But bear with us a moment. We think we're on to something important here.

For the last month the news from the superannuation markets has been mostly positive for share prices, and the Baby Boomer's who count on them to keep going up. $81 billion in new money invested in the market this year, with a little kicker from a one-off incentive for investment property owners, who can plow $1 million into super tax free before June.

But if the asset markets are mostly rigged to make it easier for the Boomer's to retire in comfort, there is a flaw in the plan. The flaw-if you can call it that-is life. It would be nice to think that a diversified portfolio guarantees a comfortable, healthy, sun-baked retirement. But with age comes decay, illness, and rising medical costs.

We know this in the two main ways people know anything, wissen (theoretical knowledge) and erfahrung (experience.) For example, we read yesterday that the U.S. markets were spooked by a larger-than-expected rise in core U.S. inflation. Digging into the figures from the U.S. Labour Department, we learn that, "Medical care costs rose 0.8 percent in January and are 4.3 per cent higher than a year ago. The index for medical care commodities prescription drugs, nonprescription drugs, and medical supplies-increased 0.6 percent. The index for medical care services advanced 0.9 percent." On an annual basis, in fact, American health care costs are rising faster than any other set of prices in the economy.

Hold that thought. Now imagine that your mother was out enjoying the early years of her Baby Boomer golden age, riding a horse in Colorado. Imagine she suffered an accident and severe head injury. Imagine her in the hospital in a coma for three months. Imagine your joy as she emerged from that coma and began to remember things about her life and you. And then imagine watching a hospital accountant slowly ad up your bills and tell you in a calm, reasonable voice, that you owed the hospital US$1.7 million dollars.

This is exactly what happened to one of our friends recently. We caught up with him in Colorado and exchanged stories on the shock and awe we experienced in navigating the American health care system.

"It's like there are two sets of prices in the world," our friend Jason said. "The first set is what you and I pay for dinner here, the gas I put in my car, and the rent I pay on my house. Then there's this whole different set of prices in the world of medical care. They might as well just arbitrarily ad a few zeroes to everything. It's so unrealistic it can't even be believed. How can people possible pay for catastrophic care? Even routine care is getting absurd."

We nodded in agreement, having hours earlier looked at one of our father's hospital bills. It was a one-week stay in a specialty wound-care facility. He was sent to the facility because a staff shortage (and negligence) at another facility led to him acquiring a nasty and dangerous bed sore on his back. The cost for one week's stay in the specialty facility was US$38,000.

How to even begin making sense of these numbers? What do they mean? Who can afford to pay them? What will happen to the millions and millions of Baby Boomers who don't have adequate insurance or family support? Will they receive care? Who will pay for it?

And if you thought there was a shortage of skilled labour in the resource sector, wait until you see what's coming in the health-care sector. Who will take care of the ageing Boomers when they can't take care of themselves? Who will deliver them their morning meds, their afternoon lunch, and change their bed pans, catheters or bandages?

The problem never really stuck us in the gut until we wandered down hallway after hallway of rooms filled with hospital patients. The lucky ones had family visitors and good insurance. The unlucky ones lay quietly all day with nothing but the sound of a beeping machine to accompany them.

Before then, we'd only known it abstractly, in the head. Obviously it was all quite discouraging. One poor soul had his bed surrounded by a mesh cage, to prevent him from wandering off unattended while the hospital staff worked on other matters. We also realised that in whatever time he has left, our father would spend more time talking to his nurses than he would talking to his family. We looked at the nurses more closely after that.

But out point is not to present a Dickensian version of the demographic consequences of the Boomer retirement era. Plenty of people have done that already. It was just that a light bulb (non incandescent, of course) finally went off in our head that the cost of the whole transition is going to be staggering. So will the social implications.

On the bright side (not occupied with the potential sadness and human tragedy) an entire category of firms will have a booming business. You can already see this in the figures of CSL, which yesterday upgraded its profit guidance for the rest of the year, after announcing a 46% increase in net profit for the prior six months. The company has a great portfolio of products, from blood plasma to a cervical cancer vaccine.

As you dig through the numbers, what you find is that much of the growth is entirely organic. The company did not go out and "buy earnings" through an acquisition of other firms (although it is now benefiting from previous acquisitions a few years ago.) Our point is that it's easy to understand what is driving earnings growth for CSL. Prices are rising. So are sales volumes. Both are rising faster than costs, especially because CSL has positioned itself in the high-margin end of the medical services business.

Yet there are other ways to make money in health care too, even in sectors where labour costs are rising. "Private hospital operator Healthscope (ASX: HSP) has more than doubled its first-half earnings and flagged its interest in Symbion Health if it came up for sale." We readily admit this is the first we've ever heard of Healthscope. But obviously the story fits snugly in the long-term strategy we've lately stumbled on: namely that health care is going to be a damn good business for well-managed firms in the next twenty years, much better than property, resources, or sovereign government bonds.

There will be a spectrum of investment opportunities, from the mature companies to up-start drug makers. But all of it is driven by the relentless ageing of the boomers, and their incessant desire to live longer, fuller, more medically perfect lives. For what it's worth, the biggest earnings growth will come from the newest and smallest companies. That's where we'll be looking in the coming months.

RBA Governor Stevens didn't have much else to say about the Boomer's yesterday in Perth. He did, however, have a word of caution about the leverage associated with the private equity boom. "Most fads or manias or bubbles or whatever words you want to use," he said, "start with something fundamental and at some point along the way they lose track of that…What that means is that in an event of shock to income, life gets harder quickly."

There are few more shocking events to affect your income than an illness you aren't prepared for. Then again, how many illnesses are you ever really prepared for, in the emotional sense? Of course it's the financial sense we're concerned with here.

Here's a prediction: the massive inflation in health care costs is just beginning, and not just in America. The government response to it will be increased medical subsidies, which will probably lead to higher costs anyway. In addition, governments will print money (and may even decide to spend less on foreign wars) to help fund the demographic crisis at home.

The opportunity in this crisis will be in the health-care industry. And frankly, given the huge cost of future medical care, having some investment gains from the industry will be a welcome consolation. The age wave isn't just coming. It's here. And it's brought virulent inflation with it.

And finally, an additional thought on risk. Why is it people fear losing money more than they want to make it? Perhaps greed is a luxury. But something in our makeup reminds us that the world-in addition to being beautiful and inviting-is also dangerous. Bernard Mandelbrot explains in his book, "The (Mis)Behaviour of Markets."

"For more than a century, financiers and economists have been striving to analayse risk in capital markets, to explain it, to quantify it, and ultimately, to profit from it. I believe that most of the theorists have been going down the wrong track. The odds of financial ruin in a free, global- market economy have been grossly underestimated. In this sense, the common man is wise in his prejudice that-especially after the collapse of the Internet bubble-markets are risky."

Dan Denning
The Daily Reckoning Australia

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