With the U.S. Supreme Court set to hear arguments about the constitutionality of the Affordable Care Act (ACA) on 10 November, the death of Justice Ruth Bader Ginsburg has raised doubts about the law’s future and led stocks of hospitals and insurance providers to sell off. But Portfolio Manager Andy Acker and Research Analyst Rich Carney say the reaction may be overdone.
- The ACA has become an integral part of the U.S. health care system, and with its future now more tenuous, health care stocks have come under pressure, particularly those of insurance companies and service providers.
- However, the range of potential outcomes is much broader than might first appear and subject to factors such as the U.S. election outcome, the seating of a ninth justice and legal interpretation.
- We think it is important for investors to consider downside risk, but we also note that negative sentiment can cause valuations to dislocate from fundamentals and create opportunities for long-term investors.
Following the death of U.S. Supreme Court Justice Ruth Bader Ginsburg, the future of the Affordable Care Act (ACA) – the decade-old legislation that expanded health care access in the U.S. – has become less certain. That is because the Supreme Court is set to hear a case challenging the validity of the law on 10 November, one week after the election. The suit, led by a coalition of Republican state attorneys general and joined by the Trump administration, argues that the law became unconstitutional after a 2017 federal tax cut removed the tax penalty associated with the ACA’s mandate that all Americans obtain health insurance (known as the “individual mandate”). The Supreme Court has twice upheld the ACA in previous legal challenges, but Justice Ginsburg had been a key part of the 5-4 rulings.
The ACA has become an integral part of the U.S. health care system, not just in terms of expanding access to care but other key policies, such as banning insurers from rejecting patients with pre-existing conditions. With the ACA’s future now more tenuous, U.S. health care stocks have come under pressure, particularly those of insurance companies and service providers (i.e., hospitals), both of which could be directly impacted by changes to the law.
Source: Kaiser Family Foundation, as of 22 September 2020.
Plenty of curveballs at play
We recognize that the ACA’s future is at risk, potentially leading to significant disruption for the health care system. But as dire as some headlines cast the turn of events (“Ginsburg’s death leaves Obamacare in greater danger than ever”1), we would point out that the range of potential outcomes is much wider than might first appear and depends on several unknowns:
Healthcare can experience significant volatility and a wide dispersion of returns, and 2019 was no exception. In biotechnology, the top-performing stocks saw gains of over 300%, while the worst performers declined by more than 90%.4 We believe this disparity is driven by the binary nature of drug development, where the clinical and commercial success of new medicines can be difficult for the market to predict. Given such binary outcomes, we believe it is important for investors to take an active approach to the sector, and 2020 will likely be no exception.
- The November U.S. election: If Democrats win the White House and take control of the Senate, one potential option that lawmakers could choose is to reinstate the tax penalty – even one as low as $1 – throwing out the basis for the lawsuit.
- The ninth seat: If a ninth justice is not seated when oral arguments begin in November, precedent suggests that only eight justices would be eligible to vote, raising the possibility of a 4-4 split. Should that happen, the case would return to the trial courts from where it came – and where it would likely be re-argued for years to come.
- Standing: Many experts believe the legal arguments behind the case are weak, more so than past challenges to the ACA. Essentially, the plaintiffs contend that by reducing the ACA’s tax penalty to zero, Congress made the law coercive insofar as the legislation “commands” individuals to buy insurance (Congress has the power to tax but not regulate interstate commerce.) Thus, the mandate – and by extension the entire ACA – is both unconstitutional and causes harm to the plaintiffs. But in the absence of a financial penalty, it is possible to argue that no harm has come to the plaintiffs and, as a result, they lack standing to sue.
- Severability: If the Supreme Court were to decide that the plaintiffs do have standing and the individual mandate is unconstitutional, the next question is whether the mandate – as well as other provisions of the law – can be severed while allowing the rest of the ACA to stand. The question of which parts of the law could be repealed has created the most uncertainty, but given recent Supreme Court decisions, the odds that the majority of the law could remain intact look favorable. In fact, this year, the court decided in two separate cases to sever unconstitutional provisions from federal laws while leaving the remaining litigation as was. As Chief Justice John Roberts wrote in one opinion, even in the absence of a severability clause, the “traditional rule” is that “the unconstitutional provision must be severed unless the statute created in its absence is legislation Congress would not have enacted.” To that point, there is little to no evidence that Congress intended to invalidate the ACA when it removed the financial penalty.
Given the wide range of variables, the tail risk of the ACA being invalidated has grown. But even then, it is important to remember that remedies exist should parts of the law be rolled back. For example, if the U.S. Supreme Court determines that the individual mandate is unconstitutional and thereby pre-existing condition protections and guaranteed issue are invalid, states or Congress could legislate to replace these protections (guaranteed issue requires that insurers furnish policies to individuals regardless of health status.) Furthermore, invalidating the entire law would effectively throw the U.S. medical system into chaos given the ACA’s wide reach and longevity. And the optics of undoing the law during a global pandemic would be horrible. Thus, as Mark Twain once quipped about rumors of his death, we think reports of the ACA’s demise “are greatly exaggerated.”
What it means for investors
In the U.S., sentiment could weigh on health care stocks in the near term, particularly for hospitals and providers that have benefited from ACA provisions like Medicaid expansion. But we would also point out that negative sentiment could cause valuations to dislocate from fundamentals, as happened a decade ago when the ACA was first being legislated. Today, the U.S. health care sector trades at a large discount to the broader markets, even as many companies develop breakthrough therapies – including vaccines for COVID-19. In our view, these types of dislocations create opportunities for investors and can make a significant difference to long-term returns.
Health Care at a discount
Source: Bloomberg. Index and sector data from 31 December 2019 to 24 September 2020. Averages reflect quarterly data from 31 March 1992 to 30 June 2020. S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance. S&P sector indices comprise those companies included in the S&P 500 that are classified as members of the respective GICS® sector.
1Politico, 19 September 2020
Fundamental analysis: The analysis of information that contributes to the valuation of a security, such as a company’s earnings or the evaluation of its management team, as well as wider economic factors. This contrasts with technical analysis, which is centred on idiosyncrasies within financial markets, such as detecting seasonal patterns.
Price-to-earnings (P/E) ratio: A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.
A forward P/E ratio is calculated by taking a company’s current share price and dividing it by its ‘predicted’ earnings per share.