Not-So-Dire Diagnosis

Warren Buffett once famously stated that “Berkshire [Hathaway] buys when the lemmings are headed the other way,” conjuring up visions of rodents blindly following one another off a cliff. But the idea that lemmings participate in mass suicide is a myth, propagated by a Disney documentary. The widespread misuse of the lemming metaphor by investors to illustrate herd behavior itself reveals the herdlike behavior of investors and the scarcity of original insight.

Original insight is also uncommon among doctors. Physicians are trained through rote memorization, and independent views are often ridiculed by peers and prosecuted by malpractice attorneys. The hiring of physicians as consultants by investment firms seeking unique perspectives has instead led to a greater tendency toward consensus thinking.

Although the healthcare sector has exhibited strong growth in both revenue and earnings, the prevailing view of the industry is anything but optimistic. Most investors remain on the sidelines or have added to the record short interest in healthcare stocks.

Part of the investor angst mirrors the political polemic that views healthcare as a cost to society. Never mind that the politicians spouting apocalyptic rhetoric about healthcare costs seek quality — if expensive — care when it comes to their own families. Instead, healthcare can and should be viewed as an investment in society. Helping people live longer and stronger promotes human endeavor and prosperity.

Other sources of investor angst include uncertainty over regulatory procedures and impending congressional reform. As a firm, we view government agencies like the Food and Drug Administration and the Centers for Medicare & Medicaid Services as our co-investors with shared interests in improving the health of society. Progressive legislation, which inevitably creates market dislocations, can produce new winners, new losers and — for those paying close attention — potentially handsome returns.

Of course, the primary driver of opportunities in the healthcare sector is not policy, but innovation. Per capita, healthcare costs are higher in the U.S. than in other countries in part because we reward innovator companies, which then subsidize and export benefits to the rest of the world. As an example of world economic integration, the U.S. is exporting healthcare deflation to the rest of the world through scientific innovation, in the same way, developing countries export labor deflation to the U.S.

As human ingenuity, entrepreneurship and serendipity continue to yield new healthcare technologies, we may also witness a surge of innovations based on design thinking, which is a way of making better use of existing technologies. For example, current drugs for chronic diseases often create physiologic dependency over time. An alternative approach, which we call paradoxical medicine, would use drugs for the opposite purpose of their original indication. Under this paradigm, hypertension might be treated by pharmacologically increasing blood pressure such that the body’s response to the challenge constitutes the therapy. We already do this with exercise.

Although drugs are commonly pilloried as the source of escalating healthcare costs, they collectively account for only about 10 percent of the $2.7 trillion now spent annually on healthcare in the U.S. The overwhelming majority of spending goes to services, and the potential benefits of design thinking apply here as well. Knobless doors, cashless cafeteria transactions, and buttonless elevators represent opportunities where design innovation can improve the quality of hospital care by using available technologies to lower the risk of contagion and reduce costs. Given all these favorable trends, we see many reasons to invest in the healthcare industry. Pension funds may consider high-quality healthcare investments as a better way to match returns to liabilities given the progressive lengthening of the human lifespan.

It has long been known that decreasing heart rate variability in an individual may indicate an impending functional decline. On the other hand, high variability in heart rate is typically associated with good health. Heart rate variability makes a good analogy for price volatility in the markets. Whereas low market volatility may portend latent systemic risks, high volatility, such as what we now see in the prices of healthcare stocks, may indicate a market gathering strength — a healthy sign indeed.

Dr. Joon Yun is president of California-based Palo Alto Investors, which he joined in 1998. He also served on the clinical faculty in the radiology department at Stanford University from 2000 through 2005.

Originally published in Institutional Investor on September 23, 2008.