​This Dramatic Shift in Healthcare Spending is Creating Alpha Opportunities for Investors

David Friend |

Within healthcare, the opportunity is emerging to create alpha everywhere in the post-acute care space. That is the area of healthcare that focuses on caring for patients after they leave the hospital. While these opportunities are everywhere, in this article, we will primarily focus on skilled nursing facilities.

The primary driver behind this opportunity is the fundamental shift that is underway regarding how skilled nursing providers will be paid for their services.

Historically, skilled nursing facility operators had been paid a daily rate regardless of the clinical quality of care they provided. The business model was fairly simple: Keep costs low, keep beds filled with patients, attract patients with a nice lobby, marketing representatives and hospital discharge planners.

However, that world is about to be turned upside down for two simple yet profound reasons, detailed below:

1. While skilled nursing facilities have been receiving five-star quality ratings for their clinical care for many years, there has never been a direct link between those ratings and financial payments. That is about to change on April 1, 2016

2. , Medicare, through data analytics has realized that there is a significant variation in the length of stay (think cost) for the same illness with no correlation to health outcomes.

As a result, CMS has finally decided to focus on reducing this variation by changing the rules of reimbursement by linking payment explicitly to clinical outcomes.

To illustrate the power of this change, let's try this analogy.

First, I will ask you some simple questions:

If you can go to the BLUE local gas station and pay $2 a gallon for regular gas or can go to the RED gas station across the street and pay $4 a gallon for regular gas, where would you go?

Hopefully you did not say the RED station. Why on earth would anyone buy gas at the RED station once they realize it is the same quality that the BLUE station is selling for half the price?

Now let's introduce quality into the equation. Let’s assume there are two grades of gas available, Regular and Premium. Further, let’s assume the RED station sells only Regular and the BLUE station only sells Premium and that both stations charge the same price. Where would you go?

Hopefully you would not choose to buy Regular gas at the RED Station when you could buy Premium at the BLUE Station for the same price

Finally, would there ever be a time when you pay MORE to buy Regular gas from the RED Station when you can buy Premium gas from the BLUE Station for LESS? Let’s hope your answer is a resounding “No.” Yet every day, thousands of patients are receiving care at the equivalent of “RED” skilled nursing facilities and we the taxpayers, through Medicare, are paying for it. Why? Because they have never had the price of care linked to the quality of care.

Until now.

Navigating Rapid Change in the Health Market

Now let's say you've heard that the government was about to become, slowly but surely, a rational purchaser of skilled nursing services on behalf of 60 million Medicare beneficiaries who use these facilities.

You would quickly figure out that the government was going to send virtually all the business they could to BLUE facilities. If the marketplace did not understand this, it would mean that BLUE stations would be undervalued.

Simultaneously, it would mean that RED stations would lose a lot of business and are therefore likely overvalued by the marketplace.

This is the current situation with regard to skilled nursing facilities. The facilities with a rating of three, four or five quality stars are currently equivalent to the BLUE while the facilities with a rating of one or two quality stars are RED.

A change in purchasing behavior is about to occur, as Medicare is in the process of allowing roughly 800 hospitals to begin purchasing care for patients provided by skilled nursing facilities in a bundle or supply chain model. In this arrangement, hospitals will be given financial and regulatory incentives to purchase care on behalf of Medicare patients based on quality and cost. In particular, they will receive a special incentive when they select a three star or better skilled nursing facility.

While this purchasing process will roll out first for patients needing hip or knee replacement, I believe the government will save so much money while at the same time improving care that the program will rapidly expand to virtually all medical conditions covered by Medicare.

Further, once the state Medicaid programs see how much the federal government is saving, they will adjust their purchasing behavior to align with the federal program.

The total public and private market capitalization of these facilities exceed one hundred and fifty billion dollars…if I am correct… many of them are now mispriced.

The five-star rating system is dynamic, and has some attributes of a zero sum game so skilled nursing facilities will have to continuously improve the quality of care they deliver. That’s a good thing for patients, but it means that investors will have to continually monitor the clinical quality as well as the financial performance of their investments.

We will write more on this topic as events develop.

Investment conclusion in rank order to generating alpha:


  1. BLUE facilities that can stay BLUE and are most cost efficient
  2. BLUE facilities that can stay BLUE and become more cost efficient
  3. RED facilities that can be improved to BLUE


  1. RED facilities that are stuck in RED
  2. BLUE facilities at risk of being downgraded to RED

David Friend, MD, MBA

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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