#4 Recent addition (3/23)-UNH

Two of our last three additions were in the healthcare sector. Before going into a brief description of those names, a few words on our investment philosophy. While we do not aim to achieve particular targets in terms of industry representation (ie, set percentages of the book in healthcare, tech, consumer), we do try to think from a macro perspective what sectors should outperform the market. We like to think of our approach as bottoms-up, but it is almost as necessary to have a good world view. It is foolish to think that one can do such good bottoms up analysis so as to overcome any macro challenges, so a basic tenet for us is that it is easier to make money with tailwinds than in headwinds. The problem with the current environment is that it is hard to know if we are in the midst of tailwinds or headwinds.

I am not a healthcare sector experts by any stretch. I have looked at pharma and biotech names from time to time, but still need to refresh the basics of CMS policy and Medicare Part D every time I start looking at a name. From a macro perspective, it appears that a few things are going on:
-patent cliff expiration for big pharma after 2010 (which is driving M&A)
-general concern that Obama's plans for healthcare (which I am not full aware of) will squeeze profits out of the industry
-general acceptance/expectation that healthcare needs to modernize which is a boon for healthcare IT.

I first started to look for healthcare IT names. One I came across was Athenahealth (ATHN) which provides internet-based services like billing and customer management for physicians. From a macro perspective this seems like a business I would really want to own, but the valuation (over 30x 2010 eps) seemed richer than I was willing to pay at the time. I think there is a good GARP (growth at reasonable price) story here but that requires more work. So, I moved along to low p/e names with decent ebit margins.

The first name I bought was United Healthcare (UNH). It is the largest managed care provider in the US. The sector has been hit hard over concerns about the new Obama administration and its yet unannounced healthcare initiatives. Other metrics worth watching are enrollment figures and operating margins. I admit that I need to do more work on this name (in particular operating leverage and book value) but when we added the position on March 23, the stock was trading at around 7x 2009 earnings. Incidentally, the consensus estimate for UNH appears to be around $3 in 09. Although that is slightly higher than 2008 (in today's environment it is important to do a gut check on whether you think consensus 09 ests make sense compared to what the results were over the past 5 years), I did like the fact that the 2007 eps appeared to be $3.50. Basically I don't think I am buying a business at peak profitability so I think the 7x p/e is a legitimate calculation. I took this 7x multiple and compared it to historical p/e for UNH. Again, it appeared to be closer to the low end rather than high end. (the green line below represents historical p/e). All in all, it seemed I could buy a key healthcare player on relatively conservative earnings at a conservative valuation. If (1) the earnings exceed expectations, (2) the market decides to value these companies at a higher p/e or (3) it turns out companies like UNH are more a part of the solution than a part of the healthcare problems in the US, this investment could make money.