This article is authored by MOI Global instructor Todd Wenning, a senior investment analyst at Ensemble Capital Management, based in Burlingame, California. Visit Ensemble’s Intrinsic Investing website for additional insights.
In January 2017, we wrote a post on the opportunities and threats of investing in healthcare stocks over the next decade.
To recap, over the prior 20-year period, the U.S. healthcare sector outperformed the S&P 500 by nearly two percentage points per year, on average. Many companies reaped the benefits of a highly inefficient U.S. healthcare system, where prices surged without delivering proportionate value to patients.
We continue to believe this is unsustainable. Whether it’s through government action or market forces, changes are on the horizon for the U.S. healthcare industry to better align costs with outcomes.
As such, we demand two things when looking at new healthcare companies:
- Do these products and services improve patient outcomes?
- Do this company’s products and services help reduce system-wide costs?
Frankly, we have not found many companies that fit both criteria. Yes, there are many technological advances occurring in healthcare. In fact, PWC expects healthcare to have the most R&D spending in absolute dollar terms of any industry by 2020.
Unfortunately, innovation in healthcare doesn’t always translate into improved outcomes and lower system costs.
To illustrate, here’s what the Congressional Budget Office wrote in a 2008 study:
The added clinical benefits of new medical services are not always weighed against the added costs before those services enter common clinical practice. Newer, more expensive diagnostic or therapeutic services are sometimes used in cases in which older, cheaper alternatives could offer comparable outcomes for patients.
We think one of the intrinsic problems is that, because it’s the incumbents – i.e. the primary beneficiaries of an inefficient system – doing the bulk of the innovation spending, there’s little incentive for them to change the status quo.
California-based Masimo piqued our interest because it takes an outsider’s approach to finding healthcare solutions. Indeed, the company’s mission statement is “Improving patient outcomes and reducing the cost of care.” A natural fit.
But this isn’t just marketing spin. The company’s founders, Joe Kiani (current Chairman & CEO) and Mohamed Diab were electrical engineers by trade and started Masimo in 1989 after working with early versions of pulse oximeters that used sensors to measure oxygen levels in the blood.
Those early pulse oximeters were particularly unreliable when the patient was in motion – think premature babies, emergency situations, etc. Medical professionals would either use invasive procedures (via syringe) to get a more accurate reading or assume the reading from the sensor was correct and risk misdiagnosis.
We’ll get into more details in a moment, but fast-forward to today and Masimo’s pulse oximetry sensors are the standard of care in most of the country’s operating rooms, NICUs, and ICUs.
From our recent trip to Masimo’s headquarters for an investor day, we confirmed that the company’s engineering-first spirit remains a key differentiator in Masimo’s corporate culture. Each solution starts with first principles and a blank sheet of paper rather than starting with the status quo.
Put another way, Masimo is a technology company pursuing better solutions in the healthcare industry, rather than a healthcare company using technology as an avenue for higher-priced solutions. We consider Joe Kiani to be a visionary-outsider leader of a company that’s running circles around incumbents with eroding moats.
Okay, let’s take a step back. How does Masimo fulfill our first criteria to improve patient outcomes?
Starting with Masimo’s core business – Signal Extraction Technology (SET). With FDA approval in 1998, Masimo’s proprietary SET was the first platform to accurately measure pulse ox when the patient is in motion (common in emergency situations) and low perfusion (low levels of oxygen).
With the use of LED sensors and encrypted algorithms, Masimo sensors obtain vital information in a non-invasive manner. In non-medical terms, it shoots a known quantity of light from one sensor and gets a reading based on the amount of light it receives on the other end. These are similar principles to how your Apple Watch or FitBit operate.
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