"Jesus, take the wheel!" (DaVita; NYSE: DVA)

Plus, Uncertainty as Investment Advantage

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First, an Update and a Wild Tangent

I got one thing wrong and one right lately. Our post about bank earnings has a 70% open rate so far, which surprised me. I thought you’d see “BANK” in the title and run. What’s wrong with you guys? Banks are boring!

What I called right is our portfolio overview post has the most total views. I knew it, man. I knew you guys were shameless, greedy AF, get-rich-quick, capitalist pigs.

Near future, we’ll finish Part 2 of our update on the banks, as our Bank of America and Ally positions released earnings this week. Beyond that, it’s probably timely to talk about our Brookfield position.

Now, Back On Track

In this post we’ve one conclusion, but we’ll get there combining 3 things using The Magic of Financial Synergies:

• Human beings’ — including portfolio managers! — hatred of uncertainty, and why that’s an advantage if you can learn to control your emotions¹ and think rationally when rationality matters most.

• A little on our DaVita investment

• Some Really Scary Stuff that just happened to DaVita, sending my stock off 20%.

Beginning with…

Uncertainty

We humans hate uncertainty and the unknown. We HATE it. There is no word I know that truly describes the discomfort most of us feel when faced with the unknown, and our lack of control over it. It often breeds creeping fear and anxiety.

This stuff’s deep in our primate brains.

Many of us have a host of irrational fears derived from this. Take Thalassophobia (Greek for “ocean” and “fear”). For those with it, if we go swimming in open water, we can’t submerge our face and look down at our feet without… feeling something unnerving. The feet are just dangling there, no terra firma. Instead, below and all around stretches a dark, silent abyss.

It reeks of Lovecraft’s cosmic horror. Cthulhu might even be down there! Dread and panic might well up inside and hijack the mind. It sure feels like a good time to get back to the boat!

Just thinking about it creeps some of us out. And that’s just one phobia among many that we humans have. (Mine’s being in the basement in the dark, especially if there’s a noise. Sheesh.)

We’ll often trade anything to make uncertainty and fear of the unknown go away, no matter the cost. We want to restore order and safety, and avoid what we can’t control.

Yet… the future’s uncertain, financial markets are about the future, and financial markets are full of humans. You see the problem, yes?

When things become too uncertain, we freeze, or run. Rational thought’s out the window. You can see this during a general market sell-off. Whenever the economy goes from smooth-sailing-expansion, to

• Oh-My-God-There’s-A-Housing-Collapse-And-Global-Financial-Crisis, or

• Pandemic!-We’re-Going-To-Die-And-The-Economy-Is-Shut,

It sure feels like a great time to get back to the boat!

This is the key interplay between markets and human behavior. Think about it: there’s no inherent reason for markets to be volatile. They’re volatile because our inability to stay rational under uncertainty makes them volatile.

Peak-to-trough, the S&P 500 declined ~50% during the ‘08 crisis. In March 2020, as COVID cases grew exponentially, I remember lunch with two friends, both investment analysts. We checked our phones. The S&P 500 was down 12% that day. The whole market. 12%. In one day. “My eyes are bleeding,” said one.

Now, we were all experienced investors at the time. We knew there was no choice but to hold or buy more in businesses we knew were cheap and would not die from this, even though annualized GDP was down 30% (more than the Great Depression). You had to push chips in no matter how you felt.

From the COVID bottom, my Berkshire stock doubled. GM & KKR tripled. Adient quadrupled. (Of course, I am dumb, so I (a) made weighting mistakes and (b) didn’t sell GM for example, which has since halved and I’m now waiting for recession-fearing markets to pay any semblance of a fair price.²)

Why was it rational to hold or buy in March 2020? If you checked your emotions and looked at the facts, that was the only intelligent option.

Most of the economy is small & mid-sized businesses. They usually have 1-2 months’ cash. Many consumers also live hand-to-mouth. Total lockdown was too blunt a tool and an alternative was needed. Fast. Otherwise, businesses would start toppling like dominoes. We’d rapidly undo 200 years of economic growth and re-enter the Late Medieval Period.

Sure enough, there was masking, social distancing, etc.³ In America and many other developed countries, governments and central banks also fired the biggest money bazooka ever fired in the history of the money bazooka.

The uncertainty lifted. Markets started ripping almost the day the bazooka was fired.⁴

If you can stay cool when others are going bonkers, behavior is the best advantage you can have. It requires no thinking: in those situations, everyone already has the same set of facts and conclusions. You aren’t buying undervalued stocks by out-smarting anyone with unique insights. The stocks are undervalued because no one’s acting rationally. People are simply unwilling to act because fears and uncertainties prevent them.

Think about it:

If, standing in the middle of the ‘08 crisis, you asked anyone if 2010 would look like (a) a post-apocalypse, or (b) an economic recovery with growing businesses and employment, they’d say (b). But with the market at a 10% free cash flow yield and 3% long-term expected growth, were people actually taking that bet? They were not.

When you recognize times when people are paralyzed by uncertainty, you don’t need to be a genius. You need to be a cold, calculating machine. That is all.

Let’s chat about what DaVita before we talk about how this applies to the investment.

DaVita

DaVita came to me in a dream a quantitative stock screen I ran for highly profitable companies with high free cash flow yields. This screen usually spits out good businesses that have something wrong with them at the time.

DaVita runs a chain of 2,700 US dialysis clinics, serving 200,000 patients. Kidney dialysis is a medical treatment for patients with ESRD, or end-stage renal disease, where your kidneys no longer work. This is the last stage of CKD, chronic kidney disease. There is no cure for ESRD. Generally speaking, CKD’s progress can only be slowed by not revered.

Dialysis demand is extremely stable. An ESRD patient has 2 options: get a kidney transplant from a matching donor, or go onto dialysis. Without working kidneys, we die within days, from metabolic wastes accumulating in our blood. There is an organ shortage, so most patients are on dialysis.

This isn’t something you wish on anyone. You go to a clinic and sit reading a book or texting for 4 hours while you’re connected to a dialyzer machine that filters your blood of waste. You do that 3-4 times a week for life.

Healthcare providers treat patients but usually don’t make their money from them. They’re reimbursed by the “payers”: commercial insurers or governments (Medicare and Medicaid in the US). The patients pay the payers for healthcare coverage, then the payers pay the providers for treatments.

The industry’s a near-duopoly. DaVita and Fresenius each have ~40% market share. The third biggest player, ARA, is 1/10th DaVita’s size. It drops off fast from there.⁵

DaVita and Fresenius have several scale & cost advantages over the small peers, and DaVita has a cost advantage over Fresenius because… well… DaVita just works smarter for the healthcare system.⁶ The insurers can’t screw DaVita or Fresenius because with 40% share each, they have twice the relative market share & scale of even the largest insurers. It’s like if you had a monopoly on Kirkland Cashews. No matter how big and successful Costco gets, you can still dictate your cashew terms of sale because those things sell like hotcakes and Costco’s got no one else to source from.

They also reduce the payers’ costs. The healthcare system would be worse off both financially and in terms of patient health if you removed DaVita from it.

DaVita earns ~13% on incremental capital and its main market grows maybe 2-3%. The business reliably produces $0.7-1 billion in free cash flow no matter the economy, since patients come for dialysis or they’ll die.

This niche business has one issue: dialysis and ESRD patients are expensive.

One treatment can cost an insurer ~$2,000, and Medicare ~$250.⁷ If you add up all the other costs ESRD patients incur, like drugs, appointments with specialists, emergency hospitalizations, etc., one ESRD patient costs an insurer >$250,000/year (and Medicare >$100,000/year). In fact, 1% of those on Medicare have ESRD, but they’re nearly 10% of Medicare’s costs. DaVita isn’t even milking the system and only makes ~15% margins. They don’t even make money treating those covered by Medicare. It’s just costly to treat ESRD

Maybe you can see why this is the issue.

Because ESRD patients are expensive, there’s an economic incentive to find ways to keep them alive more cheaply, and an incentive to keep people from getting CKD and ESRD in the first place. About ~500,000 Americans have ESRD and are on dialysis. At ~$150,000/patient/year, that’s a $70 billion problem companies and smart entrepreneurs will always be trying to fix.

Yet, this is a very hard problem to solve.

If you’re a psychopath, maybe you go: no, this is easy, kill all the ESRD people. Jesus man, that’s just not why healthcare exists. We as a wealthy, developed civilization have chosen to spend part of society’s resources to prolong life when people and families decide a life is still worth living. In some hunter-gatherer tribes, when someone was old and chronically ill, a younger family member might walk up behind them and hit them over the head with a wooden mace. It wasn’t evil. They’d celebrate the person. But there wasn’t enough food that winter. We now have surplus wealth, so this is not how healthcare cost-benefit analysis works.

One major reason this isn’t an easy problem to fix is this:

• 37 million Americans, or 1 in 7 adults have CKD (yes, that many). Most don’t know it.⁸ If you are early-stage CKD, everything seems fine.

• CKD progresses over decades. Because we die of many different things, usually what happens is those with CKD die of something else first.

• Only a tiny percentage end up with ESRD: there are ~130,000 new ESRD cases each year, less than 1 in 250 people with CKD.

If most people don’t know they have CKD, how do you find them? It costs money to test. If you can find them, how do you treat? That also costs money. If you can find and treat them, how do you predict which needles in the haystack will get ESRD? That also costs money.

People with CKD generally have it as a consequence of other diseases. Most of those with CKD have it because they have type 2 diabetes or hypertension (high blood pressure). Abnormal blood sugar/pressure slowly damage the kidneys.

That relationship makes CKD sufferers easier to find. Yet, T2 diabetes and hypertension are often called “lifestyle diseases” because the main risk factor is being overweight from poor diet and sedentary lifestyle. (Sorry if I’ve scared a few of you into doing some push-ups and eating a salad.)

This makes treatment expensive and difficult. It’s nothing like getting antibiotics for a simple infection. You need to change someone’s lifestyle. These are habits built up over decades. I have family with diabetes and CKD. They still eat cake knowing it’s not smart. Plus, anyone who’s tried arguing with a 60 year old knows it’s almost the same as with a 6 year old. They might now be wise and understand your side of the story, but you still can’t win.

Is the money spent treating CKD worth the money saved preventing them getting ESRD? Remember: it has to be worth it to the insurers. If there’s anyone on Earth who is good at probabilistic cost-benefit analyses and calculating expected value, it’s insurance companies.

Now you understand a bit about DaVita, and the nature of one of its main issues: it’s always at risk of obsolescence, but barring some huge tectonic shift, it’s a hard, uphill battle.

Owning DaVita: “How I Learned to Stop Worrying and Love the Bomb”

It isn’t even just obsolescence. Because of where DaVita sits in the system what these patients cost, there are always rainclouds around the company.

Every couple years there’s a political issue involving the industry, or Medicare, etc. Insurers have also sued many times (in America, healthcare’s so litigious, lawsuits are just how providers and payers chat). If you aren’t the calm-under-pressure type, you’ll get scared out of this stock. I actually bought DaVita when it had two problems (long since resolved). Going on 5 years, I’ve owned it through new problems, too, like a 1-in-100 year pandemic that disproportionately killed its patients in what I thought should have been an incredibly stable business. We bought the stock so damn cheap that we’ve made good money in spite of it all.

The main reason the political, legal, and other problems are resolved or never amount to anything is: DaVita genuinely makes the payers financially better off, and improves the patients’ health vs. any alternative. It can’t be removed from the system without a better alternative first. That’s the fulcrum on which the whole thing turns. I’ve talked to short-sellers and to people who have sold, and they often miss this.

To discover that DaVita Secret Sauce in early 2019 — that this business makes the healthcare system better off and can’t be removed, and that it has a few profit growth opportunities ahead — I spent 3 weeks in a cafe reading, making notes, and thinking, because this industry’s got complicated economics & incentives.

DaVita’s got a new problem, and the market’s again concerned. This new problem though, is hard.

You might know it. If you read the news or doom-scroll TikTok, you might have heard of the drug Ozempic (or Wegovy, which has the same ingredient, semaglutide).

Ozempic’s been in market since 2017 and is approved for to treat T2 diabetics and help manage weight, hunger, and blood sugar. Those studied in Novo Nordisk’s (and competitors’) trials have generally lost 5-15% of their body weight.

It’s often touted as a miracle weight-loss drug, like other miracle weight-loss drugs from the 90s that’re no longer used. But because a staggering ~40% of Americans are considered obese, Ozempic has caught on.

Some know they can press for it from doctors, even without T2 diabetes. Doctors can prescribe medicines for “off-label” use. Patients have seen social media testimonials where people describe feeling like someone hit the off-switch on their excess hunger. If you feel it’s hard to control yourself and that’s why you are the way you are, that’s tempting.

Novo Nordisk, Ozempic’s maker, has been researching expanded uses for semaglutide, including its effects on CKD, and will probably look to sell it for weight loss overall.

The logical chain of consequences to DaVita goes like this:

• DaVita treats people with ESRD

• Everyone with ESRD first has CKD

• Most people with CKD get it from having diabetes and hypertension, often because they’re overweight, as that’s a big risk factor

• Every year, a growing percentage of Americans are overweight

• Ozempic helps fix the problem of being overweight

• More people are using Ozempic

• If a lot of people take it, and it helps reduce weight, there will be fewer overweight people in the future

• That means fewer with T2 diabetes, hypertension, and progressive CKD

• That means fewer people with ESRD

• DaVita’s volumes would go into terminal decline

The stock fell ~20% recently after Novo Nordisk disclosed that its CKD-related trials are looking good. When things fall 20%, you will be scared. Are you wrong? Will people think you’re dumb?

To think this one through, you need to turn off those thoughts and emotions, and become a machine. Anything less and you’ll probably lose money.

(I won’t judge you if you give up here and go buy Procter & Gamble or US Treasury Bills at single-digit expected returns. You don’t need to do what I do to make money.)

If you aren’t off buying Treasurys, then get your thinking hat.

Semaglutide (Ozempic/Wegovy) and its economics:

• It’s ~USD 1,000 for a one-month supply, or $12,000/patient/year. (Yeah, maybe you can already see how someone’s TikTok excitement will die down quickly.)

• This class of drug might sell ~$20 billion annually within a couple years in the US, between all the competitors (Novo Nordisk, Eli Lilly, etc.).

• That’ll imply 1.7 million Americans being treated.

• Double that out of fear to ~3.5 million.

• That’s 1 in 10 people who have CKD, assuming people with CKD comprise all the incremental demand. I already know they don’t:

  • A lot of the incremental demand is coming from people who don’t have T2 diabetes, since the drug’s already been marketed to their doctors for 6 years. Most of the physicians who probably want their patients on semaglutide already made that call.

  • Instead, from Trilliant Health (a data provider), only ~50% of recent prescriptions are going to T2 diabetics. Corroborating that are news reports of diabetics complaining of shortages because of the growing population taking the drug off-label, and Novo Nordisk can’t keep up with the demand.

  • That means it’s not 1 in 10 people with CKD, but much less, maybe 1 in 15 or 20. It’s a little tricky because many people with CKD are not diabetic.

  • That 1 in 15-20 implies a one-time, high-single-digit impact to DaVita’s volumes, spread over the course of years, to a business where volume’s growing 2% already. So maybe volume ends up flat.

  • The stock’s got a 10-15% free cash flow yield depending on how management executes on other initiatives, so the stock already implies shrinking profits.

  • Thus, at this price, where’s the risk of loss to my investment?

Maybe I’m wrong because the system’s going to get really smart and find ways to disproportionately prescribe semaglutide only to people who have later-stage CKD.

• Only half of those with ESRD have a “primary diagnosis” of T2 diabetes; 25% are from hypertension and 25% from other causes. If the FDA approves semaglutide for CKD broadly, the range of prescriptions doubles.

• Yet, it’s already been approved for diabetics (the first half of the ESRD market) for 6 years⁹, and hasn’t really affected DaVita’s volumes.

Lastly: many insurers are already not putting the drug on their formulary because the cost is high. It’s also not reimbursable by Medicare.

• Smart insurers like Anthem know that CKD patients today cost them about $25,000 annually, most of them are diabetic, and most of their cost would still be there if the patients received Ozempic, so why spend $12,000 a year on them?

• There’s no incentive to reimburse this drug forever without some obvious future benefit, such as reducing ESRD since ESRD patients as a whole cost a fortune — as much as Google’s and Apple’s profits combined.

• Yet, only <1/250 CKD patients end up with ESRD and go onto dialysis, and no one can predict which CKD patients that’ll be. You can’t target. Even if you could target or just go after people with stage 3-4 CKD, that’s still ~40% of all the people with CKD, or 15 million people, of which each year only <1% of them (<150,000) go on to be diagnosed with ESRD.

• If you wanted to give Ozempic to all the people with stage 3-4 CKD only, the system would be spending $180 billion annually.

• You’d then save: 150,000 new ESRD cases, times $150,000 per ESRD patient per year in costs. It varies by age, but people have a ~5.5 year conditional life expectancy once diagnosed. 150,000 * $150,000 * 5.5 = $112 billion benefit. This math also assumes Ozempic magically prevents all ESRD cases, which it doesn’t. So far, with ~2% of diabetics on it already plus some others, there’s been no material impact to DaVita.

There’s one final reason the insurers are disincentivized from paying for Ozempic for CKD:

• CKD progresses extremely slowly

• By the time most people who ultimately get ESRD get it, they are often retired, off commercial insurance, and on Medicare.

• They also end up on Medicare even if not retired because… for complicated reasons that don’t apply to any other disease… the insurers get the option to “put” ESRD patients to the government within a short period. If you get ESRD, your insurer soon stops being your insurer, and Medicare (the federal government) becomes your insurer instead.

• This is why only about 10% of ESRD patients are commercially insured.

• Why would an insurer be the one to want to pay for Ozempic to solve a problem they won’t see the economic benefit of, because the government will instead?

If Ozempic actually became reimbursable under Medicare, it’d even be a “backdoor” for DaVita. If you could prescribe it to diabetics with ESRD, that’d be good for DaVita:

• If people with CKD on semaglutide get healthier, then so will those with ESRD

• If people with ESRD get healthier, they’ll live longer and die of other weight-related complications less often, too

• That means they’ll stay on dialysis longer, because you can’t un-fail kidneys

• That means DaVita will do more dialysis treatment volume

• That means DaVita won’t go into decline

Finally, patients at DaVita clinics tend to skew low-income. Many historically had issues with access to insurance. Given the drug’s cost, and the cost of other treatments to manage diabetes and slow CKD (remember, the average CKD patient costs the system $25K annually), the ones who are already coming out the other end of the CKD pipeline are also the ones who are probably a lot less likely to be getting easy access to expensive drugs like Ozempic in the first place.

Yeah, look, I’m sorry if you look like this:

It gets deeper, for example if you stop taking semaglutide you lose all the benefits (and possibly more). But we’ll call it a day.

It’s not an easy think, but the takeaway is there’s no clear means or economic incentive for this to cause widespread chance despite obesity being a big problem. Economic incentives have for decades been a big part of the moat around DaVita’s castle.

Finally, also turn the rational part of your brain off, too. Ignore everything. Don’t even think. Become a quantitative hedge fund.

• I have white papers containing data on the historical corporate events in the stock market over decades, and what the stock price performance has tended to be after a big event causes the stock to immediately drop, say, 20%. I have all the “base rates”.

• I already know that stocks tend to do well after this type of event, given the type of business DaVita is.

In what ways can I be wrong?

• In the drug industry, competition always increases, usually when the drug’s patent expires and the generic producers go to town. This always makes the price fall. This might make insurers (and maybe even Medicare) more likely to carry it on their formulary, since the calculus will change. That’s 10 years out, though.

• Nobody knows what the drug’s penetration is going to look like or the long-term effects on CKD. Maybe somehow most of the people with CKD are going to be able to afford it, and it’d solve all their problems for all of them.

This has always been the story of CKD and ESRD for decades. We’ve always been getting better at slowing CKD or diabetes in the population, with drugs like metformin, dietary recommendations, and behavioral therapies. It’s just easier to eat and sit than it is to do other things. As treatments per-person get better, the overweight population’s still growing as a percentage of the American population. That’s the uphill battle.

The takeaway: the evidence doesn’t seem to match the market reaction. There are even outs that work against improved CKD therapies. It’s really not so cut and dry, but “new” stuff always feels that way. There’s a range of outcomes, but most outcomes lie to the upside. We have no idea exactly what’s going to happen — hence, “Jesus, Take the Wheel” — and there’s a lot of uncertainty, but the risk is less than what I think many believe because most of the outcomes are favorable.

I have less conviction in this issue the issues surrounding Brookfield or Bank of America. New information will come out, and I’ll also be re-evaluating. For reasons like that, I bought a little more DaVita, but don’t own as much of it as I do other ideas because we’ve got to allocate capital to where the risk/reward’s most compelling, and where we have the strongest sense of what the odds actually are.

Man, how can you not love investment research? How cool is this puzzle? Doesn’t it tickle your neurons? How can you not feel like Ryan Gosling in The Big Short after you think through this stuff?

What a cool business with some sneaky, subtle stuff going on in the value chain.

If you take away anything else from this post, let it be:

Exercise and eat well. Muscle. Veggies. Muscle and exercise keep you metabolically healthy. We are not meant to eat cake and sit.

If you’re enjoying this stuff, please consider sharing.

Chris

1. Alternatively, it’s helpful if you’re psychopath and don’t feel much, anyway.

2. I mean, GM is a $40 billion company that is currently printing $10 billion annually and they’re not even at peak production because there’s a slowdown. Pick-up trucks are an oligopoly defended by very sticky, picky customers, and that business is >65% of GM’s profits. KKR’s also halved and we are again at silly prices: the industry’s growing 10% annually and the business earns ~17% on capital all-in. The company can earn ~$7 per share, and the stock’s $60.

3. By the way, this is exactly what people did during the Spanish Flu pandemic during World War I. It’s amazing what kind of futures you can be prepared for if you just learn the past.

4. Notably, the repercussions of that bazooka are still being felt today and are one of the main reasons we have had 2+ years of strong inflation. There was more stimulus than needed.

5. Nobody new is going to come in for… reasons we’ll talk about one day.

6. That’s not a guess. I have plenty of evidence for this from all the research I’ve done.

7. The huge price difference is a story for another time

8. We find out about them because the US surveys a random sample of adults once every 5 years, and 15% of them have CKD. It’s called the NHANES survey.

9. (DaVita’s volumes have fallen in the last 3 years, but that’s because existing patients were having higher mortality rates from a global pandemic, not because of fewer new incidences of ESRD.)