3 Surprising Reasons Drug Stocks Tank Every Time the Republican Health Bill Hits a Snag

When Donald Trump surprised the pollsters and won the November presidential election, it was widely believed by pundits that the Affordable Care Act (ACA) would shortly be headed out the door. The ACA, which is more commonly known as Obamacare, has been a reviled piece of legislation that the Republicans have wanted to repeal for years. With the GOP retaining its majority in the Senate and House, a repeal was expected.

However, that's not been the case. President Trump's and the GOP's numerous bills to repeal and replace Obamacare have been met with poor support from the public and, in many cases, lukewarm support from within the Republican Party. For the time being, Senate Republicans can't even wrangle enough votes to consider trying to pass their recently introduced Better Care Reconciliation Act.

Drug stocks tumble every time Republicans hit a snag in their health bill

When Senate Majority Leader Mitch McConnell (R-Ky.) announced on Tuesday that the Senate would not be able to vote on its recently introduced healthcare bill until after the Independence Day recess, the stock market dropped. In fact, it was the worst performance for the broader market in more than a month. The sector that led the market lower, and continues to lead the market lower every time there's a hiccup in the Republican Obamacare replacement bill, is healthcare. More specifically, drug stocks.

Why on earth are drug stocks tanking every time the Republican health bill hits a snag? On the surface, the move lower in drug stocks might be a bit confusing -- after all, the Better Care Reconciliation Act was scored by the Congressional Budget Office (CBO) and estimated to cause the loss of 22 million insured consumers a decade from now. One would presume that the loss of consumers would not be good for drug companies that are looking to reach as large of an insured patient pool as possible.

But if you look at the bigger picture, there are some clear negatives for the drug industry if Republicans struggle to pass their health reform bill.

1. Uncertainty begets selling

For starters, the entire market, including drug stocks, dislikes uncertainty. Certainty did exist for a couple of years under Obamacare, but it's predominantly been dashed by seemingly unsustainable premium price inflation for unsubsidized plans, national insurers dropping out of the ACA's marketplace exchanges, and the potential for Republicans to drive a knife through the heart of Obamacare by pulling the plug on cost-sharing reduction (CSR) funding. Cost-sharing reductions help pay for some of the costs of actually seeing a physician for consumers earning under 250% of the federal poverty level, and a court case won by Republicans could give them the right to cease funding for this critical ACA subsidy.

Drug stocks and insurers are looking to Republicans to create a sustainable plan that'll allow them to accurately price their products. Every time the GOP's plan hits a speed bump, uncertainty on pricing and future enrollment moves to the forefront, sending investors to the exit.

2. Drug stocks probably fear a bipartisan bill

Secondarily, and perhaps more interestingly, there may be concern among drug companies and investors that the only way Republicans can pass healthcare reform is by working with Democrats. Imagine that, bipartisan cooperation on a bill.

While bipartisan cooperation would likely please the American public, it's not such great news for drug companies. The reason is that Democrats have been pushing hard for drug-pricing reforms, whereas Republicans generally believe in free-market pricing. We don't have to look far to find questionable pricing practices of late. For instance, the price of Mylan's (NASDAQ: MYL) anaphylaxis treatment EpiPen has catapulted from $94 in 2007 to $609 as of 2017, a 548% increase. Even after agreeing to a $465 million settlement with U.S. federal regulators for improper charges to Medicaid, Mylan still has strong pricing power.

Even though President Trump has himself, on numerous occasions, proclaimed that he'd help drive drug prices down during his presidency, the chances of placing restrictions on drug pricing seem very low with a Republican bill and much more likely with bipartisan healthcare reforms. If drug companies want to maintain their pricing power, they'd be wise to cheer the Republican bill on.

3. Losing Medicaid patients is positive for margins

A third and final reason drug stocks run in the red every time the GOP health bill runs into trouble may be related to changes in the Medicaid program.

As noted above, the CBO expects the Senate health bill to reduce the number of insured Americans by 22 million in a decade, of which there will be an estimated 15 million fewer enrollees under the Medicaid program. Though having fewer Medicaid patients would seemingly reduce the prospective patient pool for drug stocks, it also removes a number of low-margin patients from the equation. Even though Medicaid provides a guaranteed payment from the government, the Medicaid program is allowed to negotiate drug prices on its behalf, leading to substantially higher discounts and rebates relative to list prices. Comparatively, the Medicare program isn't allowed to negotiate drug prices, which leads to much juicier margins for drug stocks.

Essentially, every time the Republican's health bill hits a snag, drug companies are looking at the prospect of having to cut significant deals with Medicaid, accepting lower margins for their products in the process. If the GOP bill passes, there will be fewer patients, but those who remain will be higher margin.

What's next for drug stocks?

So, what next? The truth is no one has any idea at this point. We could see Republicans rally around their health bill with some modifications and push Obamacare completely out the door. On the other hand, we might also witness a rare act of bipartisan cooperation and reform with the ACA remaining in place after some changes. There are simply too many variables at this point to know what will happen next.

However, I wouldn't suggest investors change their game plan in the interim just because of the roller-coaster ride lawmakers have taken the market on over the past couple of months. Prescription drugs are an inelastic product considering that people can't control when they get sick or what ailment they have, meaning demand for pharmaceuticals should remain strong and grow over time as the population expands. If drug stocks drop enough on concerns over the GOP's health bill, it may even be time to go shopping.

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Sean Williams has no position in any stocks mentioned. The Motley Fool recommends Mylan. The Motley Fool has a disclosure policy.