“The battleground is no longer having access to information. That was yesteryear’s investing. Today’s investing in 21st century is about asking the right question. You’re no longer going to be a good database. You’re going to be a good search engine. The answers are there to be found. It’s the right questions to ask. That’s how we differentiate ourselves as well. We’re not looking for information. We’re looking for insights. “                                                         
                                                      Rupal Bhansali[1]CIO, Ariel Investment International Equities
 
In the original British version of House of Cards, the Chief Whip Francis Urquhart tells a reporter “perhaps we should start by asking some questions.” While things didn't work out so well for the reporter Mattie Storin (you can see the original series here), Mr. Urquhart went on to become Prime Minister.
 
I bring this up because over the years I’ve realized having access to good data is only half the battle. The ability to ask not only good questions - but also the right questions - makes all the difference in your investment performance. I wish there was any easy way to develop these questions, but there isn’t. An enormous amount of work is required to obtain the data, devise the right criteria, understand what you are looking for, and obtain insights valuable to your investment process.   
 
An example of asking the wrong questions was the performance of privately held Spoonrocket – a meal delivery vendor in California. According to a recent Bloomberg article, investors in the company never thought to ask the company about its last financial statements that were creative (and I’m being generous here) to the point of nonsensical. As an example, the company "failed to achieve profitability by conventional definitions," but was "contribution margin positive." This latter statement simply meant they made money if they excluded "costs of customer service, central employees, office rent, and marketing to drivers.[2]" While the company showed remarkable growth and customer service, it might have been helpful if someone had simply asked, “can you make money with this business?”
 
Spoonrocket shut down in March and sold some assets to a food delivery company in Brazil. Profitable indeed.
 
While it may be hard to develop industry or company specific questions, I’ve found there are some broader questions that are simple go/no-go in the decision to further investigate. These questions may not require a lot of technical ability, but common sense and intellectual curiosity are a prerequisite. More money has been lost by emotional failures and intellectual laziness than by any other means. Here’s my list of essential questions as you begin to evaluate a potential investment.
 
What is the Company Worth?
It is so easy to lose sight of this as a northern star, but it’s probably the single most important question you can ask as you get started. No matter how you come up with it - price/book, price/earnings, dividend discount, or discounted free cash flow - estimate a value for your investment. We avoid companies that have business models that we can’t estimate profitability (ever wondered why it’s so hard to estimate the value of a company with no earnings or free cash flow?), financials so obtuse it’s impossible to understand (Enron comes to mind here), or proprietary technology and operations that can’t be shared (I’m looking at you Theranos). If you don’t know how to value a company, then it clearly doesn't fit inside your portfolio.
 
Do I Fully Understand How the Company Makes Money?
It seems like a relatively easy question, but it’s surprising how few investors can answer this question about their holdings. For instance, many investors will tell you pharmaceuticals’ main customer is a physician. Actually, pharmaceuticals have no business or financial relationship with a physician beyond providing free samples or paying thought leaders to speak on their behalf. Pharmaceuticals manage the actual distribution of drugs from manufacturing facilities to drug wholesalers - and in some cases - directly to retail pharmacy chains, mail-order and specialty pharmacies, hospital chains, and some health plans. They have no relationship with managed care companies, patients, or almost all employers. If you don’t understand how your investment makes money, then don't make it an investment.
 

Will the Company Be As Successful 20 Years From Today?
 
The concept of having a wide moat means it will take considerable time and treasure for a competitor to make inroads against your investment’s products and services. We are all relatively clear on what Coca Cola (KO) will be doing for business twenty years from now (though there moments when clarity was lacking – like the time they acquired a shrimp farm), but how clear are we when it comes to Building 19[3] (“Good stuff….cheap”). The latter isn't really an option (it filed for bankruptcy several years ago), but what about a company like Lexmark (LXK)? Could you really – with a real sense of security – predict what Lexmark will be doing in 2036? If you can’t come up with a concise and confident answer within 30 seconds it doesn't belong in your portfolio.
 
Are My Data Inputs Valid and Well Reasoned?
 
This is a relatively subjective question but still critical. The easiest person to fool in investing is your self. The ability to obtain multiple data sets, understand their sources, work out any assumptions, and assure yourself of their accuracy is essential to building out great valuation models. Nothing pleases me more than when I can get to completely opposing viewpoints supported by a great deal of data. Rather than seeing that as a problem, I like to see it as a tremendous learning tool. For instance, I was recently reading two diametrically opposed viewpoints on Nintai Charitable Trust (NCT) holding Expeditors International (EXPD). One writer believed the international supply chain was near collapse based on the China slowdown, crash in commodities, increasing competition, and pricing pressure. The other highlighted EXPD’s operational strength, deep industrial relationships, outstanding management, and slow (but upward) international growth. Who was correct? I think they both were in some ways. In both articles the data was well founded/researched and the arguments provided a tremendous resource in my investment education.
 
How Do I Break My Investment Case?
 
In a recent article (you can read it here) I discussed the importance of getting to zero or “breaking” your investment case. In most cases when I calculate an estimated intrinsic value through my discounted free cash flow model, I will halve the companies 1, 5, and 10 year free cash flow growth estimates. After reviewing the impact on valuation, financial strength, etc., I halve it again. Why do this? To me it’s a simple - and ruthlessly effective - tool in creating a scenario that tests the financial limits of a potential holding. As an example, CBOE Holdings (CBOE) - an NCT holding - has grown free cash flow by 14.3% annually over the past 5 years. What would the impact on my valuation if growth was halved to 7.1%? Or halved again to 3.5%? Does the company have the financial strength to handle such a catastrophic event? As you run such models you find there aren’t that many companies that can take such an event in stride. Those that do qualify for further research at the Nintai Charitable Trust.
 
Conclusions
 
Asking questions that give you out-of-the-ordinary insights is far more art than science. Much like trying to figure out the best query on Google (how many times have you heard someone say, “I’m a terrible searcher”), investors need to really think about what they are trying to solve and then develop the best questions to obtain helpful insights. In the last twenty years the world has flattened considerably when it comes to finding investment research. GuruFocus is something Warren Buffett would never have dreamed possible starting out in his father’s brokerage house. But data is slowly becoming a commodity. Insights - ones that give an investor a true advantage - are much harder to come by even with all of today’s technology. If you can create a handful of core questions that provide insights into a value-based investing model, then you are half way home already.
 
[1] Her full interview can be found at www.latticework.com

[2] “Tech Startups Come Up With Some Creative Definitions for ‘Profitable”, Bloomberg, Ellen Huet, May 15th, 2016

[3] Anybody who grew up in New England will realize this is an actual example along with Building 19 ¼ and 19 ½, 19 1/9, etc. 

I had the privilege of speaking at the Gurufocus Conference in Omaha earlier this month. The basis of my talk was finding value in healthcare. In the presentation I talked about the fact that new wide-moat companies are frequently found outside the traditional biopharma space. During the Q&A I was asked about Valeant and whether I saw value in the stock. I have written earlier about the company (which can be found here) and discussed the myriad issues for the company going forward. In this article, I want to discuss trends that started with Valeant but will affect many players over the next several years.  
 
Drugs, Pricing, and Access
 
For the past twenty years the drug distribution model has been relatively static. Doctors write prescriptions, patients use a pharmacy benefit manager (PBM) to fill the prescription, the PBM evaluates whether the drug is on their formulary (meaning they will pay for the drug with a defined co-pay from the patient), and the patient’s insurance provider is billed. This model generally worked quite well as biopharma companies launched blockbuster drugs with relatively small costs (such as Zocor or Zestril). These drugs were in pill form and generally cost under several dollars per dose. Since 2005 this model has changed dramatically. Three trends in particular have created these changes. 
 
The Rise of Specialty Drugs: Since 2005 there has been an explosion in specialty and orphan drugs (meaning medications targeting generally rare or “orphan” diseases. This is a disease with less than 200,000 patients in the US). To give some notion of the growth one only has to look at FDA drug approvals for the periods 1973 – 1983, 1983 – 1993, 1993 – 2003, 2003 - 2013.  During the first decade roughly 15 orphan drugs were approved. In the second decade (after the passage of the Orphan Drug Act) roughly 65 orphan drugs were approved. During the third decade roughly 125 orphan drugs were approved. Finally, in the last decade roughly 180 orphan drugs were approved. In 2013 alone there was 260 approvals. By 2020 it is estimated orphan drugs will make up roughly 20% of total prescriptions totaling an estimated $175B in sales.
 
The Rise of Therapeutic Costs: With the rise in the amount of orphan drug approvals has come the rise in cost per treatment. A new immunotherapy for cancer can cost as much as $180,000 annually. Gilead’s Harvoni (treatment for Hepatitis C or HCV) is priced at roughly $90,000 for a 12-week course of treatment. Compared to the costs for treating hypertension (roughly $150 per year), these new drugs are placing enormous strain on insurers and patients.
 
The Rise of PE Biopharma: In the last decade we have seen the creation of what I refer to as private equity biopharma. These are companies engineered to take advantage of the United State’s unique healthcare model that is half for-profit and half not-for-profit. These companies acquire a target that has one or two approved drugs (sometimes branded or under patent protection and sometimes generic), strip the company of all R&D assets, and hike the price of the drug anywhere from 50-800%. An obvious example of this is Valeant but others such as Allergan and Endo Health follow the same model. Price increases are an essential component of these companies’ business model.
 
PBMs Push Back
 
Price inflation on some generic drugs and the cost of new specialty drugs has caught the attention of those who have to pay for these medications. These companies pay pharmacy benefit managers (PBMs) to negotiate prices and generate cost savings across the board. The largest PBMs have enormous leverage when negotiating. For instance Express Scripts covers roughly 85 million patients. The largest PBMs have taken steps to rein in these costs and seek out the cheapest option whenever available. In particular, two new trends will impact biopharma the most.
 
Market-Event Action: Currently PBMs are required to get individual patient approvals to switch to a cheaper version of their prescription. Several PBMs are moving to a more centralized – and quicker – process. Under new market action processes, employers or insurance plans will give Express Scripts advance permission to try to shift patients to cheaper alternative medicines when an old drug jumps suddenly in price. Express Scripts expects to have the market-event process in place by the end of 2016.
 
Indication-Specific Pricing: In Europe, regulators compare the clinical and cost-effectiveness of new drugs with existing treatments to determine whether a drug qualifies for inclusion in their formulary. The goal is pay an amount based on improving quality and/or length of a patient’s life without substantial side effects. For instance, Genentech’s Tarceva can increase the survival of a metastatic non–small cell lung cancer (NSCLC) patient by roughly 3 months. Treating a patient with pancreatic cancer with the same drug increases survival by less than 2 weeks. Indication-specific pricing would argue that the price should be different for each instance – based on clinical results - rather than one universal price. 
 
Why This Matters
 
As any investor in Valeant or Gilead can tell you, the ability to drive earnings growth is highly dependent on gaining market share and increasing drug prices. As PBMs begin to reject coverage on some drugs, seek generic alternatives, and begin indication-specific pricing, the impact on Biopharma will be profound. Some companies will be impacted more harshly than others. PE biopharma will face the largest impact as their model is based primarily on price increases. Both market event and indication-specific pricing will likely prove to be catastrophic for these companies. Valeant’s 87% drop in share price reflects these new realities. Endo’s 44% drop in the last week is another example of the investment community grasping the magnitude of these changes. Large biopharma (such as Pfizer and Merck) will face similar pressure but the impact will be far less. That doesn't mean they are out of the woods. Far from it. Market event and indication-specific pricing will slow earnings growth significantly over the next decade. Conversely, if the major PBMs succeed in driving down prices, their revenue from shared cost savings (PBMs take a percentage of savings derived from price decreases) will likely expand significantly over the same time period.
 
Conclusions
 
Picking the winners and losers from these trends isn’t as easy as it may seem. Additional actions such as Medicare/Medicaid reimbursement, hospital order sets, and evidence-based medicine could play equally large roles in the future. With so many moving parts it will be vital to fully understand what is a remarkably complex marketplace. Companies that are one-trick ponies (focused on only price increases or having one product in multi-treatment therapy) will pay the highest price. Finding a company that blends new products, significant drug efficacy, and reasonable pricing will likely be your best bet. Companies like Novo Nordisk (I own this in the Nintai Charitable Trust) are well positioned. NVO has roughly 25% of the diabetes market with three of their products in either number one or two market position. Their drugs are highly effective with only one real competitor (Sanofi). The company’s financials are rock solid with no debt and roughly $750M on the balance sheet. Finding companies like NVO will take a significant effort but they are out there. Investors should keep their eye out for companies that thread such a needle. It’s a prescription for a healthier portfolio and adequate returns.