“Don’t ever be deceived about big data and informatics in healthcare. The vast majority of data and informatics are transactional – structured, codified, and mechanical in nature. Going forward, nearly all the companies expounding on paradigm shifts, tipping points, and cloud-based ecosystems will fail. Never forget healthcare is a business industry. Partially for-profit and partially not-for-profit but an industry nonetheless. And industries will always seek out business solutions rather than theoretical solutions. So far, Big Data and healthcare informatics are mostly theories in search of a problem to solve”.  
                                                           
                                                                              -  David Geoghegan
 
Nelson Hsu - a fellow contributor and eloquent writer at GuruFocus - recently asked me if I might write an article on healthcare informatics. From 2002 to 2014 I had the pleasure of being Managing Director of Nintai Partners – a boutique consulting group specializing in the field healthcare informatics. In the past few weeks I’ve written about how running the firm impacted and taught me so much about value investing. I thought it might be interesting to take up Nelson’s request and look at the healthcare informatics market from the value investor’s perspective.
 
Healthcare informatics: Room for Value?
 
Like any other industry, healthcare informatics is driven by technological innovation, market adoption, and corporate profitability. And like many technology driven markets, investors are faced with the possibility their investment can find their services unneeded, their technologies obsolete, and their competitive moat drained and filled overnight. Finding value takes a great deal of research, knowledge of the healthcare industry, and turning over a great deal of stones. Certainly the greatest risk is buying into the hype of paradigm shifts, industry transformations, and the cloud tsunami. I would caution all investors that investment price must be driven by business value. Companies that provide significant value to their customer’s operation in both the short and long-term will be the winners in the industry. 
 
A Rapidly Changing Environment
 
No industry is going through as much macro changes as healthcare. The first major shift has been the passage in 2010 of the Patient Protection and Affordable Care Act (PPACA), commonly called the Affordable Care Act (ACA) or Obamacare. Hospitals and primary physicians have been tasked with transforming their practices financially, technologically and clinically to drive better health outcomes, lower costs and improve their methods of distribution and accessibility. This has led to a far more integrated approach to data, informatics, and analytics across the delivery system. The second strategic initiative was the 2009 ARRA (American Recovery and Reinvestment Act) funding of roughly $19 billion for healthcare information technology including the adoption of electronic health records (EHRs) at the point of care. Third was the federal government’s Meaningful Use regulations requiring the gradual adoption and performance standards for those organizations using EHRs. All of these have led to a rapid transformation of data to a digitized format as well as an increased need to use the data in patient care, delivery systems, and patient outcomes.  
 
What Drives Value?
 
When looking for investments in the healthcare informatics market, there are three (3) major drivers of value. Each of them falls under a broad theme – the company’s offerings must provide a vital function in the strategy or operations of their customers. Far too many companies are based on consultant visions and “build it and they will come” mentality. Without a clear business need, many informatics companies simply don’t provide real, measurable value to their clients. We are currently at the peak of the “hype cycle” and investors must be extraordinarily careful in their selection of investment opportunities.
 
Competitive Moat
 
Most important, look for healthcare informatics companies with deep competitive moats. An example of this is IMS Health (IMS). They are the clear industry leader in pharmaceutical sales and de-identified prescription data. There is simply no competitor that can provide the breadth and depth of their data.
 
IMS’ competitive moat is driven by two key components. First, their data and analytics are considered essential to pharmaceutical commercial teams when developing sales and promotional strategies. There is literally no biopharma company that would go to market without IMS’ services. Second, IMS has remarkable control over their data sources. Their relationships with pharmacies are deep and long term. It would be remarkably difficult for a new competitor to develop such a source of data in today’s market.  
 
Finding a healthcare informatics company with such a deep competitive moat is rare. By focusing on companies with deep penetration into their client’s operations and the strength of data ownership, investors will start with a strong core group of investment candidates.
 
Compounding Capability and High ROC
 
Another criteria value investors should look for is the ability of the company to compound value through steady long-term growth and opportunities to reinvest capital at high returns. An example of this is Wolters Kluwer Health (XAMS: WKL). As providers of clinical decision support and clinical drug data and analytics, the company has steadily added functionality and data sources over the last decade. A case of this has been their push into specialty drug data that will drive biopharma sales over the next 10-20 years. This growth has allowed WKH to achieve 13+% growth and return on capital of 57% over the past decade.
 
Pricing Power
 
A third criteria to look for is the company’s pricing power. In healthcare informatics this is generally driven by two broad capabilities – a stickiness of the company’s services and/or a duopoly or monopoly of services. A great example of this Nintai Charitable Trust holding Computer Programs and Systems (CPSI). As the leader in smaller, rural-based hospital Electronic Health Record market, CPSI provides a service that once installed is very difficult to switch providers. By focusing on smaller health systems, the company has little competition as most of their clients simply can’t afford or need the larger EHR systems such as Epic. The company has some of the highest margins, ROE, and ROC in the industry.   
 
 
Conclusions
 
Without a doubt, healthcare informatics will be a high growth market for the next decade. Regulatory requirements alone will drive a far more comprehensive use of data and analytics from drug development to clinical care. The companies I’ve highlighted in this article are examples (not recommendations!) of organizations that have created a profitable and growing business in the field. By identifying companies with their attributes – deep competitive moats, compounding machines, and pricing power – investors can find opportunities in the healthcare informatics market.
 

One of the benefits of writing regular articles is the ability to go back and review your predictions and recommendations and see how things ultimately end up. Sometimes you can look back with a certain amount of pride (like our recommendation to be aggressive buyers in the 2008/2009 Great Recession), but most of the time these things seem to come back and haunt us for the remainder of our careers (for such a truly horrendous example please read our article “Lessons We Have Learned” which can be found here)[1]. Unlike many politicians who live by L.P. Hartley’s dictum “The past is a foreign country: they do things differently there”, at Nintai we are quite comfortable looking back at our historical musings and measuring our performance. Sometimes right, sometimes wrong, there is always something to be learned.
 
Revisiting the Overreaction Hypothesis
 
With that said, earlier this year I wrote about the “Overreaction Hypothesis” in which violent movements - both up and down - in individual equity prices are usually matched by an equal and opposite response (the article can be read here). This concept was first proposed by Richard Thaler and Werner De Bondt in their seminal work "Does the Stock a Market Overreact?". In their article[2], Thaler and De Bondt stated:
 
“If stock prices systematically overshoot, then their reversal should be predictable from past return data alone, with no use of any accounting data such as earnings. Specifically, two hypotheses are suggested:
 

• Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction.
• The more extreme the initial price movement, the greater will be the subsequent adjustment”.

 
The Overreaction: SolarWinds
 
In the article, I used SolarWinds (SWI) as a potential example of overreaction hypothesis. As background, on July 17th, SWI’s management reported Q2 numbers. In addition to missing Q2 revenue estimates (while beating on EPS), the company guided for Q3 revenue of $130M-$134M (below a $136.1M consensus) and 2015 revenue of $502M-$512M (below a $519.7M consensus). EPS guidance was better: $0.49-$0.53 for Q3 (consensus is at $0.52) and $2.00-$2.08 for 2015 (consensus is at $2.00). These results provoked a collapse in the stock price – dropping to $35.54 or down 24.5% from its close of $47.05 on July 16. Utilizing a DCF model, management’s revised earnings estimates reduced our estimated intrinsic value by less than 2% ($54/share revised down to $53/share) yet Mr. Market would have us believe the company was worth roughly one-quarter less than the day before[3].
 
Testing the Hypothesis
 
According to Thaler and De Bondt, there are three (3) effects that will ultimately inform us about both the overreaction as well as the counteraction to take place in the future. These include:
 
Directional Effect: Extreme movements in equity prices will be followed by movements in opposite direction. According to this effect, we would see an extreme movement to the upside after such a drop in price.
Magnitude Effect: The more extreme the initial price change, the more extreme the offsetting reaction. In this case, we should not only see an upward price move, but a move of significant magnitude since the drop was nearly 25%.
Intensity Effect: The shorter the duration of the initial price change, the more extreme the subsequent response. Since the drop occurred in a singly day, we should see a dramatic move occurring in a very compressed amount of time.
 
In essence, Thaler and De Bondt argue that after SWI’s 25% price swoon on July 20th, the markets should produce a swift, massive upward price surge.   
 
So how did their model work out? After dropping from $47/share to roughly $36/share on July 17th, the stock slowly rose to $41.50 through October 8th. On October 9th the stock jumped nearly 14% after the Board announced they were exploring strategic options including the possibility of an LBO or acquisition. Talk on the Street has mentioned discussions with PE firms and a sale price of roughly $55-$60/share.   
In this instance, Thaler/De Bondt’s hypothesis of a rapid, substantial, and upward price move has taken place. As owners, we couldn’t be more pleased that Wall Street recognizes the value of the company. 
 
Possible Reasons for the Overreaction Hypothesis
 
So do the data guarantee an equal and proportional response for every sharp price movement? No. But Thaler/De Bondt’s research does show that it happens often enough that we can make some general observations going forward. First, we can assume a considerable price movement gets enough animal spirits moving that we can see roughly correlative reactions to the initial actions. Second, these animal spirits are often driven by emotions rather than sound qualitative thinking. This puts the basis for these market reactions less about data and more about passion. Last, profound price changes can provide incentives for varying types of investors. A significant drop may produce interest in activist hedge fund players. So it shouldn't be that surprising when market reactions frequently counteract a significant pricing event.
 
That said, I would posit there are several conditions that might enhance an investor’s chances of achieving positive results from such dramatic price moves.
 
Price Movements Push Valuation Extremes: In the case of SWI, the dramatic drop in price pushed the stock’s valuation into highly undervalued territory. We think investors would be rewarded most when the price action pushes valuations into highly over or undervalued territory. These valuations would greatly enhance the chance of Mr. Market making a strong counter move.
 
Quality Can Impact Your Outlook/Position: We believe investors would be wise to look for sudden downward price moves with high quality companies (in this case go long) or the opposite for low quality stocks (short the stock after sudden upward price moves). In the case of SWI, we believe the market saw a high quality company trading at a very low price – hence the surge upwards.
 
Always, Always Focus on Valuation: Ultimately investors have no idea about the catalyst in the Overreaction Hypothesis. As value investors we are best to focus on the impact of the sudden price move on valuation, and ultimately let the chips fall where they may. In the final analysis, we believe Nintai’s investment in SWI will ultimately work out because we purchased a piece of a business at a significant discount to fair value.
Conclusions
 
Thaler and De Bondt’s research has stood the test of time since they first published roughly 30 years ago. Data tell us we can expect – in general – a reaction similar to our experience with SolarWinds. Whenever we see a case of the Overreaction Hypothesis we take a long hard look at the company, the reasons behind the pricing event, and the relationship between the new price and estimated fair value. While I never assume we will see a reaction as outlined by Thaler et al, we certainly are aware it could happen. Watching SolarWinds work out as an Overreaction Hypothesis candidate has been great to watch.  Unlike my call on Michael Jackson, I might just come out ahead on this one. And that's something I won’t complain about.
 
 
[1] Another classic ill-made prediction was my statement in 1978 that Michael Jackson was clearly going to flame out and have no impact on the music industry. How I reached this conclusion is beyond me, but I am reminded every so often (in a remarkably joyful manner) by friends and family.

[2] “Does the Stock Market Overreact?”, Werner F. M. De Bondt and Richard Thaler, The Journal of Finance, Vol. 40, No. 3, Papers and Proceedings of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984

[3] On July 20th, 2015 the Nintai Charitable Trust initiated a substantial long position in SWI at roughly $36/share. 

The third quarter saw some dramatic movement leaving the markets down significantly during the quarter. The S&P 500TR was down by (6.4)%, the Morningstar Total US Equity Index was down (7.5)% and the Nintai Proxy (70% Vanguard US Equities Total Market Index, 15% Vanguard Global Equities Total Market Index, and 15% Cash) was down (8.8)%. The Nintai Charitable Trust Portfolio was down (7.8%) net all fees. Through September 30th, 2015, (YTD) the S&P 500TR is down (6.4%), the Morningstar Total US Equity Index is down (7.8%), and the Nintai Proxy is down (9.8%). The Nintai Charitable Trust Portfolio is up 2.1% YTD net all fees.
 
Several stocks have driven our outperformance YTD. Morningstar (MORN) was up 26%, Novo Nordisk (NVO) was up 44%, and Synaptics (SYNA) was up 27%. Several companies have produced significant drag through Q3 including Computer Programs and Systems (CPSI) down 21%, Collectors Universe (CLCT) down 22%, and Qualcomm (QCOM) down 22%.
 
Portfolio Changes
 
I made two changes in the portfolio in Q3. Both were made during the “mini-crash” in late August. The first is Paychex (PAYX), a holding we previously owned but sold in 2013 due to valuation concerns. On August 28th the price dropped briefly by 11% and we purchased shares at a roughly 20% discount to our estimated intrinsic value. Earlier this year I wrote about PAYX and our thesis for keeping it on our watch list. In that article I wrote:
 
“Two companies on our watch list represent another area – payroll outsourcing in Paychex (NASDAQ:PAYX) and Automatic Data Processing (NASDAQ:ADP). Both companies provide outsourced payroll services. While this area has been relatively stagnant over the past five years, both companies have created cross-selling models that include PEO services, retirement plans, HR services, and several others. We expect these to drive growth as well as the return of normalized interest rates that provide significant “float” revenue”. We would gladly add either to the portfolio if a greater discount to our estimated fair value could be obtained”.
 
The second change to the portfolio was the purchase of Linear Technology (LLTC). Similar to PAYX, a revision in our estimated intrinsic value combined with a severe drop in price on August 28th gave me the opportunity to establish a position. Earlier this year I wrote about the business case for LLTC:
 
“Linear is the type of company we love to purchase and hold for as long Mr. Market will allow. The company is the leader in high-performance analog (HPA) chips. These require extreme precision and very high reliability in devices used across multiple sectors. Currently, their highest need is in the automobile and industrial sectors. Because of the stress on reliability of the chip (combined with the small cost related to the entire piece of equipment), many of Linear’s clients are happy to pay top dollar for their chips. What we truly love about Linear’s chips is their long product life helping the business maintain extraordinarily low capital requirements. The inability for other competitors to create similar chips at cheaper prices, the depth of Linear’s relationships with key customers, and the skill of their work force give the company a wide competitive moat in our opinion. We are also very impressed with Linear’s management. They have done an extraordinary job at maintaining a laser-like focus on the very profitable HPA market. They are quite willing to let projects go by if clients are unwilling to recognize the value of Linear’s product quality. With gross and net margins of 76% and 35% respectively, management has demonstrated their commitment to long-term profitability. In addition, over the past five years the company has generated an average ROE of 80%, free cash flow/total sales of 40%, and ROC of 38%. This is a company that is a true cash machine. Finally, the company has no short or long term debt, $1.2 billion of cash on the balance sheet and yields roughly 3%”.
 
These are two companies where we couldn’t be more happy as owners in outstanding businesses with excellent management and capital allocators.
 
Other Holdings
 
I would be remiss if I didn’t take the time to write about three (3) small-cap holdings that have performed very poorly since our purchase earlier in the year.  These include Collectors Universe (CLCT), Computer Modelling Group (CMDXF), and Computer Programs and Systems (CPSI). These three stocks are down 21%, 7%, and 22% respectively since our initial purchase. In each case we still believe in our investment thesis and don’t believe our estimates are impaired in any significant way. We think Seth Klarman had it right when he said, “Buying early on the way down looks a great deal like being wrong, but it isn’t. It turns out you won’t be able to accurately tell who’s been swimming naked until after the tide comes back in”. In this case, we eagerly wait for the next phase of the moon. With yields of 8.9%, 3.7%, and 5.7% respectively, I am more than happy to stay invested with management and utilize dividends to compound our returns over the long term.  

Thoughts On The Quarter
 
While disappointed with the portfolio performance this quarter, I am pleased with YTD results (beating the broader indices by roughly 7%) and its long-term performance. I put a considerable dent in the portfolio’s cash position reducing from 15% at the beginning of the quarter to roughly 8% by quarter end. The benefits of holding so much cash became evident when we saw the markets swoon in August and I was able to put some capital to work purchasing outstanding assets at fair prices.
 
Notice I say fair prices. Even with the roughly 8% drop in the S&P500 the vast majority of equities are trading at fair – or slightly above fair - values. There simply aren’t many opportunities out there right now. That said the Charitable Trust has partial ownership in a selection of outstanding companies I would love to own for an extended period of time. Management that wisely allocates capital combined with such a long time horizon should provide the Trust with more than adequate compounding investment returns.