It’s not often we write to our clients on the reasons we haven’t yet invested in a company. However, in the case of Ramsay Health Care (Ramsay), we felt it would be prudent to explain our thinking on a company, which, on the face of it, would be a certain inclusion in our portfolio.

Ramsay comfortably meets our key investment metrics — it has demonstrated a long history of predictable growth in revenues and maintains a very strong competitive position as a Global top 5 provider of private hospital services. In fact, it’s is one of the highest-quality companies we have ever met with.

However, the private health market will see some serious structural changes in the near future and we’ve chosen to wait and see if Ramsay’s business strategy going forward, navigates these successfully and profitably before we invest with them.

The first big change to this market is volume.

The long-term patient demographics suggest that demand will be overwhelming as the baby boomer cohort start to move into the phase of their life where they are more reliant on medical intervention.

However, this trend is being overshadowed by the beginnings of a decline in private health insurance participation. It seems constant premium increases and high co-payments are taking a toll on the consumers ability to pay.

Given the healthcare system’s reliance on the private hospital industry, however, we don’t believe we are entering a long decline in private health insurance participation — we think initiatives will be implemented to support the long-term sustainability of the private system.

Also, we believe the system will adapt, with operators adding more supply as well as changing the way patients are cared for by moving patients into ‘out of Hospital’ care for less acute conditions. In doing so, they can treat patients at a lower cost.

On balance we believe changes to volume don’t pose a serious threat to Ramsay, but we prefer to watch and see how their mitigation strategies unfold.

The second significant market dynamic that’s changing is pricing growth.

Historically, in Australia, pricing growth has been driven by a balance of power between insurers and operators, but also by a unique industry structure where the payer, provider and customer are all separated. This has caused large information asymmetries and the confusion has enabled this pricing environment to persist.

We believe that changes to technology and treatment options will continue to increase transparency in the market, reducing the occurrence of inconsistencies and consequent confusion. Add affordability to this and inevitably pricing growth will slow over time. Increased costs, and less ability to pull the price lever mean that the returns on capital in the hospital setting will continue to decline.

In order to adjust to these changing industry dynamics, Ramsay have stated they are going into adjacent verticals — for example, Pharmacies.

While barriers to entry in these verticals are lower, and there will be more competition (i.e. lower margin), management have assured us that the return on invested capital here will be similar to its hospital business since the cost to roll these out is significantly lower.

Despite lower barriers to entry than the Hospital Sector, we believe the regulatory requirements in these adjacent verticals will be enforced. There will be requirements placed on operators focusing on clinical compliance, patient and dosage management and patient information.

In this environment, only the integrated operators who are able to remove duplication and have access to patient information across their treatment life cycle will flourish.

As a well-integrated operator, we believe Ramsay will have a competitive advantage in this space and will be successful over time, but while their strategy to grow outside the hospital walls makes sense, it is still a small market compared to the domestic hospital business and may not mitigate the effects of the changing industry dynamics on Ramsay’s bottom line.

There is one other element of the Ramsay business strategy being considered to mitigate the effects of these changing dynamics that we’re also concerned about and which has consolidated our decision to remain as ‘observer’ for the moment.

We believe there is a preference by management to drive growth through a larger acquisition into another territory. The choice to pursue growth in another region brings additional risks particularly given the similar structures of the hospital industry globally.

Despite the likelihood of success over time, we’re more comfortable waiting to see more details on this before committing capital.

We want the best for our clients and not just for the short-term. This means we need to be very careful and considered when we’re choosing organisations for our portfolio.

After all, that’s what good active investing is all about.

The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. For further information visit www.ecpam.com. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial advice. ABN 26 158 827 582, AFSL 421704, CAR 44198.