The Drug Price Misconception11/30/-1 Author: David Lieberman, Portfolio Manager
In 2015 Martin Shkreli’s Turing Pharmaceuticals increased the price of an anti-malaria drug, Daraprim, by 5,000%, which was understandably met with widespread anger and triggered a backlash for drug prices more generally. But this anger was and remains misdirected. A vast majority of drugs have experienced price deflation and we must isolate generic price deflation from the news grabbing price increases that the media likes to write about to best understand possible changes.
Recently, Cardinal Health announced that they expect generic drug prices to fall by mid-to-high single digit percentages. This compares to an expectation that branded drug prices would increase in the mid-to-high single digits. When thinking about drug prices, we must isolate most generic manufacturers, whose profits have been pressured by years of falling drug prices, from manufacturers of patent-protected branded drugs. While some generics firms are led by villains like Shkreli, who increased prices on highly sought after generic drugs, it has been far more typical for generics prices to be reduced rather than increased. While the media likes to focus on the egregious price increases, these increases are not the norm and this is evident in the large pricing pressures that generic manufactures have faced.
The US Government Accountability Office found that under Medicare Part D, the price of a changing basket of almost 2,400 generic drugs fell by 59% from the first quarter of 2010 through the second quarter of 2015.1 Of the 1,400 generic drugs that remained in the study for the entire period, pricing declined as well, albeit only modestly. By the end of the study period, prices were slowly climbing. This was driven by fewer than 10% of those 1,400 drugs, which experienced price increases of more than 100%. For drugs facing limited to no competition, drug companies retain pricing power. Indeed, that is precisely why Shkreli was able to increase the price of a generic drug by 5,000%. Such price increases were a result of a total lack of competition that Shkreli exploited. Effective competition will usually prevent heavy price increases, but there needs to be increased oversight for generic drugs made for a small market, which is another market Shkreli exploited. If a drug is only needed by 10,000 possible consumers, only one manufacturer is likely to supply this market, unless the generic drug is priced at extremely high levels. Thus, for small market drugs, some kind of regulation makes sense.
What does all of this mean for President Trump’s policies and for healthcare as a whole? Trump has vowed to fight against drug price increases, but this opinion puts him at odds with lots of Republicans and in rare company with a majority of Democrats who support controlling drug prices. Any drug pricing effort is complicated by the fact that generic drugs tend to fall in price over time, at least when there’s competition in the market. This is in direct contrast with pricing for branded new drugs, which must be priced more expensively so that companies can recover the cost of research, development, and the drug approval process. But most importantly, it is difficult to dramatically lower the prices of drugs that are already falling. Complicating matters further is the fact that many of the cheaper drugs in the US come from abroad, where a lot of the generic drugs are manufactured to help keep their manufacturing costs low. If we force manufactures to produce those drugs in the US, it will only drive costs and prices will rise.
Drug price reform will be a far more complicated and less partisan issue than most other issues chosen by this government. At the same time, drug companies provide substantial financial support for Republicans (and Democrats), and their lobbying power in Washington is strong as a result. Without the backing of a large portion of the Republican base, it will be difficult for dramatic reform. But even if this administration is able to pass drug pricing controls, such policies will be less likely to impact generic manufactures than branded drug makers. At the same time, stocks from both categories have been heavily penalized from the market’s concern that limits to pricing will constrain profits significantly. But it’s hard to imagine that Trump will effectively target drugs which have already been falling in price. Following a 2016 where healthcare was the worst performing sector, an increasing number of interesting investment opportunities have appeared in the healthcare sector.
President Trump is creating all sorts of disruptions and opportunities across many industries. Some changes will be large and sweeping, but others more muted or non-existent. Generic drug pricing is more likely to fall into the latter group. This, in and of itself, is an opportunity.