It’s already a major political issue entering 2007.

House Democrats have made it clear that they intend to repeal a provision in the 2003 Medicare drug benefit law that prevents the government from being involved in negotiations of prescription drug prices.

While opinions are split, some surveys say this legislation could find favor with voters.

A new poll conducted by the Kaiser Family Foundation shows that 65% of Americans strongly favor having the federal government negotiate prescription drug prices for Medicare. An additional 20% are somewhat in favor of this change.

Incoming House Speaker Nancy Pelosi said Democrats intend to make this legislation one of the very first things they pass come January. The president, however, is against it.

We’re against it, too, and we think quite a battle is in store. And here’s why…

Right now, dozens of private insurers offer Medicare drug plans in every state. The way each plan competes for enrollees is through 1) competitive monthly premiums, 2) favorable choices of drugs and 3) convenient access to pharmacies. The onus is on the insurers to hammer out the best deals, and they use their pharmacy benefit managers to negotiate the lowest drug prices with manufacturers and pharmacies.

Getting the government involved could be a nightmare, and there is no guarantee that it will lower drug prices as originally intended.

Here’s what could happen if Democrats get this legislation passed: The federal government could use the considerable muscle of having 43 million Medicare beneficiaries to radically reduce prices on some medications. The way that might happen is that a few drugs will get highly favored by negotiators over all others. This could dissuade new drug development, limit choices, saddle patients with certain side effects that would not have been there with other drugs, etc.

The White House is opposed to the plan, and Congress would need a two-thirds vote to overturn the executive branch veto. We think that the Democrats might not be able to swing this.

Democrats argue that the U.S. Department of Veterans Affairs has had great success with allowing the federal government to directly negotiate lower drug prices for veterans, so they believe it should also work for Medicare. But that’s not an apples-to-apples comparison. The value of the VA’s drug spending is one-fortieth of Medicare, as you would imagine. Plus, the structure of the VA’s drug buying is different, as it runs its own pharmacies and has a much smaller number of drugs with which it deals.

So how do you play this with small caps? And how do you do it so that you win either way this legislation goes?

Well, let’s first look at the top five most used drugs for people who are both eligible for Medicare and Medicaid:

The principal developers and manufacturers of these drugs are the major players of Big Pharma, and have large-cap stocks. However, some of the contract manufacturing and generic producers of these drugs are small-cap public companies.

You would think that government negotiators would focus on the top-utilized drugs to get the best pricing…not necessarily.

The government would likely copy the VA model — which focuses on older drugs and has policies in place to virtually ignore newer, more expensive therapeutics.

Whatever happens, here’s a way to win:

If we invest in the most attractive small-cap drug producers of popular, older drugs for Medicare enrollees, we win if the Democrats get their way or not. Here’s how: If the federal government negotiates all pricing for Medicare prescriptions, some small-cap suppliers will be preferred over others, stifling competition and creating a moat for those lucky companies. On the other hand, if the Democrats lose, we will likely see more spending on drug development, which will increase the net present value of these firms long term, not to mention simply lifting a “black cloud” that hangs over these stocks right now.

If we invest selectively — looking for value — we should win either way.

We’ll be exploring this in much greater detail in upcoming issues of Small-Cap Strategy Report, and we’ll be offering specific investment strategies to profit from this.

Until next time,

Craig Walters
December 21, 2006

Craig Walters

Craig Walters spent years entrenched in the investment industry doing what he loves best: performing financial research on scores of small-cap companies. Craig was formerly an equity analyst and Systems Director for Ferris, Baker Watts. Special Report: HOW YOU COULD TURN $200 INTO $1.2 MILLION!

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