Exogenous vs. Endogenous Factors

Posted on April 8, 2014 by David Laidlaw

Broadly speaking, a stock will rise and fall based on either an exogenous factor (something outside its control like inflation or the level of employment) or an endogenous factor (something in its control like the development of a new product). In general, we prefer companies whose performance is based more on endogenous factors as we believe this gives them more control over their long-term performance. This difference is why we like brand names and avoid commodity producers. Some of the recent activity in our portfolios demonstrates this thinking.

We sold Laboratory Corporation of America Holdings (LH) in late February. LH was a strong performer—we originally purchased the stock in September 2004 and it more than doubled, outperforming the S&P 500 over that time by more than 40 percent. LH and Quest Diagnostics Inc. essentially have a duopoly in the clinical laboratory testing market. The market is slow growing but consistent and LH relies on price increases for organic growth.

However, the testing market has come under increased scrutiny as the government (Medicare & Medicaid) looks to lower costs. Part of the Healthcare Reform Law was to cut reimbursement rates by 1.75% over the next 2 years. In the end, we decided we were not comfortable holding a company that was subject to such exogenous factors, i.e. LH could not control whether or not political bodies would rule in their favor.

In addition to selling LH, we bought Edwards Lifesciences Corp (EW). EW’s fastest growing segment is in the transcatheter heart valve market. These valves can be inserted into the heart without cracking open the chest which allows for use among those who cannot survive open-heart surgery. EW is also in the healthcare market and thus heavily regulated. The cost of their valves (and the surgery) is reviewed to ensure that regulators deem it to be a worthwhile expenditure based on the survival rate with and without the surgery and compared to alternative surgeries (open-heart surgery).

We believe EW was worth the investment despite the regulation because ultimately the driver of its stock price will be how successfully their heart valves sell when compared to the competition. The transcatheter heart valve market is a growing market and EW is battling Medtronic for supremacy. This is an endogenous factor, i.e. EW can control the quality of its products. EW is not relying on regulation to allow price increases.

This dichotomy can be seen in recent news. LH’s price increased on the news that a bill in the House of Representatives included a provision that would prevent Medicare and Medicaid from cutting clinical laboratory fees until 2017. This news came after Congressman Henry Waxman was calling into question the high price of Gilead’s hepatitis C drug—sending Gilead and other biotech stocks down. These two proposals illustrate the randomness in medical regulation. LH happened to get the positive proposal while Gilead and other biotech stocks got the negative proposal.

EW was up on the news that its newest heart valve, the Sapien XT, was easier to use than the competition’s (Medtronic’s CoreValve) and like the CoreValve had a better mortality rate than open-heart surgery. The contrasting events illustrate why we prefer EW over LH. We believe EW can control, to some extent, how its products are perceived in the market. We do not believe LH has much control over the Medicare and Medicaid’s pricing dictates or what proposals members of Congress are going to put forward.

At the end of the day, we can’t predict the timing of news or even if it’s good or bad. We do know that every company works hard to influence endogenous factors. So the more it controls, the more likely that news will be good. Incidentally, both Edwards and Laboratory Corp are up about 6% since our buy or sell. But, we are still more bullish on EW going forward.