Should CVS Split Up? Plus, the Case for Small-Caps.

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If an index has poor execution because of how they're making their trading and rebalancing decisions, that comes straight out of the index return and therefore becomes harder to evaluate, but is really meaningful Hello and welcome to the Barron's Streetwise Podcast.

I'm Jack Howe, and the voice you just heard is Marlena Lee. She's the global head of investment solutions at Dimensional Fund Advisors. In a moment, she'll talk with us about what she sees as some of the problems with traditional indexing now and about the case for small-cap stocks. Before that, we'll say a few words about CBS, and its newly announced strategic review and my strategic preview of that strategic review. Listening in is our audio producer Jackson. Hi Jackson.

Hi Jack.

You're back after 2 weeks on vacation. I know folks were saying, well, wait a second, there was a podcast that whole time. Yes, through the magic of pre-podcasting. We presented the illusion of uninterrupted podcast service, but you were away. Uh, would you like to give us 4 words about your exploits?

Uh, uh, sheep, Ireland, France, heirloom tomatoes.

Are you trying to one-word heirloom tomatoes?

They're pretty good.

I'll give it to you. You know, they've got those here now too.

Oh, really?

Yeah. They've made their way to the US.

I feel iffy about the term heirloom tomatoes because it just feels like these are very old tomatoes.

Yeah.

Yeah. Yeah. It's like tomatoes sitting up there on the hearth next to grandma's ashes. Yeah. Yeah. All right. Well, we're not going to get to gardening in this episode, but we do want to talk about CVS, which this past week announced a strategic review.

The healthcare giant reportedly speaking with advisors for a strategic review of its business and laying off nearly 3,000 employees.

Another trending ticker we're watching is CVS Health. Company facing the potential start of an activist stance from hedge fund investor Glenview Capital. This is according to Wall Street Journal. Just what is potentially CVS proposing here? A strategic review is never really good news. You don't announce one of those when things are going great. When things are going great, you just say no review necessary, we're killing it over here. But in CBS's case, there are some problems. It's actually a strange situation. On one hand, the stock has returned roughly zero over the past decade, and that's a decade that's been a pretty good one for stocks. So something is obviously very wrong, and there's an activist investor on the scene pushing for changes. But at the same time, the Federal Trade Commission issued a report in July. It's titled Pharmacy Benefit Managers: The Powerful Middlemen Inflating Drug Costs and Squeezing Main Street Pharmacies. Now, CVS has one of these powerful drug middlemen. It's called Caremark. And so it sounds like it would be the beneficiary of whatever squeezing the FTC is talking about. But of course, CVS is also a drugstore chain which I guess means it's squeezing itself. It's not working out financially. We'll come to that. I've heard a lot of talk this past week about potentially breaking the company up. If you're not familiar, CVS is the drugstore chain that you're familiar with, plus the healthcare plan Aetna, which was bought in 2018, plus the PBM, or pharmacy benefit manager, called Caremark, which was bought years before that. 2007. So CVS put all this stuff together saying this is going to be great for business. It hasn't been. Now the thing is, maybe it should break all this stuff apart. Maybe that would be good for business. I argued sarcastically in Barron's that the company should immediately split into at least 7 pieces and then aggressively recombine and do the stuff that bankers talk about, like cross-selling synergies into total addressable markets and what have you. And if that doesn't work try turning the company off and then on again. But I wouldn't be able to earn much in advisory fees for sarcasm. So what does CVS really need? Let me start with some basic observations. We've all heard of the Magnificent Seven, right? These are the big tech giants, the artificial intelligence giants. At one point, they were the biggest 7 companies in the US stock market. By stock market value. But what if instead we ranked companies by revenue? Then we would get what I call a pharma-filled five. The top companies by revenue in the US: Walmart, Amazon, UnitedHealth Group, Apple, and CVS. And every company there except Apple sells prescription drugs. Those are big businesses for UnitedHealth Group and CVS. And side hustles for Walmart and Amazon. And according to the FTC, 4 healthcare companies— CVS, UnitedHealth, Cigna Group, and Humana— had combined revenue last year that equaled 22% of America's total healthcare spending. That's up from 14% in 2016. All that is to say that whatever's ailing CVS, it's not lack of business. There are plenty of customers spending money with the company. Now compare two of those companies that I just mentioned, CVS and UnitedHealth Group. Revenue for them is humongous and pretty close to each other. For CVS, it's projected at $369 billion this year, and for United, $398 billion. But financial performance couldn't be more different. UnitedHealth stock's returned more than 700% over the past decade. That puts the company's stock market value recently at $546 billion. CVS stock's lost decade has left its market value at just $78 billion. In other words, even though revenue is comparable, CVS is less than 15% as valuable as United. And so why is that? One of the things the FTC points out is that all these healthcare companies are vertically integrated. In other words, they all do similar things. Both companies have health insurers. For CVS, it's Aetna. For United, it's UnitedHealthcare. Both of them have PBMs, pharmacy benefit managers. Those are those middlemen whose job it is to negotiate about which drugs will be available on which health plans and at what cost or reimbursement rate and at which pharmacies. CVS's PBM is called Caremark. And United's is called OptumRx. So two similar pieces for those companies, but it's the third piece that's different and that matters so much for financial performance. For CVS, that third piece is the nation's largest chain of drugstores, and for United, it's the nation's largest network of doctor's practices. Think about it, one of those businesses is busy filling pill orders in the back of its stores and selling spooky Halloween fun-size Snickers in the front of its stores. The other one is providing heart surgery and colonoscopies. And that contrast goes a long way to explain the difference in free cash generation for the two companies. Next year, CBS is seen producing just over $10 billion in free cash, but United is expected to generate closer to $31 billion. Jackson, you giving out Halloween candy this year?

No, I live in an apartment complex, so there's no trick-or-treaters.

We get no trick-or-treaters either, but it's because we live on sort of a winding country-ish road without much shoulder. It's not for walkers, and our driveway is quite long, and it's up a steep hill. But if you're willing to make your way all the way up, I suppose I could find a candy bar or something like that lying around. Watch out for the attack dogs. None of CVS's 3 key business parts are doing great right now. Let me quickly explain why, and I'll come to what I think is the main shortfall facing the company. It has to do with exposed backsides.

Are you talking about classic long johns?

You mean like the union suits with the trapdoor? Is that what you're— Yeah, yeah. No, no, that's not— that's close, but that's not what I'm talking about. The drugstore business just isn't great in general, and you can see that by the fact that Rite Aid filed for bankruptcy about a year ago. One problem is that the PBMs are so powerful. The top 3 control 81% of the market by prescription volume. That's up from 48% in 2008. If you look at the top 5, they control 96% of the market. So that doesn't leave drugstores with a ton of bargaining power when it comes to reimbursement rates. In the past, they've made up for that by getting more customers to switch to generic drugs, but they've kind of reached the limit of that. Generic adoption has flatlined for years. At CVS, generics already make up close to 90% of prescriptions, but they're only 15% of prescription revenue. That's because the branded drugs are so much more expensive. So in theory, it sounds like if you have your own pharmacy and your own PBM and your own health plan, then you're basically in the position of negotiating with yourself. And it sounds like you ought to be able to come out ahead in that negotiation. But the reality is that the PBM business is just competitive enough to keep a lid on margins. And there's a lot of scrutiny there too, as evidenced by that FTC report. So in an analysis earlier this year, JPMorgan estimated that CVS's PBM, it generates about $3 per prescription claim in operating profit. Basically, the business units that contain the PBM and the drugstore, they each had mid-single-digit operating margins last year. In other words, profitability is pretty ho-hum. JPMorgan wrote at the time, we believe that the source of consternation around drug pricing sits with manufacturers. In other words, if you're upset about how much you're paying for medicine, don't yell at the person at the counter at CVS. Most of the blame resides with the companies making the drugs, according to JPMorgan.

And even if it was, I don't think the person at the counter is who you should be yelling at.

They're not personally putting the money in their pockets, right? Also, it's not nice to yell at people. Also, it's your neighborhood CVS. You might need to see this person again in the future. All right, so the drugstore and the PBM are not super duper profitable. Aetna has problems too. That's the health plan. One problem is that seniors in particular sat out of elective medical procedures during the COVID-19 pandemic. They didn't leave the house, but now they're making up for it. They, they're getting out and around and seeing doctors and having things done, and that's increasing costs for health plans. Another problem is that Aetna's biggest customer is the US government, and Medicare, despite its reputation, is a pretty hard bargainer. It's done a good job of growing its costs more slowly than private payers. And then there's this matter of star ratings from Medicare. Medicare is a government health plan for old people. It has a base level of coverage and it has supplemental coverage, and private insurers can compete to basically take over the coverage. That's called Medicare Advantage. And Medicare rates the plans that participate in that program, and it gives them bonus payments that depend in part on their ratings. So you might have heard this past week that Humana, another drug plan, announced in preliminary data that it had lost its leading position in star ratings. B of A Securities estimated that for Humana, that would be more than a 3.5% revenue hit. That stock suffered 2 straight days of declines of more than 11% this past week. B of A downgraded Humana to underperform. I mentioned that because CVS had something similar happen last year. These problems are fixable over time for Aetna. Margins there could improve, but it could take a year or 2 to start to see the difference. There are a lot of parts of CVS's business that I haven't mentioned. Some of the stores have what are called MinuteClinics where you can go for basic healthcare treatments. Back in 2019, I visited a store in Houston, Texas, where the company was testing what it calls a Health Hub format, basically more healthcare services. Around the time Larry Merlo, the former CEO, was talking about the retailization of healthcare. The idea that CVS would become really a front door for people's healthcare needs. If you can't get an appointment with your doctor because their office is overworked and understaffed, you can come see a nurse practitioner at CVS. It was a compelling pitch. I wrote a cover story about that effort for Barron's, and in the following 3 years, the stock price more than doubled. But since then, it's given up most of the gains. And that brings me back to exposed backsides.

I was waiting for this, Jackson.

I have a theory. Your, your, your wife is a doctor. I haven't formally studied healthcare administration, but my theory is, you know those, uh, you know those gowns they give you in the hospital where they never quite tie closed in the back? It's always a struggle to keep your backside from being exposed. I think they're like that for a reason. My theory is that the healthcare stuff that has the best margins involves putting on one of those. You see what I'm saying? And I'm more than willing to go down to my local CVS and roll up my sleeve Do you get like a flu shot? By the way, I think it's flu shot season, right? I'll probably head down there soon, get a flu shot. I'll roll up asleep, but I'm not putting on a hospital gown with an exposed backside, uh, in between the Alka-Seltzer and the greeting cards over there on aisle 3. You see what I'm saying? I think that might be against store policy. I'm not sure where— CVS is probably happy that I wouldn't do that. I think the feeling's probably mutual. The point here is that MinuteClinics are not going to cut it. They're not attracting the services that produce the best margins for CVS. CBS. And the company has done some dealmaking. Last year it bought two companies that provide a broader array of healthcare services, one in medical centers and another in homes. So it can continue down that path, but it has a long way to go to even attempt to catch up to a company like UnitedHealth. And CBS's debt already stands at $62 billion. The shares go for less than 10 times earnings. The dividend yield was recently 4.3%. So we can talk with bankers or advisors, but I'm not sure it's going to find easy levers to pull here. Think about it. If you split the company up, right, if you have— let's say you split the PBM away from Aetna. Okay, well, now you've got to go out there with your health plan and negotiate for new contracts with a customer that's going to have to go somewhere else to get their drug plan. It'd be a better pitch if you had your drug plan in-house, which CVS does now. So you want to keep those two together. Well, what if you split the PBM from the drugstore chain? Then you're as exposed as Rite Aid. I don't think anyone wants that. It's a strange situation because you haven't really seen the payoff from bringing these business units together, but at the same time, you could imagine that there might be negative fallout from splitting them apart. So I think that the best the company can do for now is to just continue gently pruning the store base like it has been, and maybe shop around for more of those deals to increase that hospital gown type of work. Basically, it's a cheap stock, but by no means an easy fix. But maybe I'm missing something. Who knows? Jackson, any, uh, last minute Advice for CVS on how they can turn things around?

How about political costumes for Halloween?

Okay, you're thinking short-term bounce then. It's an election year and we did just have the vice presidential debate. And what would delight America's children more than going as Tim Walz or J.D. Vance this year? If you're listening in Woonsocket, Rhode Island, that's CVS's headquarters. You're welcome. Let's take a quick break and we'll come back and hear some investment advice from Marlena Lee. At Dimensional Fund Advisors.

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Welcome back. Let's get to my conversation with Marlena Lee at Dimensional Fund Advisors. I'll tell you two quick things just to set things up. First of all, Dimensional is not an active fund manager. They're not out there picking stocks, but they're also not a traditional indexer. They're not just weighting companies by stock market value. They have their own strategies that result in different weightings. They use factors like— Jackson?

Yeah, operating profitability, momentum, and taking advantage of the size premium.

They mentioned RIS. Short for charisma. That's what the kids are saying. They got rizz.

That's the new momentum.

Okay. And the other thing I'll mention is you might hear the terms size premium and value premium. And if you're wondering what the heck are those, you're totally forgiven for not knowing because we haven't seen much of them for a long time. There's well-established research that says that over long time periods, Small companies are supposed to outperform large companies by a little bit. And value companies, companies that trade cheaply relative to different measures of economic value, those are supposed to outperform growth companies or companies that are more expensive relative to those same measures. You don't hear much about those anymore because big pricey stocks have done pretty well. If you own an S&P 500 fund, your returns have been great. And they've been dominated by gigantic tech companies. And some of them have traded at times at pretty lofty prices. But if you just hung on, you've done great there over the past decade. I'm a fan of keeping things simple and cheap with traditional index funds, but I hear lots of people asking, have they done too well for too long? And what are some of the alternatives? And with that, let's get to my conversation with Marlina. What do you say to the person who says, Okay, you know, I know that the index was loaded up on these handful of tech stocks, but haven't they been working so well over the past decade or so? And all I hear about is artificial intelligence and so forth. And so why wouldn't I just want to keep going with what's working? What would you say to that person?

So when you see a high price or high ratio, price ratio, whether that's price to book, price to earnings, it has to tell you one of two things. So either the market has priced in pretty high or aggressive earnings growth in the future or very low expected returns. And looking back through time, you can't separate those two things. Today, it's probably a little bit of both, right? We saw this in like with NVIDIA's last earnings report. So August 28th, they had a really fantastic earnings report, right? Their earnings were up to $0.68 per share. That was versus $0.27 per share just a year ago. That's an increase of over 150%. Yet their stock values fell by 6%. What is that telling us? Even though the market, even though they had really great earnings, it told us that the market was probably expecting even better earnings. So I would say, you know, we're optimistic about what productivity gains we might get from technology or from AI. But I would say that those expectations are built into the prices already. Outside of the US, we are seeing much bigger size premiums. So having a small-cap tilt in developed markets, emerging markets has benefited investors. And then even in the US, at least our approach has held up pretty well. So we've, managed a small-cap portfolio now for over 30 years. And over that entire period, the returns have been pretty in line with what we're seeing on the S&P 500. So if you put it all together, yeah, we're beating large caps globally across all of our small-cap portfolios.

How much small-cap exposure should I have? If I look at an all-cap index, an index that has big, medium, and small companies, And I look at whatever the weighting is there for that index, a regular cap-weighted index, I guess it's going to probably be a small sliver for small-cap stocks. If I have a weighting that's equal to that, am I okay? Or based on what you're saying about the tendency of small caps to outperform over time, should I be overweighting them relative to what that cap-weighted index would do?

The way we measure small caps, we would consider it as like the bottom 10% of market capitalization in the US. So. Depending on how people want to measure it, might be 10%, might be 12%, 13%. That might differ. But starting with a market cap portfolio is probably a good place to start with how much small caps you should hold, right? They're part of the market portfolio. You should hold them just for diversification reasons. And then depending on whether you want to pursue higher expected returns than what that market cap weighted portfolio could offer, there is benefit to tilting a bit. So adding a bit to that 10% small cap allocation How much one wants to tilt, how much you want to overweight small caps, really depends on how much tracking error relative to like the S&P 500 or to the market index you're willing to tolerate, because there are going to be periods where the size premium doesn't show up, and being able to tolerate those periods of a potential underperformance is what's needed, and sticking with it so that you can capture the premiums when they do appear.

I asked Marlina, if I like what you're saying and I want to increase my small-cap exposure, why not just choose a fund where there's an active manager who picks small-cap stocks, and she said of the active managers who were around 20 years ago and who were still at it today, only 17% have beaten their benchmarks. So I asked, why not a traditional index fund? She said that's a better choice, but those funds tend to use a rigid approach that leaves money on the table. Then I asked about fees. Many, many years ago, there was a commercial on TV for a muffler store, and there was a— the customer would always say, I'm not going to pay a lot for this muffler. And I always think of that in the back of my mind whenever somebody is talking about Wall Street and financial products. But I'm the kind of guy, I'm not going to pay a lot for this muffler. So when we're talking about your firm and your approach, would you say that the fees for that approach are closer to the index world or closer to the active management world?

Oh, much closer to the index world, although we've been seeing fees kind of dropping across the industry. But I think what's really important to consider is having an evaluation that's just, that's more than the expense ratio, right? There's both the value side of the equation of what's being added in terms of improving expected returns, but then there's also things that are, that go beyond the expense ratio. So things like if an index has poor execution because of how they're making their trading and rebalancing decisions, that comes straight out of the index return and therefore becomes harder to evaluate. But is really meaningful. I'll give you one example. It's getting, uh, it's, it's a few years old at this point, but when Tesla was added to the S&P 500, that was towards the end of 2020. What we saw was from when the index announced that it was going to be added to when it was actually added, we saw a run-up in returns of 73%. And then right after it was added, that following week, it dropped by almost 5%. So all of the index managers who are trying to track the S&P 500, they basically bought at a high. And we run a fund that's similar-ish. It's very similar to the S&P 500, but we're going to give it a little bit of flexibility around these reconstitution dates. And on that one day when Tesla was added, we actually had 8 basis points of outperformance net of fees. So on one day. So just giving you some, it's, it's example of the type of cost. You know, you can get an S&P 500 index fund for much cheaper than 8 basis points, but the cost here came straight out of the index return but was greater than the cost of the expense ratio, just to put it in perspective. So what we'd say is, is you have to pay attention to more than the expense ratio.

Thank you, Marlena, and thank all of you for listening. If you have a question for the podcast, just tape it on your phone, use the voice memo app, send it to jack.how@barons.com. Jackson Cantrell is our producer. He's not going as J.D. Vance or Tim Walz for Halloween this year. We don't make things political on this show. Jackson's going to go as a network debate moderator. When he says trick or treat, don't evade the issue by talking about your childhood. You can subscribe to the podcast on Apple Podcasts, Spotify, wherever you listen. Tell your friends, you influencer, you. See you next week.

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