Lessons in Disaster Management and Health Insurance Stocks

• Posted by Leigh Drogen
• on December 10th, 2009

As the debate in the Senate over the health care reform bill heats up, the market for health insurers is on fire.  While the broader market continues to churn into the end of the year, it seems we finally have somewhat of a real stock market instead of a market of stocks.  The health insurers are showing great relative strength over the past few weeks.

Before I get to looking at a few of the strongest names, I want to tell a short story about an experience of mine revolving around one of the major health insurance names, Wellcare Health $WCG.

While risk management should always be your number one focus when trading or investing, understanding that some things are just out of your control is important.  There are certain aspects of the trade we can control like the amount of capital we put into an issue, when we enter, and when we exit.  But when you are dealing with companies, as opposed to commodities, you are exposed to something you can’t control, equity risk.

Equity risk is your risk to the underlying business of the company.  We can see this play out when a stock gaps up or down after significant overnight news, be it government interaction, earnings, or a business deal.  While we can set stops to limit our intra day risk, a stock can gap up or down through that stop overnight, rendering your stop useless and nullifying your risk management.

While working for a fund back in 2007, I gained first hand experience in equity risk.  On October 24th, 2007 the FBI raided the offices of Wellcare Health $WCG after the close.  Supposedly, $WCG had violated no less than eight major Medicare contract provisions with 40% of clients being denied coverage they were entitled to, and failing to respond to clients appeals after being denied coverage.

It was a complete disaster and we knew it.  The holding wasn’t more than 4% of the portfolio, but we knew there was pain to be felt the next day.  Some serious damage control was in order and I was about to learn a great lesson in how not to panic when things look their worst.  $WCG closed that day at 115.17 after making a new all time high at 128.42 the day before.  The stock had been on an amazing run and was a perfect candidate, both fundamentally and technically for the momentum portfolio we ran.

Wellcare Health stock opened at 64, cut in half from the previous day.  There was no chair throwing or screaming in the office, no panic, frankly I expected there may be some as this was my first go around with a massive disaster in a holding.  I don’t remember exactly how the stock traded off the open, but I remember my PM being very patient, watching the technicals, and holding.  The stock made a high of 80 dollars and reversed, my PM sold the position in the mid 70′s and we were out.

WCG closed the day at 42.67 after making a low of 27.50.  There was a complete exodus from the issue, it traded 36 million shares off an average volume of just over 550,000.  We took our lumps, but the disaster could have been far worse, even if he had sold right on the open.  He relied on his technical experience in the middle of a storm and mitigated the damage.

I learned an excellent lesson that day.  We may believe we are masters of the universe, throwing around millions of dollars from second to second, but at the end of the day there are some things which are out of our control.  When the shit hits the fan, concentrate, understand what you can and can’t control, and use your skills.  As well, once the fundamental picture of a company has been called into question, don’t fight it, there are plenty of issues out there to invest in and having reservations will always hurt you.  Wellcare Health eventually traded all the way down to a low of 6.12 in the 2008 bear market.

Below are a few charts of the strongest health insurers.  Remember that this group has a high risk to government involvement, commit capital to them understanding that they could experience large overnight moves due to pending legislation.

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