(PUB) Investing 2016

The Independent Adviser for Vanguard Investors

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October 2016

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FOR CUSTOMER SERVICE, PLEASE CALL

800-211-7641

then exchanges. All of those channels have different levels of pricing, so

there’s no one price. Medicaid and Medicare get significant discounts

from the pharmaceutical industry. Large payers, depending on their

strength, get large discounts. So the list price, which has been the focus

of all the attention, is very different than the net price, and it’s very differ-

ent in different channels. There have been some outliers, but when you

look at the net growth of the industry, it has been much more subdued.

Why health care? I was visiting a lot of companies in Europe last

week, and this is a special time in health care, particularly for the

biopharmaceutical sector, which is the vast majority of our opportunity

set—this is an unheralded time of scientific discovery.

When you think about what in the economy is going to create value,

I feel very strongly that these companies are going to create so much

value for patient outcomes.

All the discoveries that happened in the last five years are just the

beginning. We are going to see significant innovation, and that innova-

tion will be paid for. That’s where we are trying to tilt the portfolio.

Vanguard Health Care investors are getting a portfolio of companies

heavily skewed toward high innovation while hopefully avoiding compa-

nies that we think will be facing a lot of biosimilar competition or just

don’t have the pipelines that will create the value.

In the last year and a half, we hired two PhDs to our team because the

amount of research we had to do—the science is double or triple what

I did over the last 20 years. So we added resources to our team to make

sure that we are looking at the science completely.

Politics has always played a role in the health sector, but recent-

ly the failures of certain parts of the ACA have been particularly

evident. Insurers are pulling back, and many of the original non-

profit “co-op” health insurers have failed. Is the ACA achieving

its objective, and will insurers eventually find a way to make it

work, or is it, as one consultant wrote, in a “death spiral”?

The ACA can definitely be a functioning market, and many of the

health insurers were hoping it would be a functioning market, but it’s

definitely at a point where things need to be tweaked—some parts of

the law have to be tightened. This is a very large bill, and what normally

happens when you have a very large bill like this is that as you go along,

you correct things that aren’t functioning right. Think of 2014 and 2015

as years of working out all the kinks, and now we know there are things

that need to be changed in the ACA, but those cannot be changed during

election years. That’s the main issue.

If you can get 20 million people in the risk pool with many different

kinds of risks, it should be a very functioning market, but right now there

are too many people coming in with very high risks. What’s unsustainable

is for people to be losing so much money. The structure of the ACA is

likely to stay, but the question is, will it become more like the exchanges

or will it become more like Medicaid? That depends on whether we have

a Democrat or a Republican in the White House. We do believe the ACA

will stay—you can’t take a benefit away from 20 million people without

giving something in return.

The portfolio has become more concentrated over the past year,

both in terms of fewer holdings and a larger allocation toward

the top 10. You mentioned in your recent letter that you consoli-

dated “during a time of intense volatility,” but you didn’t say why

this would be.

From September 2015 through March 2016, everything went down—

the companies that are well-positioned and those that were not well-

positioned. So that made us more intensely focused. Also, there was

more fundamental news in the past year that made the winners more

clear. We bought companies where we have the highest conviction in

part due to the price movement and partly due to fundamentals moves.

Also, if you look back a couple of years, we had bought a basket of

medical device and tools companies. That sector has done well, so we

sold more individual companies in that sector. There’s so much innovation

happening in a lot of companies under $5 billion. As those companies

grow, I would suspect that the number of names [in the portfolio] will go

back up again.

When you can’t sleep, what worries keep you up at night?

I have to tell you, I am a notoriously good sleeper. What would make

this fund not investable? If you had a U.S. health care system that was

a single-payer system, it would not be positive for our investment oppor-

tunity because it would materially reduce profitability. So that would be

number one. Number two would be if all the innovation was happening

only at the small company level, it would be hard [for us] to invest. But

the good news is that the large companies have a tremendous amount

of innovation. And number three, if companies weren’t able to price

innovation in the U.S.—if new drugs coming to market weren’t able to

be priced at levels that create blockbuster drugs—that would reduce

the opportunity set. So it’s all about what would reduce the opportunity

set—you can rest assured, if that happens, we’ll let everyone know.

Glad to hear that. Thank you, Jean.

exceptions. In June 2014, the number

of holdings went from 654 to 805. The

managers gradually worked that down

towards the 650 range, but in May

of this year the number of holdings

jumped from 652 to 1,021. Today, the

fund holds 954 stocks. Vanguard says

the recent spike is related to an in-kind

transaction to facilitate a shareholder

purchase, and noted that nearly 300

positions are under $10,000 in size. In

other words, Vanguard accepted a lot

of tiny stock positions from an inves-

tor instead of making that investor sell

those stocks to raise cash for the pur-

chase of the fund. I expect we’ll see the

number of holdings drift back toward

that 650 level, unless Vanguard accepts

another large in-kind transfer.

Of course there’s absolutely noth-

ing wrong with trying to minimize

taxes. But with the introduction of the

Russell 1000 ETF—which by its nature

should be highly tax-efficient and has

just barely underperformed T-M Capital

Appreciation, before taxes, through the

end of August—what’s the real value

here? Why do the minimums remain so

high ($10,000 versus $3,000 for most

index funds and nothing for ETFs)?Why

not just invest in an already tax-efficient

ETF or index fund? Don’t let the tax tail

wag the investment dog, or let a tax-