We’ve long known about the so-called small-cap effect, thanks to the landmark Fama French paper citing small size, as one factor (among several) that tends to enhance equity performance. Knowing full well how controversial this so-called phenomenon can be, I think I’ll stir the pot a bit and suggest the existence of a large-cap effect, with health insurer Anthem (ANTM) as a prime example.

Why Discuss Discuss ANTM At All

This issue comes to my attention via my smart-alpha Cherrypicking the Blue Chips model, the first thing I’ve been able to come up with that has been successfully identifying S&P 500 constituents whose shares have been beating the group as a whole. Given how hard it is to beat this closely watched, information-intense part of the market, any stock that makes it into the Buy list can, I believe, be approached for case-specific examination with an innocent-unless-proven-guilty mindset.

Among the ten stocks currently in the model, $ANTM has significant seniority. It’s been in the portfolio for 108 trading days, which says a lot considering that the model is rerun and the portfolio refreshed weekly. (One other senior citizen has been there for 129 days, while the tenure for the other eight stocks averages 20 days.) For all I know, the next refresh (scheduled for next Monday) may be the day $ANTM finally gets sold. Whether that happens or not, it’s clear that this is a useful example of the kinds of stocks you’re likely to see if you take an interest in and follow this model, which can be done with a free membership to Portfolio123.

Touching the Necessary Bases

As health insurers go, $ANTM is one of the giants with 38.5 million members in 14 states under the highly-recognizable Blue Cross/Blue Shield banners. And assuming its pending acquisition of CIGNA (CI), another frequent holding in the Cherrypicking portfolio, goes through (the deal is expected to close in the second half of 2016), it’ll become a lot bigger. The combination of $ANTM and $CI would have about 53.2 million members.

The characteristics that got $ANTM into the portfolio are:

• Being an S&P 500 constituent: Check!
• Having favorable valuation metrics: In the past, that was likely caused by operational efficiencies and the usual questions about how Obamacare would impact the industry. Lately, the Street has been getting more comfortable on both counts and the stock had been moving higher. But big acquisitions have a way of making investors antsy (justifiably so since many are followed by integration problems and general disappointment). So that’s been weighing on the stock most recently. Presently, $ANTM is trading at 14.6 times estimated EPS, 0.53 times sales and 1.8 times book (versus industry medians of 23.2, 1.2 and 3.3 respectively).
• Having favorable sentiment metrics: Although it’s not yet showing fully in the stock, analysts have been taking note of improved operations and tuning into the potential benefits of the $CI deal. With positive EPS surprises under $ANTM’s belt in the past two quarters, EPS estimates have been inching upward and overall analyst ratings have become modesty more bullish. The changes are by no means dramatic. But for better or worse, for sane or insane, meaningful Sentiment changes are not needed to move a stock; trivial changes of the sort I’d have long ago dismissed as rounding error tend to suffice (sigh).
• Generally good fundamentals: The balance sheet is about average by industry standards. Meanwhile, margins and turnover have been trending modestly higher and return on equity, sluggish by company standards in 2010 through 2014, look like they’ve started to move higher. Such metrics are above industry norms and are likely to be enhanced should things go well with the $CI purchase.

• The Big Picture

  Putting everything together, I think the ultimate investment case for $ANTM revolves around the aforementioned large-cap effect. I’m not referring to its membership in the S&P 500, nor am I referring to any Fama-French-like statistical phenomenon.

I’m referring to the inherent advantages a company may have by virtue of large size. Not all companies take advantage of this opportunity; in fact way too many don’t (which is why I invest a lot in small caps, where more of those firms seem proficient in exploiting a separate set of potential advantages conferred by their size). Either way, a lot of this is about scale, fixed-cost coverage, operational economies, operating leverage. Small companies tend to be weaker in these areas and their stocks can move as they go from bad to good, or even from horrible to merely mediocre. Large firms like $ANTM (without $CI or more so with it) are less likely to experience dramatic changes, but they can get a bump up in returns relative to what we see at big companies that don’t make as effective use of size, and/or a drop in risk.

On the return front, $ANTM is turning bigness to its advantage and is likely to accelerate that after completion of the CIG deal.

Scale in health-care insurance is a major plus in that it enables the company to more effectively negotiate prices for medical services (the bigger the patient network, the more eager providers are to strike a deal), as well as non-medical expenses (the sort of purchasing power enjoyed by most large entities). Scale works in the other direction as well. Having a huge provider network helps it attracts users/patients. It’s a virtuous circle.

Just as diversification is important to investors as a tool to manage risk, it can be likewise in business. Health insurance is not a monolith. $ANTM and $CI will actually wind up with a portfolio of health-insurance businesses including Medicare, Medicare Advantage, Medicaid, Dual Eligible (Medicaid and Medicare), Commercial, Specialty (Behavioral Health, Dental, Pharmacy, etc.), and so forth.

The data infrastructure, meaningful separately for $ANTM and $CI, should become even more of a treasure trove post-merger based on the entity’s ability to mine and analyze experiences in treatments, procedures, costs and outcomes in a way that facilitates the development of new insurance models and processes.

The emergence of and complexity in Obamacare is another factor enhanced by company size. $ANTM has the administrative and legal prowess to cope with the already-considerable complexities, and it would be likewise positioned if Obamacare is substantially revised in the future, as Republicans say they want to do.

Conclusion

I can’t guarantee $ANTM will still be in the Cherrypicking portfolio as of any future date. In fact, there are easily-imaginable scenarios where its exit would be a plus (after all, what owner of favorably valued shares doesn’t dream of it’s become overpriced so a nice profit can be taken). But it’s a good example of the kinds of situations this model favors. I can’t tell you $ANTM is the best in any respect. But you don’t need the best to make money in the market. Being OK-to-good in a lot of things can make for a nice situation. Corporate transition may be more important as a potential stock catalyst, and we see that here in the operational improvement $ANTM has been delivering (the sort that produced a good second quarter and the resultant favorable sentiment barometers) and the potential for further ROE-enhancing transformation the road via the $CI deal ($ANTM projects $2 billion in annual synergies immediate EPS accretion).

Is $ANTM overpaying for $CI. It’s so easy for analysts and journalists to say that, and it’s definitely a good way fro writers to attract attention to themselves. Realistically, outside investors can’t judge. We haven’t restricted ourselves with NDAs (non-disclosure agreements) and haven’t looked deep inside of either company, and we can’t evaluate the operational details. And like the purchase of an individual stock, the M&A buyer (in this case, $ANTM) doesn’t pay for past or present performance. It pays for expected future results. What we can do, from the outside, is look at the track record of the buyer (not perfect – as if any firm ever is – but on the whole, good fundamentals including above-peer ROEs) and consider whether the potential combination makes business sense. I’m thumbs up on both, and on valuation at current stock price.