YE update + Answering SMLR's most asked questions.

Plus some thoughts on Specialists, Individual investors, PFMT, and NEPH

A note for subscribers: I apologize for writing sporadically. I’ve been swamped with other tasks, namely school and research in preparation for applying to medical schools. Tis is the life of a Student. I do hope to write more often going forward and have already planned a few writeups out!

There are plenty of write-ups on Semler So I'll try not to rehash the basics. Instead of using this write-up for an in depth business description, I want to use it to address specific questions I often see asked about Semler.

Previous writeups: This one from Eagle point is good. Seeking alpha also has some good recent ones to get up to speed on the business.

Semler Scientific: An Emerging Monopoly?

Quick overview:  They sell Quantaflo, a device for the diagnosis of Peripheral artery disease.

Business Model: A unique Go-To-Market

Semler's business model is different than most, if not all, medical device companies.

This is the standard sales route: Device company sells to clinic. Clinic uses device on patients. Clinic gets paid by insurance and pays device company. The insurance company can be either commercial insurance or Medicare (in essence). Everyone 65+ in the US gets access to Medicare, while commercial insurance is usually provided through employment.

The Typical Model

Semler's model is a bit different. They sell to "Medicare Advantage (MA)" plans (primarily). MA plans are a subset of Medicare where insurers are paid by Medicare a set fee per patient. Unlike typical insurance which pays based on services rendered, Medicare advantage plans get a sum from the government per patient. ("Here's your $10k patient, figure out how to make the profits work"). This encourages "value-based care" where insurers will try to minimize costs by preventing expensive hospitalizations. (they receive the same X$ if a patient has surgery or not). The amount per patient that Medicare advantage insurance plans receive per patient is based on risk factors which can potentially lead to higher yearly costs. For example, insurers will be reimbursed at a higher rate for a patient on Dialysis to pay for that care. The risk adjustment factors extend to  peripheral vascular disease (aka Semler's test). The payment chain here is Patients pay taxes-> Medicare pays -> Medicare Advantage plans pay -> doctors.

Semler's Model

Question Number 1: Are you concerned about their customer concentration?

This is by far the number one mentioned concern. Their top two customers account for >50% of their revenue and have done so for a few years. High customer concentration adds potential risks since any issues at those companies mean slowed growth. However, the customer concentration is the nature of the market. The top two Medicare advantage plans are UnitedHealthcare and Humana who hold 26% and 18% market share, respectively. There can still exist risk with respect to pricing power, but the high ROI and ease of use of the product leave no reason for companies to switch products. However, one should still keep an eye on any significant data from customers to track market trends. For example, Humana's slowing MA growth could be a short term headwind for Semler (link).

Question 2: What is the ROI for Insurers?

Semler's value proposition to insurers is twofold: the ability to prevent costly interventions and additional reimbursement from Medicare. Recalling the RAF from earlier, a PAD diagnosis adjusts a patient's risk score upward meaning insurers are paid an extra $2800/year to care for a patient with PAD. With this alone, a low cost $50-100/test can have a positive ROI. Not screening for PAD can almost be seen as giving up $2800/year for high risk populations.

The second ROI benefit stems from preventing other costly interventions such as stroke and heart attack. Multiple studies say screening for asymptomatic ABI is cost effective assuming a 10% prevalence, in line with the prevalence for those >60. (study 1, study 2, study 3, study 4). In higher prevalence populations, screening is even more useful. Let's take an example to demonstrate the possible ROI. A patient has asymptomatic PAD and is put on medication therapy for < $150/year. This delays acute intervention costing the insurance $25,000 for 4 years. For a Medicare advantage insurer, this leads to four additional years of revenue without paying for costly hospitalization. Even the cynic in me likes the product! It’s a Win-Win-Win

Where to find the Risk adjustment codes: Medicare releases the risk adjustment factors each year at link. The base Per member per month rate paid to Medicare advantage plans is 10k per member with an additional 2800-3000 for patients with PAD.

Question 3: Why would doctors and patients want it?

For patients and doctors, the answer is simple: catching PAD early means delaying severe issues (heart attack, stroke, etc.) Semler's test is 5 minutes and can be performed by anyone. The doctor is paid for a PAD diagnosis test without needing to refer patients out (like a traditional ABI).

Question 4: What's the TAM?

About 9 million have PAD in the US with a prevalence of 10% in those above  65% and ranging from 15-30% in those with risk factors (source). The AHA recommends screening everyone above 65 and those above 50 at risk. Though these are the recommendations, the actual TAM is likely smaller because the prevalence decreases for each incremental patient group. In addition, those already diagnosed with the disease won’t be scanned. 15-20% of 50+ year olds have diabetes (link), 40% are obese, and 15% are smokers. Based on this, I'd estimate about 25% of those above 50 are at risk for PAD.

Let's now look at solely the Medicare Advantage market which has 24 million beneficiaries as of 2020. If we conservatively assume 25% of those patient should be scanned, and a $40/per test fee, the immediate MA TAM is $240 million. This is without the other 37 million patients on Medicare or any others at risk who are 50-65 years old.

Semler's internal estimates place them at about 10% market penetration indicating sufficient runway for growth in just their core QuantaFlo Product.

Question 5: Competition?

The current standard of care is traditional ankle brachial index testing. An ABI takes 20 minutes and requires a referral to another facility using a specialist technician. Semler's Quantaflo test can be plugged in to any laptop and used in a primary care office. There’s no competition here.

Other, more accessible,  "digital ABI" tests do exist even though Semler's holds some patents through 2027, but the ease-of-use and go-to-market strategy is different. For one, Quantaflo does seem to be the easiest to use/integrate with EHRs In addition, selling to insurers is a novel model exploited only by Semler. A sales rep at a competing company was taken aback when I asked if they sell to insurance companies validating Semler's strategy is unique.

Question 6; What's Next?

Semler plays their product investments, both for external and internal ones, close to the chest, but we should receive more information in March on the FY21 call. Even without much detail on new products, I expect these products to be similar diagnostic tests serving chronic conditions and sold to insurers. Strong relationships between Semler and insurers means any new product with a similar function should have an easy rollout.

Question 7: Sounds too good to be true: what the biggest risk?

The primary risk to Semler is from MA reimbursement. There are a number of reports including one from the Office of the Inspector General (OIG) criticizing MA for overpayment. One such article even explicitly named HCC108 (Peripheral Vascular Disease). (OIG report, News Article). With scrutiny on overpayments, insurers may cut back on MA rollouts if the government chooses to reduce risk payments.

However, I still Semler is strongly positioned in their core product offering. The OIG report is headlined by chart reviews rather than extra diagnostics. Chart reviews comb through patient records to adjust risk scores (yes it does seem like profit chasing). Plus the article (and USPTF recommendation) doesn't mention Quantaflo but rather "ultrasound studies". An easier test would likely lead to a revision of screening guidelines. Early diagnosis of PAD is beneficial especially in high prevalence populations and Quantaflo is a key to make that diagnosis seamless. Even if insurers are extracting revenue from the government, PAD testing is set to increase as the country shifts to preventive care. The risk adjustment isn’t the only benefit for insurers: preventive care saves money too.

The financial case:

At $80, the market is certainly not expecting much. I believe they can reach $130 million in sales by 2026 at 34% Net income margins leading to 44.2 million in Net Income and about $5.75/share. Assigning a 20X P/E multiple (appropriate for mature Medical device companies), gives us a share price of 110 and a CAGR of 9%. If you believe the multiple should be higher or they can grow faster with additional products, the IRR can be even higher. Simply put, I think it's a low risk 8-20% IRR with further upside based on multiple expansion and new products.

25% growth is conservative???:

Some immediately scoff at my description of 25% growth as conservative. People will cite base rates as why 25% 3-year revenue growth is unlikely (source), but most studies exclude microcaps and do not breakout companies by sector. Michael Mauboussin breaks growth out by sector and level of sales concluding that intangible asset heavy companies are more subject to large variations in growth. The mean 3 year growth rate for sub $1B (sales) healthcare companies is 19% (standard deviation 52%) (source). Heaps of shitty companies with unsustainable growth rates give investor a playing field with lots of opportunity. Semler is uniquely advantaged in a growing field, so 25% is conservative in my opinion.

Waiting for a fat pitch: In my opinion, Semler isn't a 'fat pitch' with 500% upside in 4 years. It is, however, a strong RR with an above average IRR using conservative estimates. Even in a risk off world, Semler's profitability provide a floor on the stock price.

2021 Results

2020 returns: 91.48%

2021 returns: 3.48%

Q4 returns: -18.04%.

Positions as of 2/01/2022

The last three months have NOT been easy, but if I was in it for the money, I would have quit a long ago. I’m in it because I love the game. Regardless of if I win or lose, I’ll continue to love it.

Here’s to a better rest of the year!

Portfolio thoughts:

This is the part I always skip to in fund letters so let's go over it. The positions I have in which I'm paying the most attention are PFMT, SMLR, and NEPH. All three are different setups, but poised to have an important 2022.

PFMT - I still believe PFMT is under valued based on it's future results, but after missing estimates in Q3, the market has been scared off. Based on guidance of 80M in revenue and what I expect is 10M in EBITDA, shares are fairly valued for a mature company at 15X EBITDA. The market is pricing in no growth. In addition, I believe the revenue earned in Q3/Q4 is set to return as Omicron subsides in Q122. The missed guidance is a result of delayed, not canceled, revenue, setting up 2022 to be a flagship year. I could be wrong and the slowdown might be a result of competitive advantage losses, but investors aren't paying much for future growth anyway.

NEPH- A smaller position initiated in Q4 was Nephros, a maker of water filters primarily for healthcare facilities. In 2017, the company saw a step change in demand when new legislation increased the use of filters in hospital systems to prevent legionella. New legislation mandating stricter compliance could boost their demand similarly in 2022. I expect Q4 pain as the Omicron surge overwhelmed hospitals, but 2022 could be a banner year. The CEO guided to 30% growth in 2022, but I believe this is conservative. I'm worried about the profitability, but recurring revenue from filters replaced every 6 months gives me comfort. They have multiple shots on goal (or are spread too thin depending on your perspective) and want to reach profitability in the core filter business this year. I encourage those interested to watch the CEO’s MCC presentation and read the most recent shareholder letter.

CMPD - Compumed is a profitable, growing, tele-diagnostic company trading at a dirt cheap multiple. It provides remote diagnostics to organ procurement organizations and prisons (mainly) allowing these organization to make diagnoses without a doctor on site The niche market has one other competitor and little information is released, but it’s an interesting company given the price. It trades at < 15x P/E and seems to be growing at 10-20%/year. They’re investing into the product and could re-accelerate growth.

GENERALISTS VS SPECIALIST INVESTORS

When I started investing, I believed whole heartedly in a generalist mandate for the best performance possible. A go-anywhere investor's universe is multiples larger than one who’s mandate is defined by one specific sector. Trevor Scott of Tidefall Capital compared it to knowing one neighborhood well vs travelling the world visiting many places. Who wants to stay confined to their local neighborhood if one can traverse the world?

The increased investment universe mitigates any sector rotation risk. Energy investors have certainly had tougher time over the last 10 years compared to software investors. Why struggle trying to find the best companies in a poor sector instead of investing in the sector with the best returns? It can drastically improve your base rate.

Generalization is lauded in other areas of life, especially after the release of David Epstein's book "Range: Why Generalists win in a Specialized World". Epstein separates situations into kind and wicked ones defining kind environments as those with known rules where we can reliably predict situations while wicked environments are constantly changing without defined rules. He argues that wicked environments favor generalists drawing on broad experience to reason into a solution.

Eliot Turner references this book in a podcast when discussing the benefits of generalist investing. Investing is a wicked environment where stock movements are driven by hidden, often unexplainable, phenomena. Stocks have no rules. Generalization allows investors to apply mental models across sectors while an abstraction from "industry experts" allows one to question the status quo. Industrial Auto investors could never have predicted or capitalized on the shift to EVs. However, some sectors (as we'll discuss) do favor specialists. (link)

To summarize, being a generalist investor is favored for a number of reasons:

1. They have a larger investable universe thus more stocks to choose from

2. They don't have risks of underperformance due to sector rotation

3. They can apply mental models across businesses and sectors

4. It’s simply more fun

5. Iconic investors are often generalists (think Buffett, Greenblatt, lynch).

Keeping in mind the aforementioned benefits of generalization in markets, specialist fund managers can be preferred if one wants to perform the sector allocation yourself.

Benefits can extend to beyond the logistical. Sector-focused funds in private equity tend to outperform generalists (link). In addition, an academic paper on the topic concluded specialists were better stock pickers while generalists were better market timers (link).

Not only do sector specialists tend to outperform when picking stocks generally, and data suggests specialists in out of favor sectors can still beat the broad market. Sure, a SaaS specialist could have easily outperformed the S&P in recent years, but J. Mintzmeyer at Value Investor's edge prove it's possible to outperform the market even in a poorly performing sector (link). They focus on shipping/energy stocks and have compounded capital at 41% over the last five years outperforming both the S&P (17% CAGR) and the shipping industry (1% CAGR). There are also a number of healthcare focused funds I follow such as Orbimed, Perceptive Advisors, and Deerfield. Although generalists are in the spotlight, specialist managers both exist and can outperform. It's counterintuitive to Epstein's thesis. I'd propose that investing, although wicked, can require specialization for certain fields and for certain people.

There are two reasons for specialization

A) lack of time to do deep research into all sectors: For individual investors like myself, the amount of research needed to understand an industry can be too much. Who has time to talk to customers, compile industry reports, etc trying to learn about multiple sectors? Individual investors are better suited to "invest in what they know", thus naturally leading to specialization.

B) Certain sectors are difficult for generalists: The best example is healthcare/biotech. The complex system combined with irregular risk profile of stocks dependent on science, reimbursement, and psychology lends itself to sector specialists. In addition, once a network of industry experts is cultivated,  research happens exponentially faster. Expert interviews alleviate some burden, but a personal network provides more timely and trustworthy opinions.

Which one is better?

It depends.

Individuals often follow a pattern: starting off as generalists until they learn just how little they know. They turn to a niche where they might have an edge and gradually work their way across companies and if possible: additional sectors. Shifting your focus to one industry sacrifices short term profits for sector-specific knowledge, but I'd argue it’s worth it become a true expert.

Don't try to drive and kiss a pretty girl at the same time: you'll do neither one well.

I would argue a similar principle applies for professional investors. Rather than starting with a broad mandate, they should begin with one sector or niche and work their way across the investment world. They have the time and resources and exploit inefficiencies in all ends of the market, but only if they’re willing to spend time cultivating a broad network and building sector specific knowledge.

Summary and Practical takeaways:

1. Specialization is better for certain industries

2. Individual investors are better as specialists due to time constraints.

3. Specialists can outperform even in times of broad sector underperformance.

4. Generalists have their place, but would benefit from deep understanding of specific industries.

The Unspoken Advantage of Individual Investors:

Another topic which I'd like to touch on is an unspoken advantage of individual investors. It’s not the oft-cited long term time horizon, but the financial comfort and constant cash flow from a primary occupation. For investors whose livelihood are made and lost on the markets, internal and external psychological forces can pressure people into poor decisions. Investing in stocks becomes easier with a consistent influx of cash. It’s the Buffett-Gardner model. Warren Buffett and David Gardner are both great investors (with different styles) who have a diversified income stream through other businesses. A constant income stream combined with appropriate financial decisions (not yoloing your 401k into shiba inu coins) allows opportunistic buying and no sleepless nights. Cash flow means #neversell can be a viable strategy if new money is allocated to the appropriate opportunities.