The very reason that President Obama wants to overhaul our health-care system is the same reason I invest in it: The sector grows two to three times faster than our overall economy.

That’s something that keeps the politicians up at night… but it sure helps me sleep tight. That’s because I prefer to put my money in something that doubles every six years — not every other decade. Watch my video briefing below then click over for the rest of the story — including the name of a stock I found that would actually boost profits if the government cuts spending.

I’ve never seen anything like this: It’s the first time I’ve found an instance where a government spending cut would mean higher profits for a company. It takes a few steps to explain:

In 1972, the federal government made a unique change to Medicare, the health-care system for those over the age of 65.  If kidney failure was diagnosed in any patient, he or she would be eligible for Medicare coverage to cover the treatments doctors prescribed, regardless of age. It’s the Medicare program’s only such provision. One provision of the plan is this: If the patient has employer-provided health coverage, then Medicare doesn’t kick in as the primary payer until after the first 30 months.

The National Institute of Health says 11.5% of adults older than 20 — some 23 million people — have some type of chronic kidney disease. Roughly 506,000 Americans were being treated for end-stage renal disease, most commonly as a side effect of diabetes, at the end of 2006. (Mass-scale health data is collected slowly.) Of those, 355,000 were on dialysis, a chemical process that removes unwanted substances from blood. Some patients will need dialysis three times a week. Most of these treatments are provided at dialysis clinics.

Medicare pays about $235 per treatment — this, admittedly, is a simplification of a very complex reimbursement schedule -- but private insurance pays a multiple of that, perhaps as much as five or even ten times. In other words, Medicare covers a lot of the industry’s costs, but dialysis providers actually make their profit from patients covered by private insurance, about 35% of the total. There’s a steady supply of new patients: In 2006, for example, 110,854 people across the country started dialysis. These are the profitable cases that drive the industry’s profits, before they become low- or no-margin Medicare beneficiaries after 30 months.

There’s some good news. Dialysis works. Most patients can be kept alive until a transplant becomes available, and survival rates for transplants are good. The other news, which I prefer not to label as good or bad, is that more and more people will need dialysis as the incidence of diabetes and heart disease increase and the overall population ages.

DaVita (NYSE: DVA), the nation’s No. 1 dialysis provider, will benefit from this. This firm already serves about 22% of the U.S. market, with 112,000 patients spread over nearly 1,500 treatment centers. Its average revenue per treatment was $333.52 last year, which, given the $235 Medicare pays, shows the degree to which private insurers pick up the slack to make dialysis profitable.

The company has delivered a compound annual growth rate of +14.6% in the past ten years, during which time operating income has grown at a +19.0% annual clip.

DaVita’s bottom line has vaulted from a -$182 million loss in 1999 to a $374 million profit in 2008.

Shareholder equity has grown by a factor of six: Management achieves between a 20% and 30% return on equity (ROE) every year. That rate of growth doubles investors’ net assets every four years.

As a plus, the shares are cheap. While the S&P 500 is actually trading above its typical valuation of 16.4 times earnings, DaVita shares are trading at a P/E of 13.9, a -25% discount to their five-year average of 19.3. Estimates for the company’s 2009 results imply a fair value of $69.12 for shares of DVA at the end of the year, nearly +40% higher than today’s prices.

Barriers to entry in this market are high. Not only does DaVita have a strong footprint comprised of 1,500 facilities equipped with the latest technology, it also has the staff: Physicians, nurses and medical technicians are as precious as gold or silver — there aren’t enough of them to go around. Another significant barrier to entry is patient inertia. Dialysis, like many other medical necessities, is a tough drill. Once a patient is comfortable with the routine, he or she is unlikely to change — especially in the total absence of price competition.

Now: From time to time, Washington threatens to decrease Medicare’s coverage of dialysis and increase the number of months that patients must use their private insurance. Though it’s rare to hear about a government program being cut, policy-makers sometimes suggest such a reduction as a means to save money. While the change might be hard on patients, it would be great for DaVita, as it would allow the firm to charge its much higher private-insurance rate for a longer period of time.

Action to Take --> DaVita is an undervalued company with great management and a leading market position in a business with high barriers to entry. Revenue is expected to grow +33% in the next several years, and DaVita’s long-term results are a textbook example of how to build shareholder value. In the past 10 years, shares of DVA have returned an annualized +24.5%, about twice the average historical return of the S&P. There’s no reason that shouldn’t continue.

I’ll be adding shares of DVA to my Government-Driven Investing Portfolio at the opening bell on Thursday, August 6, 2009. I think these shares are a solid “Buy” at any price under $52, and I intend to hold them for the long-term, with a one-year price target of $70.

Good investing,
Andy

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