Beware overpaying for healthcare stocks

In the winter of 2000, billing software maker Hansen Technologies (ASX: HSN) listed on the ASX at $1.00. Over the following nine months, the stock more than doubled to $2.31 as investors began to appreciate the enormous opportunity before them: captive customers, a capital-light business model, economies of scale in a growing industry, and plenty of untapped pricing power. This company was going to be big.

Two years later, they were sitting on a paper loss of 94%. The stock was trading at just 14 cents after the dot-com bubble burst and Hansen lost a substantial customer. It was only in March this year that Hansen's share price exceeded the high water mark set in 2001.   

But here's the kicker – in the 15 years since it listed, Hansen's net profit has nearly quadrupled, suggesting that those optimistic investors had been absolutely correct in their forecast for long-term growth. Where they went wrong was in overpaying for it. Put bluntly, they overreacted.

The same brutal optimism that punished Hansen's shareholders 15 years ago is showing its face again – this time in Australia's healthcare sector.

There's plenty to like about healthcare. Unlike resources, finance, construction or retail, healthcare companies often have strong competitive advantages, large international operations, high returns on capital and non-discretionary revenue. They tend to be more resilient in a downturn and an aging population provides a significant tailwind for growth.

But, “A great company is not a great investment if you pay too much for the stock,” as Benjamin Graham wisely said.

Cochlear (ASX: COH) and Ramsay Health Care (ASX: RHC) are both great companies with excellent financials and decent growth prospects. But they're now trading with price-earnings ratios of 32 and 33, respectively, which doesn't allow for any missteps.

A chart of Blackmores' (ASX: BKL) share price looks more like a hockey stick than a random walk. Investors are now willing to pay 50 times earnings per share to buy the stock.

Even if Blackmores were to double net profit over the next few years, should optimism subside and the shares revert to the average price-earnings ratio for healthcare, investors won't make a dime.

We love to buy high-quality companies that have competitive advantages and shareholder friendly management – but not at any price.

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