Under the Radar: In good health

The macroeconomic outlook for healthcare stocks is strong, given our ageing population, and a few could move off the charts.

PORTFOLIO POINT: The healthcare sector is known for its idiosyncratic risks, but there are two stand-out performers worth placing on your watch lists.

Anyone who saw the ABC’s special on climate change on Thursday night, no matter what their position on the science, would agree that green energy will continue to attract a lot of money well into the future.

Similarly, even if you don’t tweet, have no Facebook friends and have never used an iPad, it’s undoubtable that funds will continue to be poured into the information technology sector, creating yet more overnight billionaires notwithstanding the merits (or lack thereof) of their underlying business models.

For this reason, despite my general aversion to industries and sectors that attract a lot of mainstream hype, I was happy to profile green energy plays like graphite a fortnight ago (click here) and US dollar plays like Apple Inc. in February (see Ten-gallon stock tips).

Yet despite being a long-term bull on IT and telecommunications (especially in the developing world), green energy (and oil), agriculture, water and fertiliser, I am perhaps most bullish on healthcare and biotechnology. The problem, however, is that while the secular economic fundamentals are good, finding a stock that reflects that upside without the idiosyncratic risks so particular to healthcare equities is like finding a hypodermic needle in a haystack.

While the macroeconomic picture is positive – an ageing global population, longer life expectancies, higher expectations for productivity well into old age, the risk of new pandemics and disease – the sector as a whole, like virtually all those that are enjoying or have enjoyed a boom, is showing classic signs of a bubble. The most vivid illustration of this is in the United States, where healthcare spending as a percentage of GDP has increased threefold since 1960 and the near exponential rise in the St Louis Fed's measure of medical care inflation has priced many out of the most basic of services.

Healthy signs of sickness'¦
Source: Federal Reserve Bank of St Louis, Jesse Colombo

It's a well-known fact that over 50 million Americans lack health insurance, which has increased 40% in cost over the last decade (up 9% in 2011), and it's also well known that US health insurance overheads per capita dwarf the rest of the rich world: seven times the OECD average in 2009. More than the cost of the GFC, the wars in Iraq and Afghanistan and the continuing costs of funding the budget deficit, unrealised Medicare and Medicaid costs could quite literally bankrupt the United States.

In Australia, the situation is less dire, but with an ageing baby-boomer demographic entering retirement, the cost of healthcare is nevertheless an issue for both businesses and policy makers. And similarly, like America, the appeal of this to investors as a thematic has led to classic investment bubble mistakes, notably the various retirement home and healthcare facility schemes that went belly-up between late 2007 and early 2009, leaving thousands of Australian investors out of pocket and hundreds of elderly retirees and healthcare patients out of a home. Many will remember the names PrimeLife Corporation, Babcock & Brown Communities and MFS Corporation’s Village Life.

Picking winners is obviously harder than discussing losers in hindsight, but I have personally always preferred investments in biotechnology and medical device stocks. Despite its recent share price woes – arising from an overreaction to a relatively tiny failure rate in its devices – $3.6 billion cap Cochlear (COH) has been one of the sector's best investments, rising from $3 at listing in late 1995 to Thursday's close at $63.45, having risen to over $87 in April last year. Similarly, $4.8 billion cap ResMed (RMD) has performed solidly over the long-term, providing an effective hedge for investors during the financial crisis, though it still disappointingly does not pay a dividend (partly owing to its dual listing in New York). Most impressive, though, has been $19.6 billion cap blood plasma and vaccine products maker CSL, which has been one of the few 'ten-baggers’ the blue-chip ASX200 index has produced outside of the mining sector.

If we look at a chart from 2000, thus including the exuberance for technology-related stocks at the time, we can see how Cochlear, Resmed and CSL have compared to the broader ASX All Ordinaries.

The other big Australians
Source: Stock Doctor

So what are the next CSLs, Cochlears and ResMeds? Returning to our proverbial haystack, there are 129 healthcare companies on the ASX under the Standard & Poor's Global Industry Classification Standard system. Of these companies, 77 have a market capitalisation of more than $10 million, ranging from CSL at the upper end, to $11 million cap AtCor Medical Holdings (ACG), a cardiological technology firm, at the lower end.

Refining this list further, screening out companies with less than $50,000 in average daily trading volume over the past few weeks, we come to 36 stocks that may be considered "investable" by most traders or shareholders. And then adding a filter for profitability, as we did in late March for the energy sector (click here), we come to just 15.

Fifteen plus

Code Name Industry Group Cap (m)
Avg Daily Trade
PE Ratio
ACR Acrux Limited Pharmaceuticals & Biotechnology
$674
$3,593,250
113.45
ANN Ansell Limited Health Care Equipment & Services
$1,922
$10,149,430
15.78
API Australian Pharmaceutical Industries Health Care Equipment & Services
$195
$660,258
3.31
COH Cochlear Limited Health Care Equipment & Services
$3,612
$17,364,879
20.9
CSL CSL Limited Pharmaceuticals & Biotechnology
$19,561
$81,189,317
21.65
FPH Fisher & Paykel Healthcare Corp Health Care Equipment & Services
$928
$121,224
17.02
GXL Greencross Limited Health Care Equipment & Services
$65
$79,639
15.62
ITD ITL Limited Health Care Equipment & Services
$20
$88,662
15.74
ONT 1300 Smiles Limited Health Care Equipment & Services
$118
$90,772
19.22
PRY Primary Health Care Limited Health Care Equipment & Services
$1,406
$5,374,563
14.73
RHC Ramsay Health Care Limited Health Care Equipment & Services
$3,999
$8,528,487
18.3
RMD ResMed Inc. Health Care Equipment & Services
$4,793
$12,068,618
21.91
SHL Sonic Healthcare Limited Health Care Equipment & Services
$4,851
$15,157,724
16.07
SIP Sigma Pharmaceuticals Limited Health Care Equipment & Services
$803
$1,755,457
16.51
SRX Sirtex Medical Limited Pharmaceuticals & Biotechnology
$351
$382,499
25.44

Source: Stock Doctor

While this list will obviously exclude the very risky, but very exciting range of companies working on the next medical breakthrough before they make a profit, it also excludes much of the dross that has in many ways given healthcare a bad name among investors. It also provides a margin of safety insofar as each of these companies has a viable operating business.

Still, 15 is a relatively large pile to sift through so further screens are naturally needed. When analysed by profit margin, return on equity and debt to equity ratios, we can automatically exclude a number of them.

In terms of profit margin, by putting a minimum level of 10% as our refining criteria, all the traditional hospital and retail pharmaceutical companies – namely API, Primarily Health Care, Ramsay Health Care and Sigma (which owns Amcal and Guardian pharmacy brands) – are screened out, which is just as well, considering that I have never been overly bullish on this part of the sector.

In terms of return on equity, by putting 10% as our arbitrary hurdle, we also exclude Acrux, which has enjoyed a strong share price run of late, but saw earnings per share decline in the latest reporting period. Of the remainder, diagnostics group Sonic Healthcare comes in with the lowest annualised return on equity ratio based on its December 2011 interim statement and it wouldn't pass such a high hurdle on return on assets.

In terms of debt to equity, meanwhile, Greencross unfortunately doesn't make the cut, with a high ratio of non-current liabilities, but on the strength of its wonderful business model (something I've written about before – see Under the Radar: Investor's best friend) and strong growth in terms of both revenues and profits, I otherwise remain bullish on this company (as does Alan Kohler, who owns Greencross in his personal account).

Our arbitrary but hopefully not capricious criteria therefore leave us with just eight companies. Excluding Cochlear, CSL and ResMed it leaves us with five.

Famous five

Code Name
Cap (m)
Avg Daily Trade
PE Ratio
Debt to Equity
ROE
Profit Margin
ANN Ansell Limited
$1,922
$10,149,430
15.78
0.9
20.90%
11.95%
FPH Fisher & Paykel Healthcare Corp
$928
$121,224
17.02
0.69
25.17%
15.31%
ONT 1300 Smiles Limited
$118
$90,772
19.22
0.47
37.57%
27.27%
SHL Sonic Healthcare Limited
$4,851
$15,157,724
16.07
0.9
15.12%
11.62%
SRX Sirtex Medical Limited
$351
$382,499
25.44
0.29
26.34%
21.60%

Source: Stock Doctor

At risk of further arbitrariness, Ansell, Fisher & Paykel Healthcare and Sonic definitely don’t fit the criteria as 'under the radar’ stocks, with mid-size capitalisations and a reasonable amount of broker research. The remaining two stocks – 1300 Smiles (ONT) and Sirtex Medical (SRX) – are, however, both very worthy of a final analysis.

ONT and SRX have both appeared on my watch-lists many times and indeed I covered SRX in April last year (see Health sector's sleeper) when it traded at $5.30 (it closed Thursday at $6.30). I like SRX for the same reasons I liked it then: an exciting technology in liver cancer treatment and a huge potential global market, not to mention the possibility of a takeover. And while I haven’t profiled it specifically to date, I also like ONT for much the same reasons I like Greencross. Just like the veterinary practice group, ONT has taken the relatively straightforward business of dental practices, aggregated them, reduced the shared overheads and expanded into fast-growing locations in Queensland and northern New South Wales.

Of the two, SRX has more blue-sky appeal through the prospectivity of its selective internal radiation microsphere technology, which has been used to treat otherwise inoperable cancers and has further potential applications. Nonetheless, both companies are successfully making the most of a niche within the wider thematic of an ageing population and higher healthcare expectations – and employ proven, sustainable and low-risk business models. And as a counterpart to an investment in SRX, ONT furthermore has an investment case that is without technological or patent risk (though other, more mundane, risks common to any retail operation of course exist).

On a price to earnings basis, both ONT and SRX are relatively expensive, but on a discounted cash flow valuation of its potential future earnings, I would say SRX is good value up to $6.50 and ONT up to $4.80 (it closed Thursday at $5 per share, a little above that level). Either way, they offer strong prospects and relatively secure income streams in a world of deep uncertainty.

Neither stock will provide a miracle cure for your portfolio, but they might at least provide a healthy boost.

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