Stock Spotlight: Medical Device Co’s

TK All-Star posted on 10/22/09 at 09:24 AM

Alan Brochstein explains why he likes medical device manufacturers for growth and value.   

Healthcare comprises about 12.5% of the S&P 500 but about 36% of my Top 20 Model Portfolio.  Looking even more closely, I would characterize Top 20 Model as 27% as medical device companies, compared to only 2% representation in the S&P 500. Why the heck am I carrying an almost 14X exposure?

I started the year with very little healthcare exposure, focusing instead on what appeared to be very cheap consumer discretionary names. As the year progressed, I noticed that companies that might not ordinarily be impacted by the economy were seeing issues. Intuitive Surgical (ISRG), for instance, crumbled early in the year.  I was smart enough to jump on that one below 100 but not smart enough to book an even larger gain than we earned in the model of 57%. In any event, as 2009 wore on, not only did we see the economic issues that continue even now, but increasing concerns over healthcare reform, including a potential tax.  

I have spent an inordinate amount of time listening to calls, reading filings, refreshing myself or learning about new companies, and I have been steadily placing a big bet. Making big bets allows one to deviate substantially from the market return, hopefully in a positive way! That was certainly the case with my last big bet, which was on out-of-favor retailers with incredibly strong balance sheets. Alas, we exited many of those way too early as well.

The most recent addition to the Top 20 Model Portfolio is St. Jude (STJ), a company focused primarily on cardiovascular devices. I blogged about STJ on Seeking Alpha just days before they pre-announced negative earnings. Then I added to the position on the plunge (that is often how I roll – watch, sometimes for years, and jump when an opportunity presents itself).

My point today isn’t to necessarily highlight this one stock, but rather to emphasize that the whole sector could offer tremendous opportunity. Still, take a look at this long-term chart to get a sense of how the market views STJ:


 
See a larger version of this chart.

While sales growth has slowed, STJ’s valuation has plunged to the lowest levels in the past 15 years. This is a stock that has drifted sideways now for 5 years while sales have more than doubled. What’s more, the business’ future looks very bright.

Here is what I like about the sector:

•    Companies tend to have very high gross margins
•    International sales are quite substantial, often the majority
•    Near-term trends have been obscured by economic weakness and currency fluctuations
•    Innovation: R&D is productive, unlike for traditional pharma companies
•    Balance sheets tend to be very strong
•    Mostly low valuations across the board
•    Customer demographics look positive – these devices help aging hearts, joints, etc.

The list could go on. I view this sector very similarly to where pharma was in the mid-1990s before its meteoric run: by and large cheap, clear investor sentiment issues, lots of potential demand ahead. What killed pharma companies, in my opinion, were primarily the patents expiring and a lack of substantial new products.  Device companies tend to be more diversified and able to offer continuous improvements to their products.

I have positions in all of the stocks I am about to mention in a foundation that I manage except for Johnson & Johnson (JNJ), which I will probably add again soon.  In the Top 20 Model Portfolio, we own names from tiny to giant (in that order): Synovis Life Technologies (SYNO), Somanetics (SMTS), Volcano (VOLC), C.R. Bard (BCR) and STJ.  In the Conservative Growth/Balanced Model Portfolio, we own BCR as well as Becton Dickinson (BDX) and JNJ, which has a large devices division.

When people ask me to define my investment philosophy, I try to convey that I am flexible. Sometimes I like big stocks, sometimes small. Sometimes I like growth, sometimes value. There is no one strategy that wins all the time, so I like to spread it out.

My favorite time to invest, though, is when I believe that growth and value are converging. Most of these larger companies were too expensive for value investors historically, though more aggressive ones surely have appreciated the many favorable characteristics of these companies.

So far, I have been perhaps a little early, but I remain confident that better prices lie ahead. Feel free to comment if you have questions on any of the names I mentioned or on the sector in general.


Regards,
Alan Brochstein
Founder, Invest By Model
TradeKing All-Star Commentator

Disclosure: Alan is long all stocks mentioned in one or more model portfolios, and long BCR, BDX, SMTS, STJ, SYNO and VOLC in a charitable foundation he manages for a family member.

Supporting documentation for any claims made in this post will be supplied upon request. Send a private message to All-Stars using the link below the profile image.

In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Alan Brochstein maintains a cross-marketing relationship with TradeKing.
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Posted by TK All-Star on 10/22/09 at 09:24 AM

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