Medical Device Guru

By Alan Brochstein
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator

One of the things I have shared on this blog is that I maintain a watchlist of 100 stocks. I think it’s part of an effective discipline to focus one’s research efforts. Unless one is devoting their full-time to researching stocks, 100 is likely too large a number, but it works for me. These are the stocks I follow most closely, including listening to quarterly earnings calls (or reading transcripts), tracking daily news and evaluating technicals and valuation on a regular basis.

Perhaps because I used to be responsible for focusing on Healthcare stocks at a previous job, my watchlist remains a bit concentrated in Medical Device companies, with 10% of the list in this broad industry. My interest, though, goes well beyond familiarity, as there are several compelling reasons that companies focused on using medical technology to cure us of ailments will do well in the future. Some that come to mind included demographics, cost-effectiveness and consolidation.

The demographics story has two elements. First, the developed world is getting older, which ultimately results in more demand for things like knee replacements or heart procedures. With people living longer for many reasons, the need for new or improved parts is increasing. A second and perhaps more powerful part of this driver is increasing demand in emerging economies. It’s a recurring theme that I see among the device makers, but one that presents challenges. A rising middle class in countries like China or Brazil leads to higher demand, but there is the issue of affordability. Many of these companies are engineering value-priced entry level products to penetrate these rapidly growing markets.

Treating disease for many years meant either taking medicine perhaps for the rest of your life or enduring surgery that might not restore your health fully or that could leave you with large scars. The Medical Device companies have used technology to create products that can alleviate certain conditions and allow patients to avoid costly pharmaceutical alternatives or perhaps avoid surgeries and that minimize the burden on the body. Here I am addressing minimally invasive surgery, for instance. The point is that these companies continue to invest very heavily in developing even better and newer treatments. Several companies, for example, have developed procedures to lower blood pressure when medicine isn’t effective (renal denervation). While a medical procedure can be expensive and have complications, the benefits of a complete restoration to former health or the avoidance of expensive medicines for the rest of one’s life offset these costs.

Finally, while many of the companies in this industry have matured, they are able to grow not only through investment in R&D but also through acquisitions of younger companies with good technology but a lack of distribution. This trend could possibly increase in the coming years, as smaller companies struggle with a new tax that was part of the Affordable Care Act that was confirmed by the Supreme Court last summer. This new excise tax of 2.3% on domestic sales effectively makes it very difficult for smaller companies to remain independent. While the immediate impact of this now-effective tax appears to have been a negative, it remains potentially positive for the longer term.

There are more than 20 companies in the Russell 1000 index that can be considered Medical Device companies. While I don’t want to rule out the others, here is a perspective on the 8 that I follow that are big enough to be included in that index:

Please keep in mind that these are not recommendations. You should do your own research before buying or selling any stock.

The table above is generated using Baseline. First, the list is sorted by PE, with the cheaper names near the top. This column, in the middle of the page, shows an average PE of 14.7, not too different than the overall market. Four offer below-market PE ratios.

I have also highlighted a few other areas, including four with very low levels of net debt and three with above-market dividend yields. All of these stocks are up over the last year, with half up more than the S&P 500 and half less. Over the past three years, the performance has lagged the market slightly, and the average is bolstered by the only two that beat the market. Those two have had much stronger earnings growth.

St. Jude Medical (STJ) has been troubled by quality issues with a lead used in cardiac devices that is no longer on the market but that has led to concern over a newer product. The company has also been hurt by slow sales in cardiac implants, as they represent almost half their sales. Despite some near-term challenges, the company has several products in its pipeline that could help re-accelerate growth.

Zimmer Holdings (ZMH) focuses on hip and knee replacements. The industry has been under pressure too in recent years, some related to regulatory changes and some related to the weak economy. It’s potentially notable that aggressive repurchases have helped boost earnings.

Johnson & Johnson (JNJ) is more than a Medical Device company, but that is their largest division. The stock finally broke out of a tight consolidation last year. The new CEO, who has a device background, is a potential catalyst as the company gets an embarrassing series of product recalls in its Consumer area behind them.

Carefusion (CFN) is a spin-out from Cardinal Health (CAH). They brought in a new CEO from Resmed, and could see possible earnings growth in 2013. Their valuation is relatively reasonable. The company makes infusion pumps and automated medication dispensers.

Becton Dickinson (BDX) is focused on hospital infections and diabetes, two very large and growing areas. They have been hurt by a slowing in research spending. A recent divestiture has hurt their near-term earnings growth.

C.R. Bard (BCR) has been very aggressive repurchasing its stock. This company focuses on consumables and less on expensive devices like implants, selling products used to repair hernias or treat cancer patients. Their growth in emerging markets has been notable.

ResMed (RMD) is focused on obstructive sleep apnea and sells both the machines and the masks used to treat it. This is a medical condition that is becoming better understood for its role in serious diseases, like heart conditions or diabetes. It’s not just snoring! Medicare recently changed how they reimburse recipients, and the stock performed relatively well during that time period. Still, it could be argued to be only fairly valued.

I have shared favorable views on Intuitive Surgical (ISRG) in the past, but I am cautious on this name now due to slowing prostate removals and concerns regarding growth in other areas. The company has attracted several lawsuits alleging quality issues.

If you are looking for new ideas, I think that the Medical Device offers several companies worth considering. I have shared my perspective on the industry and some specifics on 8 stocks within the sector that are perhaps worthy of further investigation.

In the world of microscopy, this advance is almost comparable to the leap from photography to live television. Two young EPFL researchers, Yann Cotte and Fatih Toy, have designed a device that combines holographic microscopy and computational image processing to observe living biological tissues at the nanoscale. Their research is being done under the supervision of Christian Depeursinge, head of the Microvision and Microdiagnostics Group in EPFL’s School of Engineering.

Using their setup, three-dimensional images of living cells can be obtained in just a few minutes – instantaneous operation is still in the works – at an incredibly precise resolution of less than 100 nanometers, 1000 times smaller than the diameter of a human hair. And because they’re able to do this without using contrast dyes or fluorescents, the experimental results don’t run the risk of being distorted by the presence of foreign substances.

Being able to capture a living cell from every angle like this lays the groundwork for a whole new field of investigation. “We can observe in real time the reaction of a cell that is subjected to any kind of stimulus,” explains Cotte. “This opens up all kinds of new opportunities, such as studying the effects of pharmaceutical substances at the scale of the individual cell, for example.”

Watching a neuron grow

This month in Nature Photonics the researchers demonstrate the potential of their method by developing, image by image, the film of a growing neuron and the birth of a synapse, caught over the course of an hour at a rate of one image per minute. This work, which was carried out in collaboration with the Neuroenergetics and cellular dynamics laboratory in EPFL’s Brain Mind Institute, directed by Pierre Magistretti, earned them an editorial in the prestigious journal. “Because we used a low-intensity laser, the influence of the light or heat on the cell is minimal,” continues Cotte. “Our technique thus allows us to observe a cell while still keeping it alive for a long period of time.”

As the laser scans the sample, numerous images extracted by holography are captured by a digital camera, assembled by a computer and “deconvoluted” in order to eliminate noise. To develop their algorithm, the young scientists designed and built a “calibration” system in the school’s clean rooms (CMI) using a thin layer of aluminum that they pierced with 70nm-diameter “nanoholes” spaced 70nm apart.

Finally, the assembled three-dimensional image of the cell, that looks as focused as a drawing in an encyclopedia, can be virtually “sliced” to expose its internal elements, such as the nucleus, genetic material and organelles.

Toy and Cotte, who have already obtained an EPFL Innogrant, have no intention of calling a halt to their research after such a promising beginning. In a company that’s in the process of being created and in collaboration with the startup Lyncée SA, they hope to develop a system that could deliver these kinds of observations in vivo, without the need for removing tissue, using portable devices. In parallel, they will continue to design laboratory material based on these principles. Even before its official launch, the start-up they’re creating has plenty of work to do – and plenty of ambition, as well.