Few investment megatrends are stronger than healthcare. An ageing global population, medical breakthroughs and rising services demand from developing economies have made healthcare one of the great sectors for long-term investors.
Consider the effects of ageing. The Federal Government’s 2015 Intergenerational Report predicts there will be 4.3 million Australians aged 65-85 by 2024-25 – or another 1.2 million on today’s figures. An extra 100,000 people aged over 85 are expected in a decade.
Seven million Australians will be aged 65-85 by 2054-5 and almost 2 million will be aged over 85. Within four decades, 9 million Australians on average will demand more healthcare services and accommodation. It is the mother of all trends.
The scary part is the complexity of predicting demographic trends because of the unpredictability of medical breakthroughs. The average life expectancy of Australian men at birth will be 95.1 in 2055 (versus 91.5 today) and 96.6 for women (93.6 today), predicts the Intergenerational Report. Is it a stretch to suggest people will on average live beyond 100 by then due to an expected acceleration in the rate of medical breakthroughs?
Then there is Asia and other emerging markets. What happens when another 2 billion Asians join the middle-class by 2030, on OECD forecasts? Rising demand for healthcare services, some of which will be supplied by Australian companies, is inevitable.
In addition to strong organic growth prospects, larger healthcare companies have important defensive qualities. Demand for their services relies less on economic conditions: sick people need healthcare regardless of the economy. That’s the good news. The bad news is these trends are priced into the valuations of leading Australian healthcare stocks. Hospital operator Ramsay Health Care, for example, trades on a forecast Price Earnings (PE) multiple of about 28 times FY16 earnings, consensus analyst estimates show. It is a great company, but looks fully valued at the current price.
The other problem is valuation relativities. Australian healthcare stocks tend to trade on a higher valuation multiple than their nearest overseas peers because there are fewer of them listed in Australia. Local investors wanting exposure to healthcare have to return to the same small pool of high-quality companies, in turning driving prices higher.
There is a good argument that investors should favour global companies for their healthcare exposure or invest in managed funds or exchange-traded funds specialising in the sector. Why buy ResMed Inc on a forecast PE of 25 times when you can buy Medtronics, the world’s largest medical-device maker, on a PE of about 16 forward times?
That does not mean investors should avoid Australian healthcare. Ramsay and Cochlear have been stunning investments over the years. Rather, they should take a global view and think broadly about the definition of “healthcare”.
For example, athletic footwear retailer RCG Corporation, a stock I have previously analysed for the Switzer Super Report, seems an unlikely play on healthcare. But as more people wear fitness trackers and other exercise gadgets, and as the population ages, demand for walking shoes is rising. Greater interest in fitness and health is a boon for RCG, just as it is for offshore-listed Nike and Adidas.
Here are five ways to play the healthcare sector.
1. Go global
The iShares Global Healthcare Exchange Traded Fund is a simple way to gain exposure to the world’s largest healthcare companies. Bought and sold on ASX like a share, it aims to replicate the price and yield performance of an index that includes healthcare giants such as Johnson & Johnson, Novartis AG, Pfizer Inc, Roche Holding Par AG, and Merck and Co Inc.
Two thirds of the index is based on US healthcare companies and it traded on an average PE multiple of 20.7 in March 2015, iShares data shows. That is less than the PE of many large Australian healthcare stocks.
The iShares Global Healthcare ETF has an annualised return of 22% over five years to February 2016. It is unhedged for currency movements, so returns will suffer if the Australian dollar’s recent rally against the Greenback and other currencies continues. Still, it looks a good choice for long-term investors seeking global healthcare exposure.
Chart 1: iShares Global Healthcare ETF
[1]Source: Yahoo!7 Finance, 10 March 2016
2. Aged care
Several aged-care operators have performed well after listing on ASX in the past few years. Japara Healthcare raised $450 million through an Initial Public Offering (IPO) in April 2014. Its $2 issued shares hit a 52-week high of $3.45 last year but have since eased to $3.07.
Regis listed on ASX in October 2014 through a $485 million IPO. Its $3.65 issued shares rallied to $6.52 last year, before retreating to $5.14. Estia Health raised $725 million and listed on ASX in December 2014. Its $5.75 issue shares are $5.86.
I like the medium-term outlook for Regis and Japara, but have not yet formed a view on Estia. The aged-care accommodation providers have good prospects and a significant first-mover advantage having raised capital to accelerate the construction of dozens of aged-care facilities around Australia.
Regis beat market expectations with a 12% gain in revenue to $236.6 million in the first half of FY16 and a 15% rise in after-tax net profit to $28.3 million. Its second-half earnings guidance was also ahead of consensus.
Regis has 47 facilities and 6,012 places for aged-care residents. A balance sheet with no debt gives it plenty of firepower to buy smaller operators if needed, and I like how it is investing in existing and new developments from surplus cash flow rather than taking on debt or issuing equity.
Japara reported a 2.5% increase in first-half FY16 profit to $16.2 million – slightly ahead of consensus. Like Regis, Japara is well run, but of the two, Regis looks slightly better value.
Chart 2: Regis Healthcare
[2]Source: Yahoo!7 Finance, 10 March 2016
3. Healthcare consolidators
I am wary of firms that grow rapidly by acquiring smaller competitors and “rolling up” their industry. I’ve watched too many grow aggressively before imploding, and was caught out on Slater & Gordon and Shine Corporate late last year.
But some consolidators take a more conservative approach to growth. Dental groups Pacific Smiles Group and 1300 Smiles are good examples of successful small-cap healthcare consolidators and obvious beneficiaries from an ageing population needing more dental work and as baby-boomer dentists look to retire and sell their practice.
Pacific Smiles Group listed on ASX through a $42-million IPO in November 2014. Its $1.30 issued shares leapt to $1.70 on debut and by March 2015 it was $2.50, giving it a whopping PE multiple of 38 times. The shares are now $1.86 and offering better value.
Pacific Smiles is opening dental practices in shopping centres and wants to open 6-10 a year. Even after rapid growth, it only has an estimated 2 % share of the $8.7 billion dentistry market.
More conservative investors could favour well-run 1300 Smiles, which has delivered solid returns over the years and is mostly Queensland based.
Pet healthcare consolidators also appeal. Market leader Greencross, identified as one of five top small-cap stocks to watch for this report in late 2015, has since received a takeover offer. Greencross has rallied from $6 in November to $7.50 and looks fully valued for now.
Smaller rival National Veterinary Care looks reasonable value. After raising $30 million and listing in August at $1 a share, it has rallied to $1.31. It is less aggressively acquisitive than Greencross and has good long-term prospects. Takeover interest in Greencross shows there is scope for larger pet healthcare operators to consolidate the industry and boost earnings.
Medical imaging consolidator Capitol Health is another small-cap worth following (more on it in a future column).
Chart 3: Pacific Smiles
[3]
Source: Yahoo!7 Finance, 10 March 2016
4. Pathology
Sonic Healthcare stands out among blue-chip healthcare stocks at current prices. I nominated the pathology and radiology provider in mid-January for the Super Switzer Report as one of five stocks to buy during the market correction in early 2015.
It has since rallied from $17.21 to $17.99 but remains well below its 52-week high of $23.73. Healthcare fund cuts targeting pathology, diagnostic imaging and radiology led to an earnings downgrade and crunched Sonic’s price.
I wrote in January that the market was too pessimistic about the earnings downgrade and the Federal Government’s unexpected announcement of Medicare fee cuts last year. “Investors have over-reacted to the potential change and selling has been amplified in the market sell-off. Sonic’s Australia, United States and United Kingdom divisions are performing solidly, although the imaging business (a smaller proportion of revenue) was trading below expectation, in part because of regulatory uncertainty.”
That view holds. Sonic is trading below the median share-price target of $18.95 based on a consensus of 14 brokers and is expected to yield 5 %, after partial franking, in FY17. It is strongly leveraged to the ageing population, has good growth prospects offshore, and its forward PE of 16 times FY17 earnings is a less than some large healthcare stocks. It looks a good stock for income investors.
Chart 4: Sonic Healthcare
[4]Source: Yahoo!7 Finance, 10 March 2016
5. IVF Providers
The In Vitro Fertilisation (IVF) sector has several long-term tailwinds: ageing population, women having babies later, and innovations that have increased IVF success rates. But the largest player, Virtus Health, has disappointed in the past 12 months with a total shareholder return (including dividends) of minus 12%.
Key rival Monash IVF Group has returned 16% over 12 months, although remains just below its $1.85 issue price from a July 2014 IPO. Monash slumped to $1.05 last year after disappointing earnings growth and concerns about the IVF market.
Both stocks struggled amid concerns of slowing Australian demand for IVF, competition from new entrants such as Primary Health Care, and lower profit margins because of a greater uptake of frozen over fresh embryos in assisted reproductive services.
Investors who thought IVF demand was immune to economic conditions realised it is not: a sluggish economy influences demand for what can be costly, multiple IVF cycles.
Monash recently reported a strong interim result, with 31.6% growth in sales for the first half FY16 well ahead of market estimates, and almost 27.6% growth in after-tax net profit. It increased market share in New South Wales and its new ventures, particularly in Malaysia are performing well. Guidance of 25-30% growth in after-tax net profit was a touch ahead of consensus.
I have considered Monash undervalued since it listed – a reason it has been a small-cap mainstay in the Switzer Takeover Target portfolio. I suspected a private equity firm would recognise the value and swoop when it was trading near its lows. However, the market appears to be recognising the value and Monash has further to run in the next 18 months, albeit at a slower pace.
Chart 5: Monash IVF Group
[5]Source: Yahoo!7 Finance, 10 March 2016
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at March 2, 2015.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.