Great investors buy exceptional companies when they trade below their true value and often hold them for years, confident that rising earnings growth will drive share-price gains.

That sounds good in theory, but it is hard in practice. The market spots exceptional companies and they rarely trade below intrinsic value for long. When they do, investors must pounce.

Ramsay Health Care fits the bill. The private hospital operator has traits of exceptional companies. The best is a high, rising Return on Equity (ROE) over many years. Ramsay’s average ROE over the past four years is at 20%, or almost double that of a decade ago.

Ramsay has a sustainable competitive advantage. The company is one of the world’s top-five private hospital operators, with around 25,000 beds across six countries. Its 60,000 staff work with about 3 million patients annually in hospitals, day surgeries and other facilities.

Scale is critical in hospitals. Ramsay’s size gives it negotiating clout – and extra pricing power – with private health insurance funds.  Scale also benefits Ramsay through centralised administration, cheaper procurement of products and services, and efficiency gains.

As its competitors struggled, Ramsay invested in its hospital portfolio and now has several assets with monopolistic positions in their market. Large hospitals are hard to replicate because of State and local building restrictions and the cost of building new ones in capital cities. Finding sites for new hospitals in crowded cities is becoming harder.

Ramsay is exporting its strengths. Global expansion began in 2007 with a large acquisition in the United Kingdom. Ramsay expanded into France in 2010, after acquiring a 57% stake in a leading French private-hospital operator, and made other acquisitions in following years. A joint venture with a Malaysian hospital operator in 2013 took Ramsay into Asia.

An annualised total shareholder return (assuming dividend reinvestment) of 24% over 10 years justifies Ramsay’s strategy to expand in Australia and overseas. Few ASX 100 companies have delivered anywhere near those sorts of returns over a decade or can claim to be “exceptional”.

Challenging outlook

Ramsay’s gains, however, have slowed in recent years. The three-year annualised return is flat, and Ramsay is down 21% over one year – a rare blip by its standards.

The market did not like Ramsay’s first-half result for FY18, released in February. Ramsay maintained guidance for FY18 earnings-per-share growth of 8-10%, but some investors are sceptical. Hospital demand is moderating and regulatory risk in the sector is rising.

Earnings declines in the French and UK operations, and rising price pressures, also weighed on the results. Those markets account for about 45% of Ramsay’s revenue. Several brokers have revised their earnings forecasts to the low end of Ramsay’s guidance range.

As always, the key question is valuation and whether this outlook is fully priced into Ramsay. The stock has fallen from a 52-week high of $76.18, to trade near its yearly low of $56.66. Ramsay deserved to fall, but losing a quarter of its market value looks overdone.

Chart 1: Ramsay Health Care

Source: ASX

Ramsay’s long-term story remains intact. An ageing, rising population is a tailwind for private hospital operators. People aged over 60 are expected to comprise a quarter of Australia’s population by 2030, from about 22% now. That age group accounts for just over half of all hospital services because of higher rates of chronic illness and acute medical events.

Forty-six of Ramsay’s 73 hospitals in Australia are in Sydney and Melbourne. The population of both cities is expected to double by 2050, meaning rising hospital demand.

Private health insurance (PHI) is another growth driver. Declining rates of PHI are bad news for private hospital operators because it forces more people into public hospitals. Younger people see less value in PHI and more of them are cancelling policies. But PHI held by older people – the largest users of private hospitals – has remained reasonably stable this decade.

Federal Government reforms to make PHI more attractive, particularly for younger people, should help private hospital operators, at the margin. PHI rates among young people will keep falling, but perhaps slower than in recent years. Governments understand the importance of private hospitals in the healthcare sector and the need for higher PHI rates.

Greater strains on public hospitals are another tailwind for private operators. With government budgets under pressure, and capital-city populations rising, public hospitals surely face greater strains in coming years. The value proposition for private hospitals will rise if public healthcare resources decline, particularly as technology leads to better diagnosis and treatment of more illnesses. More consumers will see the value in private hospitals for elective surgeries.

Long-term trends, on balance, support Ramsay. Simply, an ageing population in Australia, Europe and UK will drive demand for private and public hospitals. Predictably, the market is focused on Ramsay’s short- and medium-term outlook and how it offsets moderating growth for private-hospital services.

The key is expansions and upgrades to existing Ramsay hospitals.  The company expects to open around $300 million of new developments this year – about three times up on 2017. Several of Ramsay’s key metropolitan hospitals are being expanded, which will boost revenues and margins.

Ramsay is also well into its four-year procurement program to achieve savings of $80-$100 million. The initiative has helped Ramsay’s margins and Macquarie Equities Research sees scope for further cost savings next financial year and in the medium term.

Valuation appeals

Ramsay trades on an expected Price Earnings (PE) multiple of 18.7 times (at $56.57), using consensus earnings-per-share (EPS) forecasts, according to a Macquarie research report on Ramsay this week.

That puts Ramsay at a 3% discount to the S&P/ ASX 200 Industrials index (ex-Financials), says Macquarie. A forward PE of 18.7 is a five-year low for Ramsay; the PE briefly peaked above 30 in 2015 and 2016, before steadily falling over the next two years.

Ramsay’s expected PE is below its nearest ASX-listed peers –  Healthscope, Sonic Healthcare and Primary Health Care – even though it is arguably a higher-quality company. Ramsay’s forward PE is less than half that of Cochlear and well below that of CSL and Resmed.

Macquarie’s 12-month price target of $74.50 suggests Ramsay is materially undervalued at the current price. As does the consensus price target of $70, based on the view of 11 broking firms. Targets range from $58.18 to about $82. Morningstar’s fair value for Ramsay is $82.

I’m not quite as bullish. Stagnant wages growth will weigh on PHI rates, as more consumers question the value of pricey health insurance and opt for public hospitals. That has to moderate demand for private hospitals in the next few years and add to pricing and margin pressure.

Regulatory risk is another factor. A Labor victory at the next Federal election could shake up the healthcare sector. Opposition Leader Bill Shorten said in his Budget reply speech in May that Labor would spend another $2.8 billion in funding for public hospitals in 2019-25. That, and other Labor healthcare initiatives, such as better access to MRI scans, could increase the perceived value of public hospitals against private ones.

Risks aside, Ramsay looks undervalued at the current price for long-term investors. Ramsay has its work cut out to achieve guidance of 8-10% growth in EPS for FY18. The market is in no mood for an earnings miss from Ramsay after its patchy first half.

Equally, beating the market’s lowered expectations would be a catalyst for a Ramsay re-rating. For all the market angst, it’s easy to forget the well-run Ramsay is an exceptional company that is trading at a discount to its peers and the broader large-cap market.

Such companies have a habit of making the market look silly when short-term headwinds abate.

• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor All prices and analysis at June 13, 2018.

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 regard to your circumstances.