“Health care is like no other industry. There is seemingly no need for the existence of some functions; you can’t decide whether it’s a profit or not-for-profit system, or whether it’s competitive or not. The regulatory environment is like no other industry. And finally the size and scope of it makes it 25-30 huge industries under one umbrella. It seems to me that the ability to pick a future winner is more an art than science.” - Adam Wallace
An elderly patient was visiting her primary care physician when she told him she was suffering from silent gas. He listened patiently and then told her he would start with some basic tests and went over to the sink to wash his hands. With his back turned, the woman decided it was the right time to pass some of this aforementioned flatulence. As the doctor was drying his hands, the woman said she just had a case of her silent gas. After a slight pause, the physician said, “Well, perhaps we’ll start by testing your hearing.”*
Much like our elderly patient, investors sometimes get the wrong end of the problem in their health care investing strategy. About every five years, I publish a top three list of the health care companies that I think can produce outstanding long-term results. This list looks to correct some of the problems we commonly see when investors evaluate a potential investment. When looking to invest in today’s health care field, an investor should keep several themes in mind.
Market Durability: Many health care companies provide services or products that work for a defined period or a defined problem. Problems arise when the issue works itself out, and investors are left holding a piece of history rather than an ongoing concern. Look for opportunities that represent a long-term strategic shift in the business model. As an example think of patient outcome data and systems rather than Y2K solutions.
Customer Stickiness/Demand: Real money is made in opportunities where the demand is both sticky and necessary for business success. This includes new patient therapeutic options (such as Gilead’s HCV franchise) or essential operating tools (such as IMS Health Holdings’ pharmaceutical data). Becoming an essential tool to business strategy and execution is the basis of a great investment opportunity.
High Returns: In health care - much like any other industry - success will draw new competitors to the marketplace. The really successful companies are ones that generate high returns on capital and equity for extended periods. They achieve such success through intellectual property rights, FDA approval or data rights (along with others).
A couple of thoughts about this list. First, these are companies I greatly admire and think have a chance to significantly compound value over the next decade or two. This is not a list of buy recommendations. These companies can only provide adequate returns when their share prices offer reasonable discounts to your estimated intrinsic value. I highly recommend you do additional research on your own to decide what valuation you might place on each company.
Second, there is a host of companies that vied to be on this list. It can be argued that some deserve to be on the list while others should be removed. This is simply a list of companies that I think have the management, competitive advantage, financial strength and profitability to produce outstanding long-term value creation.
Novo Nordisk (NYSE:NVO) is the leading provider of diabetes-care products in the world. Based in Denmark, the company manufactures and markets a variety of human and modern insulin products as well as oral anti-diabetic agents. Novo also has a biopharmaceutical segment (constituting roughly 20% of revenue) that specializes in protein-related therapies for hemophilia and other disorders.
Novo has roughly 28% market share of the $45 billion global insulin market. Demographic changes - with remarkable growth rates in obesity and an aging population - will drive the need for increased quantity and quality of treatment options. There is also a growing adoption of longer-acting insulin (such as Novo’s Levemir) versus the more traditional short-acting insulin (such as Novo’s Novolog). The introduction of GLP-1 analogs means the transition between oral treatment (for those with less serious type 2 diabetes) and insulin therapy is an entirely new market for Novo. In addition, the Centers for Medicare and Medicaid (CMS) along with Accountable Care Organizations (ACOs) are focusing on patient outcomes to a greater extent than ever before. This means primary care physicians - along with specialists - will be incentivized to proactively push patients to comply with their diabetes treatment regimen.
Novo isn’t about only diabetes though. Novo's biopharmaceutical group is more profitable than its diabetes franchise. It also dominates in several niche markets such as the treatment of hemophilia. While only 20% of current total revenue, I would expect this group to grow faster than the diabetes franchise. Both its biologic drugs – NovoSeven and Norditropin – are market leaders in their respective therapeutic class.
Novo has generated an average ROE of 61%, FCF/Revenue of 28% and net margins of 29% over the past five years. Management has generated a return on capital of 56% over the same period. The company currently has $3 billion in cash/marketable securities on the balance sheet with no short- or long-term debt. Novo generates roughly $5.2 billion in free cash annually and has a dividend yield of 0.85%.
Intuitive Surgical (NASDAQ:ISRG) designs, manufactures and markets da Vinci Surgical Systems and related instruments and accessories. A da Vinci Surgical System consists of a surgeon's console, a patient-side cart and a high-performance vision system. Da Vinci Surgery utilizes computational, robotic and imaging technologies to enable improved patient outcomes compared to other surgical and nonsurgical therapies.
Intuitive Surgical’s traditional market – da Vinci Prostatectomy (dVP) andda Vinci Hysterectomy (dVH) – is pretty well saturated. The future growth in these two fields is likely to decrease slightly over the next decade after nearly 30% annual increases over the past 10 years. Growth in new procedures will drive revenue going forward. The market for robotic surgery is nearly endless. There are current therapeutic opportunities in colorectal, urology, cardiothoracic and gynecology. In addition, new international markets such as Japan and Eastern Europe have little to no penetration to date.
Intuitive Surgical has a growing base of users who are trained specifically on the da Vinci system. Beating Intuitive Surgical with its current clients will be a difficult task for any competitor in the future. Achieving FDA approval for both the machine and the procedure creates a significant regulatory burden for those looking to enter the market.
Intuitive Surgical has generated an average ROE of 19%, FCF/Revenue of 31% and net margins of 27% over the past five years. Management has generated a return on capital of 63% over the same period. The company currently has $1 billion in cash on the balance sheet with no short- or long-term debt. Intuitive Surgical generates roughly $506 million in free cash annually and does not pay a dividend.
Waters (NYSE:WAT) makes instruments for applications that range from biopharma drug discovery/development to academic lab research and industrial quality control. The core of Waters' business is chromatography (separation of a mixture by passing it in solution or suspension or as a vapor through a medium in which the components move at different rates). In the space, Waters has significant market share and is perceived as a thought leader with new product development and launches. Waters is also a leader in biopharma mass spectrometry (a mass spectrum measures the masses of ions within a sample). The company is considered the industry standard with its high-end suite platform.
Management has been an excellent allocator of capital. The company refuses to do large deals that destroy shareholder value. Almost all capital is deployed in smaller snap-on acquisitions or internal development of new products. The company is currently focused on seeking market adjacent opportunities such as industrial quality control, production, and applied markets. Though margins will be squeezed somewhat in these markets, the opportunities are roughly four to five times greater than the more traditional biopharma and academic space.
Waters has generated an average ROE of 29%, FCF/Revenue of 21% and net margins of 23% over the past five years. Management has generated a return on capital of 48% over the same period. The company currently has $2.5 billion in cash on the balance sheet with $1.6 billion in long-term debt. Waters generates roughly $460 million in free cash annually and does not pay a dividend.
Health care can provide investors with adequate long-term returns when investors spend the time necessary to identify opportunities. Unless individuals are willing to put a great deal of effort into understanding the business strategies/structures, drug/clinical science and public policy, we suggest investors choose a solid manager (such as Vanguard Health Care ETF [VHT]) rather than direct investing.
As always, I look forward to your thoughts and comments.
Below are my selections in 2006 and 2011. Numbers are cumulative returns for five and 10 years.
2011: ISRG (+85%), NVO (+114%), WAT (+45%).
2006: ISRG (+471%), NVO (+753%), Computer Programs and Systems (NASDAQ:CPSI) (+1%).
Disclosure: The Nintai Charitable Trust is long NVO, ISRG, WAT, CPSI.
*A special note of thanks to my friend Robert B. Runnells who always had a joke at the ready no matter the situation. I’m sure he has a group of angels currently rolling on the ground begging him to stop.