Tuesday, July 16, 2024

Australian Healthcare Companies Worth Considering Investing In!

This appeared a few days ago:

Buy Hold Sell: 2 high-conviction healthcare winners for FY25


Plus, fund managers outline the key trends shaping the sector.

Livewire Markets

Healthcare stocks have been some of Australia's most consistent wealth generators, with stocks like CSL () skyrocketing more than 6000% since listing on the ASX 25 years ago. 

Over the past 20 years, the S&P/ASX Health Care Index has far outperformed the rest of the market, lifting 994% compared to the S&P/ASX 200's 121% over that same period. By a long shot, it has been the ASX's best-performing sector over the past 20 years.

And yet, while COVID-19 put our health back into the spotlight, healthcare stocks have been a mixed bag since then. Yes, the developed world's populations are ageing - which spells good things for healthcare companies, but many of the sector's former darlings are now on life support. 

So how can investors identify the companies with a clean bill of health?

To find out, Livewire's Ally Selby was joined by two healthcare analysts in Alphinity Investment Management's Stuart Welch and Yarra Capital Management's Marcus Ryan.

They share some of the trends they are seeing in terms of valuation, cost pressures, and supply chain challenges, whether investors need specialist knowledge to be successful when investing in the sector, and the one non-negotiable healthcare companies need to make their way into these fund managers' portfolios.

Plus, they also analyse three healthcare companies, including CSL (ASX: CSL), Ansell (ASX: ANN) and Sonic Healthcare (ASX: SHL), and each name their highest conviction stock pick within the sector.

Note: This episode was recorded on Wednesday 10 July 2024. You can watch the video, listen to the podcast or read an edited transcript below. 

Edited Transcript

Ally Selby: Hello and welcome to Livewire's Buy Hold Sell. I'm Ally Selby and today we're taking a deep dive into the healthcare sector. Many of Australia's greatest success stories have been healthcare companies, but since COVID, quite a few of those stocks have been on life support. So to find out which of these stocks have a clean bill of health, we're joined by Stuart Welch from Alphinity Investment Management and Marcus Ryan from Yarra Capital Management.

A lot of healthcare valuations have traditionally been more expensive than the rest of the market. Stuart, I'm going to start with you. With some of the pain that we've seen in this sector, is that still the case? 

Is the healthcare sector overvalued?

Stuart Welch: I think people have historically been attracted to healthcare because of the structural defensive growth, and whilst it was upended a little bit during COVID, I think that is still the case. We still see growing ageing populations, increasing chronic disease, and often a lot of new treatments that improve the standard of care. And so I think people are still attracted to those growth stories that can continue irrespective of the economic cycle.

Ally Selby: Over to you Marcus. How much value are you actually seeing within the healthcare sector today?

Marcus Ryan: The sector is trading on a higher PE premium relative to the market, and that's really reflecting investor expectations around the better growth of prospects. Overall, I would describe the healthcare sector today as being modestly cheap. Interestingly, the PE ratio, the premium relative to the industrial companies is around a 50% premium, and that compares to the historical average of around 60%.

We believe though that there's really a story within a story here. Using that same basis of relative PE, what's really interesting is that 10 of the 15 major healthcare companies are trading at higher PE multiples today relative to their historical average. So as we sit here today, we think dispersion in the sector is large and we are really focused on unique stock opportunities rather than the sector overall. 

Are there any headwinds facing the sector?

Ally Selby: As you mentioned there, we have seen quite a lot of dispersion in the healthcare sector, particularly when it comes to returns. A lot of those companies have been facing high costs as well as supply chain challenges. In your view, are we still seeing those headwinds today?

Marcus Ryan: I would say we are partially seeing those headwinds. What's interesting is we observe supply chain challenges across the sector. We're really noticing that it's evolving from being broad-based wage cost inflation pressures and product-specific shortages to now being more discreet issues like Red Sea shipping cost increases. We expect this to manifest when we think about the margin potential. 12 of the 15 major healthcare companies today are actually continuing to have margins below pre-COVID levels.

These issues could still provide a challenge to get those margins back. As you mentioned, FY24 was the year for stock dispersion within the healthcare space. In fact, while the sector put on almost 10% for fiscal '24, what was amazing is that the best returner Pro Medicus (ASX: PME), a healthcare technology company, jumped 119%. Whereas at the other end of the ledger, pathology names, actually dropped 25%. They were really hit hard with some of those inflation issues. So, moving forward, the key themes we are monitoring across the sector are AI, GLP-1s and how that'll impact the sector.

Ally Selby: Stuart, over to you. What are some of the major trends you're seeing right now in the healthcare sector?

Stuart Welch: So I think Marcus has touched on one of the key ones. I think it's margins. So as we came through COVID, there were COVID beneficiaries and COVID losers. Normally it's a very stable industry. We had the companies that were able to provide the pathology tests, for example, or respiratory systems for COVID patients winning. And some of the hospitals that were quasi-nationalised and CSL (ASX: CSL), for example, which couldn't collect plasma, struggle.

I think every company has been recovering at different stages, but I think in the last 18 months, they have been hit with margin pressures and that's been relatively universal across the space. And so I think that's one of the key trends in terms of trying to understand the performance of the sector - what's the outlook and trajectory for that margin recovery and how quickly that's going to come through relative to people's expectations.
Do you need specialist knowledge to be successful in healthcare investing?

Ally Selby: All the stocks in the sector are incredibly different. Do you feel like you need specialist knowledge to be able to be successful when it comes to investing in healthcare stocks?

Stuart Welch: Quite a few other sectors are a lot more homogenous. The healthcare sector is very heterogeneous. So firstly, you have the different sub-sectors, so you've got things like hospitals, pathology companies, radiology companies, aged care. But then also the three largest companies are leaders in various specific sub-segments like Cochlear's (ASX: COH) cochlear implants, sleep apnea for ResMed (ASX: RMD), and blood plasma products for CSL. Each one of those has very different fundamentals, and so it's very hard to apply a one-size-fits-all kind of approach to healthcare.

On top of that, it's not only the products they offer and the markets within which they operate, which are often highly regulated and vary country by country, but you also have to have an eye on the competitors. So it's often the product you don't know about that could upend some of these companies as well. So there's a lot to keep on top of, if you're not doing that full-time, I would suggest...

Ally Selby: ...Maybe not doing it at all. Do you feel like you need a medical degree or any kind of knowledge like that to be able to invest in these stocks?

Marcus Ryan: The answer to that would be definitely for the healthcare sector. Our investment process does lean into engagement with specialists and we find that's a really helpful part of the process, particularly for healthcare. When I think about specialist expertise, it could be with a prescribing physician who's close to patient trends. And what we've really found is that can often help identify and validate potential points of inflexion for businesses early on.

Today, consensus expectations are in excess of 15% profit growth for the healthcare sector over the next two years. That's really quite staggering compared to the last two years when the sector only generated 4% per annum earnings growth. And it's these specialist engagements that help to discern which companies will have the capacity to meet or beat those expectations. 

One non-negotiable when investing in healthcare stocks

Ally Selby: Okay. Marcus, one more question today before we get into buy, hold, sell. For you, what is one non-negotiable that you believe every healthcare stock needs for it to make its way into the portfolio?

Marcus Ryan: What we find really interesting when we look across the sector is that stocks are trading on anywhere from 15 times earnings to in excess of 100 times earnings growth. And what that says to us is a key ingredient is understanding the durability of revenue and the sustainability of earnings growth. That's our number one focus and I'd call that our non-negotiable.

In addition to that, I'd say before we actually put a new healthcare name into the portfolio, we're often asking the question, "Does this make sense from a portfolio perspective? Could there actually be a better stock outside of the healthcare space that makes better sense?"

And just finally and impressively when we think about the healthcare sector over the last decade in Australia, and this is actually quite staggering, the sales growth and the earnings growth from the healthcare sector per annum is in excess of three times the growth rate of what we've seen from ASX industrial companies. And it really encourages us with that active research to lean into the sector and to find the best stock ideas.

Ally Selby: Over to you, Stuart. What's your one non-negotiable when investing in healthcare stocks?

Stuart Welch: So it is something we apply to all of the stocks that we put in the portfolio. And what we're looking for is quality, reasonably valued companies that are in or entering an earnings upgrade cycle. These are companies where we think the earnings power has been underappreciated and earnings can come in ahead of expectations. We apply that lens across all companies that we invest in. And healthcare is no different. We do think that one of the key drivers of that over the next 12-18 months is going to be margins for some of the reasons we've talked about already. 

CSL (ASX: CSL)

Ally Selby: Let's get into buy, hold, sell now. First up today we have CSL, which is Australia's biggest healthcare company by a country mile. Stuart, going to start with you today. Is it a buy, hold or sell?

Stuart Welch (BUY): We think that one's a buy. It's a company that is yet to recover from COVID. Margins are still 800 basis points in their key business bearing below where they were pre-COVID. And it's been struggling with some of those inflationary cost pressures that we've been talking about in the healthcare space. One of the key drivers to improve that is the Rika system, which is a new plasma collection system. This will decrease the amount of time required to collect a donation but also increase the volume of donations that they can take from patients as well. And we do think that the rollout of that is going a bit faster than what people currently expect and that there's some margin upside from that as that comes through.

Ally Selby: Its share price has recovered around 12% over the past 12 months. Its share price is now trading back near $300. Marcus, is it a buy, hold or sell?

Marcus Ryan (SELL): For us, Ally, CSL today is more of a sell. We like parts of the industry that CSL operates in. We like parts of the business, and we like the management team, but what we just cannot get our heads around is the mispricing opportunity. Building on some of the margin comments that Stuart made, where we see things a little bit differently is we feel some of that margin upside story seems to be well captured by consensus expectations. When we also think about competing products and generic products, we sense that that's going to be an ongoing feature of the industry. And just finally, we feel it's actually a very well-loved stock. Interestingly, if you look at analyst reports, 12 of the 16 brokers covering CSL have it on a buy or a very strong buy. And we just think that limits the potential for positive news flow. 

Ansell (ASX: ANN)

Ally Selby: Okay, next up today we have Ansell, which sells protective equipment like medical gloves. Marcus, staying with you, is it a buy, hold or sell?

Marcus Ryan (BUY): For us, Ansell, a leading personal protective equipment company, is a buy. This is really predicated on a bunch of key points. We see the healthcare part of the business as returning to system growth as they rotate through COVID impacts. We like the cyclical upside potential from the industrial side of the business. Thirdly, we actually see the business quality and the earnings quality improved as a result of their April acquisition of the Kimberly Clark PPE business. And just finally, we think the valuation's attractive. The stock's trading at a PE discount relative to where it historically traded.

Ally Selby: Okay, its share price has fallen around 3% over the last 12 months, but most brokers rate it as a buy. Stuart, over to you. Is it a buy, hold or sell?

Stuart Welch (SELL): We would look at that as a sell. It's been getting some earnings downgrades. It's had, I think, earnings downgraded by 40-50% over the last couple of years. And actually, the first half was no different - earnings missed by about 40%. And the key issue is that these guys benefited greatly during COVID. They sold a whole lot of gloves. In fact, people ordered a lot more than they needed and have been stockpiling them. And that's been impacting the outlook for the business. And that first-half result was a 40% miss at the NPAT line. At some point that will normalise, but I think we'd need to see some evidence that that is normalising before we could get comfortable stepping into it to make sure there are no further earnings downgrades ahead of us.
Sonic Healthcare (ASX: SHL)

Ally Selby: Okay. Next up today we have Sonic Healthcare, which is a pathology services provider. Its share price has fallen around 25% over the last 12 months. Is there value there, Stuart, or is it a trap? Is it a buy, hold or sell?

Stuart Welch (SELL): That would also be a sell for us. It was a huge COVID beneficiary as well doing a lot of the pathology tests for COVID patients. And during that period, they were actually able to repay pretty much all of their outstanding debt, excluding leases. And what's happened subsequently is that they've been redeploying that capital into acquisitions that should drive growth. The underlying base business earnings power has been eroded through inflation. So they've got a fixed reimbursement from the government. And as those higher costs have come through, that's eroded the margin of the underlying business. We've seen that as some of those COVID tests have receded. And so I think we would again just need to see a bit more evidence that those inflationary pressures are under control and that the margins have stabilised before we could get comfortable investing in Sonic.

Ally Selby: That said, most brokers rate the stock or buy, or at least on the system that I was looking at. Marcus, over to you. Is it a buy, hold or sell?

Marcus Ryan (HOLD): For us Ally, Sonic would be more of a hold at this point in time. The challenge we have at the moment is just trying to understand, particularly the pathology industry, how it actually can lift margins back anywhere close to where they were pre-COVID. Building on some of the themes that Stuart touched on, what we're observing at the moment is volume demand for pathology services is still quite sluggish. We're seeing the cost pressures linked to labour costs still inflated. And while some of the acquisitions we would say look pretty good on the surface, the overall earnings trajectory is still challenged. And as a result of that, we have to be a hold.

Ally Selby: Okay, we asked our guests to bring along their highest conviction healthcare stock today. Really excited for this one. Marcus, I'm going to start with you. What stock are you backing? 

ResMed (ASX: RMD)

Marcus Ryan (HIGH CONVICTION BUY): Our key pick in the sector is the sleep apnea treatment leader, ResMed. For us today, we see the real opportunity centring around the concern that the increased prevalence of GLP-1 drugs could erode ResMed's market opportunity moving forward. We've done a tonne of calls over the last couple of weeks, building on the specialist knowledge question from earlier, to try to understand what physicians are saying and what patients are doing. And frankly, we're getting a picture back from these experts that is very different to what's embedded in the current share price and frankly, very positive for ResMed.

So what we're hearing back from the sleep practitioners, and the weight loss practitioners, is that CPAP - which is the treatment that ResMed put forward to sleep apnea - is still the primary solution for sleep apnea. The other thing we're observing is that GLP-1s, if anything, are just increasing the treatment awareness for sleep apnea.

We see ResMed as the key mispricing opportunity in the large-cap healthcare space. We like the market opportunity. There's a tonne of penetration opportunity for the company. It's the market leader. We still see high single-digit EBITDA growth over the next few years. And the stock's trading at a tremendous discount PE relative to the past.

Ally Selby: Okay. Over to you, Stuart. Your time in the hot seat. What's your highest conviction healthcare stock right now? 

Cochlear (ASX: COH)

Stuart Welch (HIGH CONVICTION BUY): It would be Cochlear. So Cochlear produces cochlear implants to improve hearing. Their key market is the adult market. They've always had a huge addressable market. The challenge for Cochlear has been unlocking that, and system growth has been reasonable in the low mid-single digit range.

Under the current CEO, they've put a whole bunch of long-term growth initiatives in including medicalizing hearing loss, putting in standards of care, seeing studies come through that link hearing loss with accelerated dementia, and a bunch of initiatives to try and free up clinic capacity and operating theatre capacity to be able to service those patients as well.

We think a lot of those long-range initiatives are starting to bear fruit and we're actually seeing an acceleration in system growth, which we think can move further as well. And that's really the key driver for Cochlear, which is the leader in the space. They own that space. They've got a 65% market share, they invest far more in R&D than anybody else and they've got a far superior product suite. And we see more of that coming, which further extends their lead, but also helps free up the industry to grow more as well.

Ally Selby: Well, I hope you enjoyed that healthcare special of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We're adding so much great content just like this every single week.

Here is the link:

https://www.livewiremarkets.com/wires/buy-hold-sell-2-high-conviction-healthcare-winners-for-fy25

I can confess I have holdings in most of these – and am certainly not equipped to offer share purchase advice – but I reckon each of these is worth a close look!

Make up your own mind and seek your own advice!

Overall I reckon the healthcare sector is quite investable as part of a properly diversified portfolio – if you have a few spare dollars available!

David.

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