Investors Finding Shelter in Medical Devices

Medical technology stocks, with their slow but steady growth, are looking more like a port in the storm.

Investors were slow to embrace the medtech sector as the economy faltered, cautious about challenges facing key products such as heart stents, defibrillators and hip implants as those markets matured and a growing debate focused on when such highly engineered, implanted devices are best for patients.

Now, having weathered a steady beat of product recalls, conflicting study data, reimbursement concerns and more regulatory scrutiny, the sector is again finding favor with investors looking for safety amid a global economic slowdown.

“As the economic fears got worse and worse, people rediscovered it as a relatively safe place with modestly growing earnings and not a lot of earnings risk. It’s really just defensive rotation,” said Tim Nelson, analyst at asset management firm FAF Advisors.

Since early July, the Standard and Poor’s Health Care Equipment Index has gained 7%, while the S&P 500 Index .INX has lost 2.4%.

Some of the best performers in the sector include Medtronic Inc., Baxter International Inc., Abbott Laboratories, Johnson & Johnson, Covidien and Varian Medical.

Nelson sees the medical device sector, along with biotech, benefiting from a rotation out of consumer and high-tech stocks and attracting money that might otherwise have flowed to pharmaceutical or managed care stocks.

Drug stocks have been punished as those companies have struggled to replenish pipelines and get new products approved, says Nelson, while the health insurance industry is wrestling with rising costs.

“More Predictable” Earnings

Doug Sandler, chief equity officer for Riverfront Investment Group, said medtech valuations are likely to rise as uncertainty once again grips the market. He favors smaller niche medical device companies over the big orthopedics and heart device makers.

“The bottom line is, in a world where earnings are extremely sensitive to the economy in almost every industry, here’s a group where earnings are pretty un-sensitive and can be a lot more predictable, which I think ultimately leads to higher multiples for (medtech) stocks,” Sandler said.

Since the Federal Reserve’s first interest rate cut a year ago, the medical technology group is up 27% relative to the S&P 500, noted JP Morgan analyst Michael Weinstein.

Nervousness about the damage the weak economy will wreak on US corporate profits during the second half may spark more rotation into medtech, Weinstein said.

However, a continued rebound in the dollar could provide some resistance. “The first headwind will be the stronger dollar,” Weinstein said.

Many believe that the rally in the dollar is sustainable with European economies weakening and European rates potentially headed lower in 2009, just as the Fed considers raising interest rates, he said.

Companies like Baxter International, Edwards Lifesciences Inc. and Becton Dickinson that generate at least half of their revenue outside of the United States have benefited from the dollar’s depreciation over the past two years as favorable foreign currency translations boosted financial results.

Hedging

The impact on specific companies will vary depending upon their individual hedging strategies. Some have outright financial hedges in place, while others have what analysts call “natural” hedges by manufacturing and selling product in the same country. But on balance, the stronger dollar will be neutral to negative for the bottom line for the sector.

“Clearly this will hurt (earnings) comparisons,” said John Farrall, analyst with National City Private Client Group.

“People looking for solid growth prospects in medtech are the ones who will get rattled because sequential growth rates will come down … but medtech is one of the better places to be for the long term,” he said.

Analysts say there’s more perceived risk for the sector than actual risk from the US presidential election.

The real risk to the bull case, according to some analysts, is not the dollar, but the continued constraints on capital spending by hospitals, a tougher reimbursement environment, and a potentially more burdensome and slower product approval process at the FDA.

Oppenheimer conducted a survey of 51 US hospital CFOs recently and found that median expectations for capital equipment spending growth were 0% for both 2008 and 2009.

“Value players are buying dividend yields of pharmaceuticals stocks and growth players are buying biotech and medtech. … I think those will continue to do well,” Farrall said.

Medtech companies with good underlying business fundamentals, such as Varian Medical, Intuitive Surgical and Johnson & Johnson, should continue to perform pretty well, said Miller Tabak analyst Les Funtleyder.

“We do believe it is a good place to hide out until the world resolves itself,” he said.

SOURCE: Reuters