Investing in publicly listed life science companies versus early stage growth companies involves dealing with very different animals. But can we learn lessons from companies in the public markets? Perhaps, by considering factors that such investors deem important we can apply those as some kind of metric or goalpost for early stage growth companies.
In public companies, investors will look for value, growth or some combination where they are largely passive shareholders. In private and early stage growth companies, investors take much larger controlling stakes, various rights (such as preference shares) and are usually involved in helping to actively build the companies.
When researching companies for my own (modest) stock portfolio, I look for a combination of value and growth, with some quality thrown in for good measure. Specifically, the search starts with companies that have relatively low valuation multiples (PE, EV/EBITDA, PCF), high return on equity (ROE), low debt and importantly a history of several years of growing earnings per share (EPS) at a steady and fairly predictable rate. This indicates such a company has a strong investment “moat”, or barriers to entry, which will reduce the chance of competitors eroding their edge over time.
When looking for such investments within the healthcare space, I found that medtech companies stood out. By breaking down the healthcare space into sub-sectors, my search this month specifically involved looking at medtech companies developing and supplying invasive technologies (such as heart implants, valves, stents, orthopaedic and spinal implants, and invasive surgical tools). While trawling through this group looking for potential watch-list stocks, I found an unusually high ratio of companies which had good EPS history over 10 years, high ROE and low debt. Also, though only a few were very good value, most were at reasonable valuations (with PE<15). A margin of safety (a phrase coined by Benjamin Graham and oft used by Warren Buffett) is always attractive so it’s a case of simply adding such stocks to a watch-list and waiting until specific situations become available at discounted prices.
The stocks which came out of the search and were added to my watch-list were Medtronic (NYSE: MDT), Baxter (NYSE: BAX), Stryker (NYSE: SYK), Becton Dickinson (NYSE: BDX), St Jude Medical (NYSE: STJ), Zimmer (NYSE: ZMH), Edwards Lifesciences (NYSE: EW), C R Bard (NYSE: BCR), Varian Medical Systems (NYSE: VAR), Dentsply International (NASDAQ: XRAY), Integra LifeSciences (NASDAQ: IART). (Of these only MDT had sufficient value for me to buy, though I’m happy to wait for others). These stocks were selected in large part due to their solid EPS history over 10 years. You may argue that’s a long time to establish a reputation, but ultimately investors are free to put their money where they feel they’ll get the best risk adjusted return. And any company that is listed, or plans to be one day, will be competing for attention with such stalwarts exhibiting growth AND value. The link below opens a graph showing the 10 yr EPS history of the stocks that made the cut:
For the eleven companies selected, EPS growth over 10 years ranged from 9% CAGR for BAX right through to 21% CAGR for VAR, with a mean average for the group of 15% CAGR. These growth rates for EPS are quite impressive, especially when compared to the broader economy over the same timeframe. Interestingly, their EPS also fared very well in the 2008/2009 market rout. However, the point is not to suggest one should buy blindly into such stocks and expect future growth rates. Clearly, there is selection bias here and we are looking back at actual performance rather than looking forward to what could happen. Rather, the point is by looking for companies with certain of the traits mentioned, you have a higher likelihood to capture growth. And if you wait to buy at the right time, when you also capture value, then you protect your downside better. What’s also interesting is that although the companies selected exhibit the most favorable EPS histories, the vast majority of the others in the sub-sector were still profitable – another point for biotechs to ponder. (NB. These are EPS growth rates to demonstrate predictable earnings. They are not the growth rates on capital that investors would have experienced – some would have done better, and some worse, depending on valuation multiples prevailing over the period and prices paid at time of purchases).
Taking a slightly different tack, how does this apply to companies in the private space? While at the Biotech in Europe Investor Forum in Zurich last week, I attended the medtech panel discussion. One of the key traits that separate medtech from biotech companies, highlighted by the panel, is that medtech companies think about commercial issues much, much sooner. And by that I mean driving revenues early and getting to profit. This does mean that a company eventually gets valued on some kind of valuation multiple and looses the potential to earn a “future promise” valuation. Though such a valuation multiple can still richly reward investors, as demonstrated by Kintec Concepts (NYSE: KCI) a company focused on developing and marketing woundcare, regenerative medicine and therapeutic support systems. I wrote about KCI as a potential value and growth play back in 2009 when it was valued at $27 versus $65 today. In July this year, ConvaTec, a private equity group, made a $6 billion bid for KCI, valuing the company at over 10x EV/EBITDA. This has since fallen to about 8.5x as the deal collapsed due to financing challenges. Importantly, though, KCI’s value is still underpinned by its earnings. It also makes for a much more reliable and predictable approach for investors to earn a return rather than waiting for a binary event which can make or kill an asset (and often a company).
And timelines to such revenues are often much shorter too than biotech. You may say the value proposition is different, and biotech is a much higher risk, higher reward game. True. Though, there may also be an element of “shooting for the stars”. For biotechs, earning some revenue through exploiting core expertise could help align scientific and commercial goals. This could be through exploiting a platform, partnering (as many do) or even services (risk-shared or straight fees). And importantly it would demonstrate to investors that management is commercially focused. There is, of course, huge importance for a company to be focused, but it can still retain scientific focus while finding multiple ways to monetize its core expertise. The focus becomes more business like – how do we make money out of what we know?
Finally, while reading the Medtronic SEC 10K annual report, I came across an acquisition which highlighted that a medtech commercial mindset can lead to enviable returns for investors. In 2010, Medtronic acquired Ardian for $800 million upfront, plus commercial milestone payments up to 2015, for treatment of resistant hypertension. Although Ardian’s device has to go through a further trial for FDA approval, it has already received CE approval in Europe and is commercially available in Australia. The fascinating technology developed by Ardian “…uses a catheter to deliver radio-frequency waves to shut down overactive nerves near the kidneys, suspected to be one cause of what’s known as “resistant hypertension.”
Perhaps more fascinatingly, Ardian was founded in 2003, had a total of $66 million investment over the independent life of the company and was sold for $800m million seven years later. High reward doesn’t always need super high risk.
This is the first of two articles looking at investment characteristics of medtech. The next related article will review the EPS histories of non-invasive medtech companies – including diagnostics, instrumentation (testing and monitoring) and other tools.
Nothing in this post is an investment recommendation. Investors should do their own research.
This post was written by Raman Minhas. Raman is the CEO of ATPBio, a consultancy providing business development and corporate development support to biotech and medtech.