Medtech Value Investor’s Magic Number

When searching for investment opportunities, every investor looks for ways to trawl through the mass of possibilities and narrow down within an area of focus, enabling more detailed examination of individual stocks or situations.

Trawling for profits?

In my day job working with entrepreneurial medtechs I see this all the time as financial and trade investors use their referral network and attendance at industry-specific events to highlight opportunities which may warrant further investigation.

In my work as a private investor, I use a similar approach. After all, when there are some 200 public US medtechs, and over another 300 or so pharma companies which fall into my broad investment remit, that’s a lot of digging. Hopefully over time, you build up a repository of knowledge about an industry, its dynamics and specific companies within it. But that takes time. And it keeps changing. How do you get started investing before you’ve acquired such encyclopedic knowledge (which, by the way, I hope to have achieved within another short 50 years or so)?

I use investment screens. In essence, you set a range of criteria that you would like your investment opportunities to have. You may go for a certain sector, size, profitability, growth, value and all other manner of criteria. Screens have pros and cons. They can save you a lot of time and trawling, enabling you to focus your research energy on companies which meet some broad criteria. But equally, set a screen too narrowly, and you end up with too many stocks excluded, throwing out the baby with the bath water.

My screens are pretty simple. I look for companies with low-to-moderate valuation based on price-earnings ratio (PER), low debt, good return on equity (ROE) and predictable earnings per share (EPS) growth over 5-10 yrs or more. After several years of trial and error, I find that keeping the screens simple gives me more than enough opportunities to research in detail, while not overwhelming me with volume. There’s no right or wrong about a screen – but if you’ve developed you’re own that’s more powerful since you understand the inputs and outputs that much better.

Also, by understanding your screen, this allows you to make manual adjustments to results. For example, I may come across stocks where the debt has become higher than I would like (often due to a recent acquisition), but I can see from cashflows that the debt will be paid down quickly and the debt levels become once again acceptable on a screen basis. The screen criteria also acts as a useful sanity check when reviewing new opportunities that I may have come across through reading or conference attendance.

As I go through using my screens, I realised there’s a number for me which becomes quite central to the whole exercise – my “magic number” if you will. What’s so special about my magic number, and what is it?

Drumroll…………………….. 15.

That’s it, plain and simple. Apologies if you were expecting something a bit more dramatic. But even Warren Buffett’s investment style is described as “simple but not easy”. And therein lies the rub – 15 is simple, but it’s not easy.

So why 15? Well, going back to my screen criteria, I look for stocks with a 1 year forward PER <15x. I also look for stocks which historically have an ROE>15%. And finally, I look for stocks where I’m fairly confident that I can earn an annualised 15% return on my investment. Let’s look at each of these in turn:

Price Earnings Ratio <15x

At heart I’m a value guy. Value isn’t something you turn on or off when it suits you. It’s just who you are, all the time. I’m always looking for a deal whether it’s for a house, a car, the weekly shop or even socks. Just yesterday, I was (rightly) derided by my wonderful wife for buying an extra-large cappuccino for us to share, rather than buying two separate mugs which would have cost £2 more (they make up the exact same volume of frothy stuff, you know?). And as anyone who knows me will tell you, I’m a cheap date. If we go out to eat, hopefully you’ll have good company, stimulating conversation and we may learn a thing or two from each other. But the food will be cheap.

One cup of coffee or two?

When it comes to stock investing, I’m all about value too. Though, maybe not in the conventional sense of looking for value on a price to book basis. I look at stocks as little pieces of businesses which I can buy a share in. As such, I’m more interested in the ongoing operations, predictable earnings streams and potential than just the break-up, asset-sale value. So a PER<15x gives me the first qualifier on a value basis. For those that think PER is too simplistic a measure, I heartily agree – on its own. I don’t use it on its own. I also consider price to cashflow and enterprise value to EBITDA. But equally, since the PER does get reported and watched so widely, it provides a useful indicator of the market’s view.

In the book, Contrarian Investment Strategies: The Next Generation by David Dreman, he looks at several studies using a low PER strategy going back as far as 1937, and compiles his own data from 1970-1996. These show that a low PER strategy actually performs very well over time. If you had invested in the lowest PER quintile from 1970 to 1996 your portfolio would have earned an average annual return of 19% (with annual rebalancing). Nice.

Return on Equity >15%

ROE gives you  a very good indicator of how effective management are at turning investment into profits. And how effectively they’re able to continue doing this over time. If a company can maintain a high ROE, this means that even as the company grows in size, it’s able to reinvest in itself and continue growing at a similar rate. The company is scalable.

ROE is also a very good measure to compare companies within a sector to see which managers are doing the best job with your hard-earned investment dollars. Of course, as with all ratios, ROE can be manipulated and skewed, mostly easily by using lots of debt. That’s why I also use a debt to equity threshold in my screens to ensure companies aren’t too highly leveraged. Other investors use a similar measure, return on assets (ROA) to achieve a similar effect (where assets = debt + equity). Either way, the objective is to screen for companies that have a history of growing EPS and are likely to do so in the future.

A good ROE level also has an additional benefit. For a company to maintain a growing EPS pattern, it must have a strong “economic moat” or barriers to entry, which enable it to stay ahead of the competition. ROE will only remain high (and have been so historically) if the company in question has managed to reinvest and grow earnings, and this comes as a result of a strong economic moat. Otherwise, as a profitable niche is uncovered, the competition enter the space and any outsized profit opportunity is soon arbitraged out.

Annualised 15% return

My day job involves working with entrepreneurial and development stage companies within the medtech space. Cheesy as this sounds, I really like the idea of being involved in developing medical device products that can help people. I like the idea of helping such products get someway to market (hopefully one day, ALL the way).

Previously, I was involved in early stage biotech companies. Despite the great work many biotechs do, I personally found the time to market too long and outcomes way too intangible. From an investment perspective, it was too much of a binary outcome (some biotech companies have gone on to do amazing things, but many, many fall by the wayside).

Medtech for me is much more interesting since: you’re dealing with tangible engineering solutions; lower risk than drug development; lower investment required; and shorter time to market. There’s even the possibility that investors who get in early can follow through all the way and make decent returns on exit.

But early stage investing, in any sector, is high risk and doesn’t suit every type of investor. Of course, we all hear of spectacular successes, but the failures tend to be quickly forgotten. So, what’s the number one lesson I learned in over 10 years and working with and observing many early stage companies?

Don’t believe the hype.

Simpsons Planet Hype

It’s human nature to be attracted to speculative opportunities with the potential for outsized returns. I’ve been guilty of this more than once. I’ve even been guilty of believing a City entrepreneur’s pitch after “seeing the white’s of his eyes” – I bought in with a share purchase (25% of my total net worth at the time), a  job and stock options. Boy, was I going to make it big – as I told a close friend – “I’ve seen the whites of his eyes and this baby’s on its way!” It was on its way. On its way down. It had seen the promised land of the dot-com boom, and as I joined had started its tumultuous decent into the 99% club – loosing 99% of its market capitalisation (being the stock genius I am, I got out at a mere 70% loss – Haha, you 99% clubbers).

What makes 15% annualised return so attractive? Have I lowered my sights and am now content with much lower performance? Maybe. Have I been burned once too often and now afraid to go back into the speculative fire? For sure.

Or maybe, I finally understood a couple of simple investment rules, again from Warren Buffett – Rule No.1 Don’t lose any money. Rule No.2 Don’t forget rule No.1 (Like he said, investing is “simple but not easy”).

Let’s look at the math behind these simple rules. If you lose 50% on an investment, you need to make 100% just to get back to zero! Do you know how hard that is to do? And just to get back to zero. Wouldn’t it be much better not to lose it in the first place? I know that’s impossible if you plan to invest anything at all, but it sets a really important framework. And why not just stick it under the mattress? Inflation. So you have to earn something on your capital.

15% doubles your money every 5 years. That’s no small thing if you’re not losing it along the way.

15% sets the bar sufficiently low that you don’t go crazy looking for huge potential gains. It allows you to include more quality in your search. It helps reduce your exposure to speculation versus investment. And most importantly, you’re not trying so hard, you search out quality and can be patient for the right opportunities. Then, over time you actually end up doing better than the hurdle (sometimes, much better).

So that’s it, my magic number 15. Simple, isn’t it?

Magic Number 15

What do you think?

This post is by Raman Minhas. He is a medtech enthusiast, CEO of ATPBio, and works with entrepreneurial companies, providing partnering, licensing and financing support. He is also an investor in medtech stocks, using a value based approach.

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6 thoughts on “Medtech Value Investor’s Magic Number

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