A Lot To Like About Small Cap Healthcare Stocks

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In this week's Weekly Insights:

– A Lot To Like About Small Cap Healthcare Stocks
– Aluminium: At Risk
– This Time It's Different: Healthcare Stocks
– Quote Of The Week
– Stakeholder Yield Remains Superior
– Rudi On TV: The Week Ahead
– Rudi On Tour

A Lot To Like About Small Cap Healthcare Stocks

By Rudi Filapek-Vandyck, Editor FNArena

More and more investors are turning towards the healthcare sector to find potentially high reward investment opportunities.

At face value, there are some simple, easy-to-digest and straightforward reasons for this. Healthcare has generated some of the best performing stocks in years past, including Ramsay Healthcare, CSL, ResMed and NIB Holdings. The year past has seen high profile floats, including Healthscope and Medibank Private (shortly).

At the smaller end of the sector, some speculative biotech developers have matured into more solid propositions (albeit still with above average risk profiles) but more importantly, the so-called life sciences sector has seen an awakening of industrial companies and manufacturers planning to exploit the wealth of business opportunities opening up on the back of a tectonic demographic shift that is occurring in Australia as well as in just about every other developed economy today. Populations are aging. It's the new, long-lasting trend.

As far as broader macro trends go, Baby Boomers approaching and moving into retirement is shaping up as probably one of the most lucrative trends on the horizon for investors, one many times over easier to understand, to self-research and to seek exposure via the Australian share market. Certainly now that "China" seems to have run its course, while greener sources of energy and the Asian food bowl themes have been difficult concepts to actually benefit from through stock market investments. We're not even going to mention the global revolution in shale oil and gas.

In the wake of the Medibank Private IPO, which will be taking up a lot of airplay in the weeks ahead, and as we approach year-end when portfolios are going to be re-assessed and strategies re-calibrated, I have produced a list of stocks in the healthcare sector that have caught my attention in the year past.

The stocks below deserve, on my assessment, further analysis and research in a general share market context of solid yield providers remaining overly popular and expensive, while the same remains the case for the few structural growth stories that are available in the Australian stock market.

Maybe a little bit of extra healthcare in investment portfolios will prove to be but a healthy decision?

Admedus ((AHZ))
Admedus, pronounce ad-ME-dus, is essentially a local sales and distribution network of medical equipment, growing consistently at 10% per annum, supporting the development of regenerative tissue treatment and therapeutic vaccines that can each on their own become a company-maker in the years to come. Admedus has one tissue product, Cardiocel, that has approval and is currently being marketed and sold. The company is in the process of building its own marketing infrastructure in key markets in Europe and the USA.

Total sales in FY14 grew by 7% to $7.9m and if it weren't for international and product development investments, the company would be solidly profitable. Earlier this year, Admedus raised fresh capital, twice, which implies it is well-funded while the local distribution business continues to generate positive cash flow.

Its sole product to date, Cardiocel, is a cardiovascular scaffold, which the company claims has superior characteristics, leading to growing usage by medical professionals as an implantable tissue. Responsible for the development of therapeutic DNA vaccines is professor Ian Frazer, of Gardasil fame. Stockbroker Morgans, which is to my knowledge the only one to actively cover the company, projects annual sales to grow to nearly $47m by FY16, when the company is expected to report its first profit.

Simavita ((SVA))
Investors looking for early stage exposure to the thematic of ageing populations who live longer and require better care need not look any further than Simavita. The company spent years developing an adult diaper with built-in electronic sensors that wirelessly send data which can then be used for detailed assessment and analysis. In first instance, Simavita's "digitised incontinence assessments" help aged care centres to save time through improved scheduling and to provide better care, which can easily turn into a competitive advantage. Further down the track, CEO Philippa Lewis has the ambition to develop a broader digitised platform that can accommodate a lot more analysis about patients and elderly, and potentially about toddlers too.

Simavita listed on the ASX in January. A sales and marketing agreement with Medline in the US has been slow in gaining traction, at first, but should now start generating concrete numbers. To my knowledge, Simavita is currently not actively covered by stockbrokers, but Edison Investment Research, which conducts research on demand, believes "The next 12 to 18 months should mark the defining events on Simavita’s journey towards sustainable profitability". Assuming everything goes to plan, annual sales should rapidly accrue to some $16m by FY16 and facilitate the company's maiden profit.

Further adding to Simavita's business case is that currently no other entrepreneur has thought of exploiting what seems a rather obvious market opportunity. Any copy cats willing to do so now are years behind in data-gathering and electronic diaper experience, according to CEO Lewis. WilsonHTM initiated coverage in September with a Buy rating.

Nanosonics ((NAN))
The next ResMed or the next Cochlear. How many times have investors heard this prediction being made over the years, every single time in vain? In the case of Nanosonics, for which similar forecasts have been made, the potential is certainly there. All we need to see next is execution.

Nanosonics is on a mission to revolutionise the disinfection processes in hospitals for equipment that cannot be heated to high temperature, such as ultrasound probes. It has developed a proprietary, patented device, the trophon, which takes care of what to date is a time-consuming, manual process involving poisonous chemicals. The trophon is an easy-to-use, one button click solution that does the trick in less time and with no residual poisons. It seems a no-brainer and there is no competition.

Sales are building and with a market share of some 30% in Australia, expectations are rising about what the company can potentially achieve offshore. Industry estimates suggest the addressable market for ultrasound systems is some US$4.5bn. Last year (FY14), Nanosonics' sales reached $24m. The company has an exclusive distribution agreement in place with GE in the US. Shaw Stockbroking, the sole stockbroker to cover this stock to our knowledge, rates the stock Buy with a price target of $1.20, expecting sales to climb to $39.4m in FY16, which should facilitate the company's maiden profit. However, management is looking into developing other products and this can potentially delay reaching profitability.

Osprey Medical ((OSP))
Osprey Medical has developed a better device that significantly reduces fatality rates for patients who require dye injections during commonly performed heart and limb procedures. The dye used for x-ray visibility damages kidneys and can cause death by kidney failure for vulnerable patients such as diabetics. As such, Osprey's alternative device should be welcomed by hospitals, patients and insurance companies.

The company is financing its own study into the health and cost savings merits of using its patented Avert device, which in its core allows for the injection of less dye without compromising the x-ray visibility. In addition, Osprey is developing a system that helps saving limbs that otherwise would need to be amputated.

Shaw Stockbroking covers the stock and rates it a Buy with a price target of $1.30. Though sales are expected to grow rapidly, Osprey is not expected to become profitable soon.

Impedimed ((IPD))
The next ResMed? Stockbroker Morgans recently placed the question on top of its reseach update, followed by the admission "We think so". According to its own website, Impedimed is the world leader in the development of medical devices utilising bioimpedance spectroscopy (BIS) for aiding in clinical assessment of unilateral lymphedema of the arm and leg in women and the leg in men. Another application is in detection of fluid imbalances.

The first business case lies in the development of the first commercial opportunity for breast cancer survivors who are at risk of developing lymphedema, but other cancers are awaiting to be tackled next. Impedimed management seems on a roll and investors are increasingly taking note. The share price has risen from circa 20c in July to more than 70c in November and more analysts are jumping on the bandwagon too.

However, management flagged in a recent conference call growth might turn out slower over the next 12-18 months. Stockbroker Morgans suspects the company is taking a more aggressive approach to rolling out sales and marketing infrastructure, which implies higher costs. Also, Morgans does not rule out the company may need to raise more capital. Medium to longer term, the stockbroker believes management is laying the foundation for a "compelling business". Rating Add with a price target of $1.71. Expected to become profitable in FY17.

Paragon Care ((PGC))
This rapidly growing micro cap company is a leading importer of capital equipment items and consumables for hospitals, aged care facilities and primary care providers. Paragon Care manufacturers its own products which are sold as high quality at a premium price. The company is a busy acquisitor. Since 2009 it has concluded eight acquisitions of which Scanmedics was the latest earlier this year.

Growth in earnings per share over the next two years should be high on the back of these transactions. The company is a steady dividend payer, offering circa 5% yield, fully franked, and DPS is expected to increase each year in the years ahead.

Bell Potter initiated coverage in September with a Buy rating and a 38c price target.

Life Healthcare ((LHC))
Listed ten months ago. Slower growing distributor of medical equipment with core business of sales of implantable spine prosthesis. The company has at least four years left on its exclusive supply arrangement with K2M – the original equipment manufacturer of the majority of its spine range.

One hurdle to growth has been recruitment of sales staff for implantable cardiac stents moving more slowly than expected. Pays decent yield of circa 5%, but no franking.

Bell Potter initiated coverage in September with Buy rating and $2.60 price target.

Pulse Health ((PHG))
Microcap private healthcare operator. Owns four hospitals and one community care organisation in NSW and Queensland, providing services out of six locations around Australia. Recapitalised the balance sheet with a $30m capital raising earlier this year.

Management is in talks with unknown target for major acquisition. Timing, price and/or success unknown.

Stock trades on high PE, which translates into low yield (100% franked). Bell Potter rates the stock a Buy with a price target of 63c on the back of very high growth expectations for the years ahead: 34% in FY15. 70% in FY16. 11% in FY17.

Capitol Health ((CAJ))
Fast growing owner-operator of the largest non-hospital based Diagnostic Imaging (DI) network in Victoria with 52 clinics. Acquisitive by nature. Has plans to expand and roll-out successful strategy in other states.

Stockbroker Morgans notes management has a strong track record of acquiring DI practices which add strategically to the business. Trades on high PE, which means the dividend yield is rather modest. Morgans rates the stock Add with a price target of 54c.

Vision Eye Institute ((VEI))
Specialises in laser eye surgery and lasik eye care treatments. Had a near death experience in 2011, but the recovery since looks more than just promising. Debt is being reduced and dividend payments have resumed, with steady increases expected for the years ahead.

Bell Potter sees single digit growth per annum for the years ahead on top of a steadily growing dividend payment (projected yield circa 4.5% fully franked). Bell Potter rates this stock Hold with a price target of 78c.

Mayne Pharma ((MYX))
Specialty drug manufacturer and distributor that made a transformational acquisition of Metrics as it delivered the company extensive distribution capability in the US. However, many products Mayne Pharma sells are generic medicines and thus subjected to price erosion.

Investing in Mayne Pharma is essentially taking a leap of faith regarding the company's product pipeline which consists of no less than 44 drug compounds. Given its success considered a logical takeover target for global pharma.

Mayne Pharma remains firmly on the radar of small cap fund managers (the share price had performed well until March this year when it peaked at $1. Most brokers covering the stock (Moelis, UBS, Credit Suisse) believe the shares are too cheap, though Bell Potter (Sell) disagrees and prefers to wait and see.

Sirtex Medical ((SRX))
One of the star performers on the ASX since early 2012 when the share price took off from $5 to over $26 today. Needless to say, Sirtex has made a lot of friends, supporters and groupies along the way. Sirtex may well crown itself as the next Big Thing in the Australian biotechnology space, alternatively labeled "life sciences" sector.

The company has successfully developed a radioactive treatment for inoperable liver cancer called SIR-Spheres microspheres. What comes next is building a global company which, given the early stage of the company's development, can potentially deliver large gains over an extended period for loyal shareholders.

Sirtex is profitable, grows at high speed (35% EPS growth expected for FY15) and it pays dividends, though the actual yield is minor given the ultra-high PE. Momentum at this point in time is strong and this translates into a seemingly unstoppable rising share price. The combination of all these factors keeps stockbrokers UBS and CIMB divided over whether investors should still climb on board.

Somnoned ((SOM))
The question whether this could be the next ResMed can only be treated with a devious smile because Somnoned is hoping it can become ResMed's main competitor in the highly competitive market for medical breathing devices that help improve people's sleep and might even stop them from snoring. SomnoMed sells the SomnoDent – a device that treats milder forms of sleep apnoea.

Contrary to ResMed's masks, which have a lot of obvious disadvantages, Somnoned's SomnoDent is a cheaper, much easier to use dental device and the company is working hard in educating and training dentists into becoming "sleep dentists".

Somnoned has finally caught the attention of investors in 2014 and the share price performance has been stellar to date. Growth is strong, but market expectations are maybe running too far ahead? WilsonHTM recently decided to downgrade to Hold as the share price is now well above its $2.15 price target.

Pro Medicus ((PME))
Pro Medicus is essentially a software developer with an innovative, disruptive technology platform that is ready to shake up the way patients, doctors and hospitals can access and use large imagery. Think MRI scans on your mobile phone. Otherwise pretty much impossible given the file size and internet connections involved.

Just like any other small cap innovator, Pro Medicus has to work hard to battle market resistance and larger vested interests, but progress is now being made from a profitable base. The company pays a (tiny) dividend. If projected growth will be achieved, the share price can and most certainly will rise a lot higher.

Management has plans to develop the company's proprietary technology platform for broader applications and additional markets, possibly outside the healthcare space. This company is essentially a US growth story.

Also:

Generation Healthcare REIT ((GNC))
Australia's only listed real estate entity that invests exclusively in healthcare property. Macquarie covers this stock.

Aveo Group ((AOG))
Wants to be the number one operator of retirement and aged care facilities in Australia. Covered by JP Morgan.

Japara Healthcare ((JHC))
One of largest operators in aged care and retirement facilities in Australia. Covered by Morgan Stanley, Macquarie and Morgans.

Ingenia Communities ((INA))
Operates communities of affordable accommodation for senior Australians. High growth. Just announced the acquisition of BIG4 Bougainvillia Holiday Park located on the Sunshine Coast, QLD. Moelis rates it Buy with 51c price target.

Investors should always make sure to do their own research. Companies mentioned above can only be researched via Stock Analysis on the FNArena website if one of our eight leading stockbrokers actively covers it.

Aluminium: At Risk

Viewed from a broader angle, the industrial commodities cycle is now firmly into a different phase. One that has seen some of the prior laggards like uranium, nickel and aluminium perform while the previous champions crude oil, copper and iron ore are now facing a much tougher environment.

In line with my own projections, dare I say it!

But investors with exposure to aluminium should be aware of the significant risk that is hanging over the market stemming from the fact that deriving financial profits from buying longer dated futures, and thus from financing large global inventories, has been a significantly profitable business in recent years. Now this is no longer the case, as aluminium is facing a potential market deficit and the previous contango, when further out futures prices are much higher priced than spot and shorter term contracts, is rapidly disappearing.

This, warned analysts at Credit Suisse last week, might lead to unintended consequences as financiers might elect to abandon the trade. If many decide to do just that at the same time, things really could go out of hand, and quickly.

Here's what the analysts published last week: "We fretted about an aluminium inventory 'time bomb' after the stocks blew out post the global financial crisis. But as the years went by and financing supported the stocks, complacency grew. We began to expect a gradual and orderly unwind. But aluminium supply has grown tighter, and the contango has just vanished. Right now, the financing trade that is tying up the aluminium stocks would be out of the money. If this persists, the stock unwind may turn into a deluge that would collapse both price and premium."

This Time It's Different: Healthcare Stocks

This time is different. I have written these powerful four words on a number of occasions, before and after 2008, and on each occasion there's at least one investor, somewhere, who feels the urge to respond. Because we all know, so the response goes, it never really is genuinely different. It's just a momentary lapse of historical trends. A delusion.

Well. Uhm. Until it is, of course.

On my personal observation, investors globally seem to be treating heathcare stocks in a different manner in the post-GFC era. My own research into "All-Weather Stocks" (see also further below) has taught me the healthcare sector is fertile ground for such stocks and this should become even more so with the tectonic demographic changes taking place in just about every developed economy today. Is the latter the reason for increased attention from investors too?

As is always the case, I think there's a multiple of reasons in play. The fact that we are, in Goldman Sachs' words, in a defensive bull market is without doubt one of the key contributors too.

The chart below, from a Macquarie research report, supports the observation that investors are treating healthcare stocks in a different way, but also that this appears justified on the basis of consistent profit generation. It used to be the case, as a generalised sector average, that healthcare profits dipped in between recessions and strengthened when times are tough. Maybe times are still tough, or this time, really, things are different?

Quote Of The Week

The motto "you need to take more risk to get a higher return" is wrong. But no one has been able to quantify a better generalisation.

Campbell Dawson from Elstree Investment Management as quoted by Philip Baker in AFR, 8-9 Nov, 2014.

After all, Goldman Sachs has called this a defensive bull market for a reason.

Stakeholder Yield Remains Superior

Research conducted both locally as well as overseas suggests stocks from companies buying in their own shares more often than not outperform peers who don't. However, a recent quant research report from Macquarie suggests investors shouldn't narrow their focus to buy-backs only.

Macquarie analysts developed the concept of "Stakeholder Yield" which covers companies ability to reward stakeholders outside the business from the cash generated inside the business. This concept covers share buy-backs, of course, but also higher dividends and paying down debt. Macquarie's research builds a strong case that companies that combine all three strategies to reward shareholders, simply deliver superior returns for their shareholders.

Investors, wherever you are, take note.

For Australian shares, the quant analysts have developed a score system and combined this with stock ratings from the fundamental analysis division. As such the Top 11 consists of the following names:

– Seven West Media ((SWM))
– Dexus Property ((DXS))
– Village Roadshow ((VRL))
– GPT ((GPT))
– Bradken ((BKN))
– JB Hi-Fi ((JBH))
– Amcor ((AMC))
– Downer EDI ((EDI))
– IOOF ((IFL))
– Singapore Telecom ((SGT))
– CommBank ((CBA))

FNArena's regular update on share buy-backs:

Ansell ((ANN))
Aveo Group ((AOG))
Cape Lambert Resources ((CFE))
China Magnesium Corp ((CMC))
CSL ((CSL))
Dexus Property ((DXS))
Donaco International ((DNA))
Fiducian Portfolio Services ((FPS))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Logicamms ((LCM))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
Rio Tinto ((RIO))

We continue to welcome your participation/contributions. Send them to info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, here are my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm
– Thursday – Sky Business, Switzer TV, between 7-8pm

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 10 November 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of October available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms