Idea of the Week: Four ‘Safety First’ Healthcare Midcaps

February 20th, 2013 by

Taking a ‘safety first’ approach to investing doesn’t mean limiting your focus to large-cap stocks that presumably are safer investments. A review of U.S. midcap companies with reasonable scores in ten StarMine quantitative models reveals four healthcare related names offer a better forecast for valuation (in the form of a prospective P/E ratio) and/or earnings growth that is better than the outlook for the S&P 500 – as well as other potential growth catalysts.

Released: February 20 2013
Length: 3 Minutes

U.S. healthcare has been a hot sector of the market during the last two years, posting a total return of 35% (as measured by the Thomson Reuters Healthcare Index) compared to 15% for S&P 500. Investors’ first instincts may guide them toward the industry giants, such as ‘Big Pharma’ stocks like Pfizer (PFE.N) and Merck (MRK.N), as these traditionally are seen as safer investments. But there is room for upside potential among the healthcare sector’s midcap companies as well, once you find a way to screen for potential sources of risk. One such approach is to use StarMine U.S. models and the rankings they produce to eliminate companies that score below a certain threshold. Using that method, we discovered four midcap names, which may offer investors below-average downside risk. Taking the ‘safety first’ approach, here’s what we found.

OUR APPROACH

The theme of ‘safety first’ drove our analysis, which focused on U.S. midcap stocks with a market capitalization of between $5 billion and $20 billion. These are companies that may be less likely to be automatically labeled ‘blue chip’ as are the industry’s very largest publicly traded companies. We made sure that any stock we considered had an average daily trading volume of at least 400,000 shares, and were covered by at least four sell-side analysts. We then applied all eleven Thomson Reuters StarMine quantitative models to evaluate them: the Analyst Revisions, Price Momentum, Intrinsic and Relative Valuation models; the Value-Momentum Model (which combines the first four), the Short Interest Model, Smart Holdings Model (a gauge of institutional demand), as well as three credit default models, Structural Credit Risk, SmartRatios Credit Risk and Text Mining Credit Risk. After ranking each company, we eliminated any that couldn’t score at least 31 out of a possible 100 (with 1 being the most bearish and 100 the most bullish) on each of the models.

RESULTS

Of the 54 stocks that made the cut, ten names are in the TRBC industrials sector, nine in financials and eight in healthcare. We found several interesting companies in the healthcare arena, a part of the market that had posted a total return more than double that of the S&P 500 in the past two years.

Four specific companies caught our eye: Actavis (ACT.N), Cardinal Health (CAH.N), AmerisourceBergen (ABC.N) and CareFusion (CFN.N), each of which we believe might be worthwhile of additional research and due diligence on the part of readers. The table summarizes briefly some key forward-looking StarMine SmartEstimates as a starting point for our discussion.

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ACTAVIS

Actavis Inc (ACT.N) is the new name of the company produced by the merger of Watson Pharmaceuticals and Actavis Group; they are the third-largest maker of generic pharmaceuticals in the world, just behind Teva Pharmaceuticals (TEVA.O), the leader, and Mylan Labs (MYL.N). The company, which has a market cap of $11 billion, has stated that its goal is to “build a global specialty pharmaceutical company well-positioned for long-term sustainable growth.” If nothing else, investors should perk up at the sight or sound of ‘global’ and ‘long-term sustainable growth’ in the message. There appears to be a healthy opportunity for Actavis to increase the proportion of its revenues originating outside the United States above its current level of 38%. Currently, the company generates revenues in Europe, the Middle East and the Asia Pacific region; the latter of these includes Japan, which is the second largest market for pharmaceuticals worldwide, as well as Australia and Indonesia.

The forward 12-month P/E SmartEstimate of 10.9 for Actavis appears attractive when compared to the S&P’s 13.6 figure. (The SmartEstimate places more weight on those analysts who have the best record for accuracy, which in this case pertains to earnings forecasts.) Over the next 12- and 24-months, analysts expect that the company’s earnings per share will grow by 35% and 14%, respectively, from the effective date of the merger, January 24, 2013. These figures compare favorably to the forecasts of 9% and 11% for the same time periods for the S&P 500. Operating efficiency is another category in which the former Watson Pharmaceuticals excelled; in the quarter ended September 30, 2012 quarter, it reported operating margins of 15.5%. That is in line with the S&P 500’s latest margins of 15.6%, and although it falls slightly short of the pharmaceuticals industry median of 22% it still tops the median margins for the healthcare sector as a whole, of 8.5%. The StarMine operating efficiency component score of 92 out of 100 contributes to Actavis scoring an impressive 93 for earnings quality of 93 among all U.S. stocks (other components for U.S. stocks include accruals, cash flow and exclusions).

Analysts favor the stock as well: Nine of them currently have strong buy ratings on the stocks, another eight are recommending the stock with a buy rating while five maintain ‘hold’ ratings. Currently, there aren’t any sell or strong sell ratings.

AMERISOURCEBERGEN

Pharmaceutical distributor AmerisourceBergen (ABC.N) has a market capitalization of $10.8 billion and has a forward P/E ratio of 14.3 (see table), slightly above that of the S&P 500. Its earnings growth is forecast to be better than that of the broader market, with analysts calling for earnings per share to grow at 13% in both the next 12- and 24-month periods. StarMine’s Smart Holdings model, which gauges the likelihood that institutional investors will purchase shares of the company over the next 90 days, ranks the company a high 92. Moreover, the company’s stock offers lower volatility than some the three others that made our short list, offering an average daily price fluctuation of less than 1% over the last 365 days.

The company has boosted its dividend significantly since February 2009, when its quarterly dividend payment was only 5 cents. Today, its 21 cents-per-share dividend offers investors a dividend yield of 1.8%. AmerisourceBergen is another favorite among sell-side analysts, with six of them rating it a strong buy, three a buy and six maintaining a hold rating. No analysts currently suggest the stock is a “sell” or “strong sell”. Among the possible reasons for this optimism is the fact that AmerisourceBergen has seen its returns on assets hover in the low 30% range, about double the average ROA for the healthcare industry of 14% to 15%. (The chart below shows the company’s ROA in blue, and the orange line represents that of the industry.)

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CARDINAL HEALTH

While technically classified in the consumer non-cyclicals sector as a drug retailer, Cardinal Health (CAH.N) can be viewed as somewhat of a peer to AmerisourceBergen, with its $7.1 billion in market cap almost a billion dollars higher than it was two months ago. At first glance, based on the data in the table at the top of this article, it’s hard to see just why investors consider Cardinal to be clearly attractive: the company offers market-like growth in earnings per share for the next 12- and 24-month periods. One factor is that the company offers a lower valuation, with its forward P/E of 12.3 falling 10% below that of the S&P 500. Another factor is that, like AmerisourceBergen, it’s a dividend payer with an even higher yield. Its current yield of 2.4% is well above the 1.9% for the S&P 500, and Cardinal has almost doubled its quarterly dividend payout the past four years, to 27.5 cents from 14 cents a share in 2009. Cardinal’s return on assets also is inching higher (as reflected in the blue line, below), while that for the healthcare sector as a whole has edged lower of late.

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Analysts take a neutral to bullish stance on Cardinal: six rate it a strong buy; seven have a buy recommendation and three are neutral. (Again, there are no sell or strong sell recommendations.) Those analyst views were all published prior to Cardinal’s announcement of its $2.07 billion acquisition of privately owned, direct-to-home medical supplies provider AssuraMed.

CAREFUSION CORP

Healthcare technology company CareFusion Corp hit our radar last year, during our December StarMine U.S. Sector Outlook, as being fundamentally attractive and as having outperformed last year. Since that report was published on December 13, 2012, through to February 14, 2013, the stock has risen another 14%. That contributes to the company’s high score of 86 out of a possible 100 on the StarMine Price Momentum (That is the second highest score on our list of healthcare-related names behind managed care provider Coventry Health Care’s (CVH.N) score of 97 out of 100.) StarMine’s quantitative models continue to signal that the stock should see more tailwinds than headwinds. Although its forward P/E ratio of 13.8 is just slightly above the 13.6 of the S&P 500, forward earnings per share growth for the next 12 months of 15% (and estimates that earnings will grow 13% over the next 24 months) are higher than the forecasts for the S&P 500.

Something investors on which investors have come to rely is the company’s history of beating the analysts’ mean earnings estimate when it reports its actual results. StarMine shows that the recent February 7 earnings of 54 cents a share for the just-ended quarter beat the forecast by a penny, or 2%.

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Again, sell-side analysts favor CareFusion, with four of them rating it a strong buy, five viewing it as a buy and another six maintaining hold ratings; again, among analysts who contribute their recommendations to Thomson Reuters, none have a sell or strong sell on the stock.

SUMMARY

The opportunities to find attractive stocks with limited risk aren’t confined to any particular strata of the market, but can be found among large, mid-cap or small stocks – as long as you are able to deploy a reliable screening mechanism. Using an objective quantitative ranking system that intelligently adjusts for known analyst biases and behaviors, as well as other market anomalies, as we have done in this analysis, is one such starting place.