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In 2008, the stock market did not spare the usually resistant medical device market, dropping the Dow Jones U.S. Medical Device index by 37%, barely ahead of the Dow Jones Total Market Index, which declined 39%. In past market declines, medical device stocks, along with other healthcare stocks, have generally outperformed the overall market index, reflecting the stability and defensive nature of the earnings of the companies that comprise the industry. However, in 2008, investors seemed to have paid little attention to fundamentals and threw out the good with the bad.

So what does 2009 hold in store for the medical device industry? We have no greater visibility on the overall market than anyone else. And certainly, the medical device industry is not recession proof. But we believe that on a relative basis, investors will fare better in the stocks of these companies, with less risk than other sectors of the stock market, for several reasons.

First, the underlying demand for healthcare continues to grow with the continued aging of the population in the U.S. and Europe. 13,000 Americans will turn 60 years of age every day for the next 20 years. Secondly, much of spending in the U.S. for healthcare is tied to Medicare, which is a stable source of funding. Third, much of the demand for healthcare is not tied to discretionary spending.

Even within this framework there are exceptions. We view the greatest risk to overall demand for healthcare to be unemployment and the loss of medical insurance. We also believe that because of the tight credit markets, providers such as hospitals may find it more difficult to provide services and may have to limit operations.

Given these constraints, which could last through most of 2009, we favor companies whose products are lower tech and in constant demand, regardless of the economy, such as point-of-care diagnostics, minimally invasive surgical instruments and general care products such as syringes, catheters, sutures, blood products, etc. This would favor companies such as Johnson & Johnson (NYSE:JNJ), Abbott Labs (NYSE:ABT), Baxter (NYSE:BAX), Becton Dickinson (NYSE:BDX) and Haemonetics (NYSE:HAE) and NuVasive (NASDAQ:NUVA). Elective cosmetic procedures, such as breast implants and plastic surgery procedures, are discretionary and can be postponed, making them less attractive investments in the current environment. Some higher tech devices, such as pacemakers and defibrillators, should experience flat to modest growth, reflecting the fact that they are used heavily to treat older patients for whom Medicare is their primary source of reimbursement. We would favor Medtronic (NYSE:MDT) and St. Jude (NYSE:STJ) in this category because of their strong cash positions.

We also believe that given the inability of smaller medical device companies to finance growth in a choppy market in 2009, many of them will become takeover candidates and the targets of the larger, cash rich medical device companies.

Recently, St. Jude announced two international medical technology acquisitions for a total of $533 million. St. Jude paid $250 million for Radi Medical AB of Sweden, a private company, and agreed to pay $283 million in installments, plus the assumption of a small amount of debt for MediGuide Inc, a private, developmental stage Israeli company. Medtronic has also been active of late completing the acquisition of CryoCath, a Canadian company and making a 15% equity investment in Shandong Weigao Group Medical Polymer Company Limited of China.

While valuations in this stock market environment are probably not the most reliable tool for investing, it is worth noting that based on 2009 estimates, the medical technology group is selling at 13.4X, one of the lowest P/E multiples we can remember in quite a long while.

By contrast, the orthopedic device group is selling at 16.8X and the cardiovascular group is selling at 14.3X, both at the low end of their historic valuation ranges. As such, for long-term investors, if any still exist, the second half of 2009 could represent an attractive opportunity to develop equity positions in companies with stable earnings prospects and exciting new technologies.

Disclosure: no positions

Source: 2009 Outlook for Medical Device Stocks