Medical Devices: The Next Big Trend?

When people are frightened, they cut their time horizon dramatically, … Even advisors will say to sell because they see portfolios crumble and they fear people will have nothing left. It’s really not rational, but it does happen.

That’s what David Dreman wrote in his book Contrarian Investment Strategies. Now, almost 30 years later, it’s looking like it’s happening all over again.

People are getting frightened they’ll have nothing left, and portfolios are crumbling.

The market’s main focus is on what the latest government plan will look like when it’s revealed later this week (talk about dramatically shortened time horizons). But hey, this was expected. We knew the stimulus plan wasn’t worth much, and frankly, hopes of a government-orchestrated solution having any impact in a few months time were just irrational. But this is just what we’ve been waiting for.

As you’ll soon see, a very strong pocket of strength is forming in one sector, and it will be safe to jump in soon. It’s shaping up just as we’ve been expecting, but first we should go over a few areas the markets will be forced to “reckon” with over the next few months.

“This is the worst”

A few months ago, we questioned whether the markets really priced in 9% to 10% unemployment. It looks like the market is starting to get its first glimpse of what it will look like, and it doesn’t like what it sees.

On Wednesday morning, the Dow was off more than 3% and the NASDAQ and S&P 500 were off even more. Hopes for a recovery in the second half of 2009 appear to have faded completely. At the time of writing, Chrysler and GM (NYSE:GM) had more or less failed to deliver a recovery plan, and now it looks like bankruptcy or more bailout cash is only a few weeks away.

There’s practically no reason to get excited about anything over the short term, and the analyst community (which seems like it’s always the last one to realize how bad things really are) is feeding a very hungry bear.

Over the weekend, Howard Silverblatt, an analyst for Standard & Poor’s, stated:

This is the worst; after the sixth quarter of negative growth, it will be the first quarter ever of negative earnings.

According to Silverblatt, the S&P is in for a horrible round of earnings this quarter. The current estimate is for a loss of $10.44 - that’s lower than already low expectations. In his 2008: Annus Horribilus, RIP post (from January), John Mauldin noted the decline of earnings expectations for the S&P 500. Take a look at the chart below:

It appears even those were a bit too optimistic. The worst part is that the Q4 decline offsets all earnings from Q3 and puts 2008 earnings for the S&P 500 at about $28. With the S&P at 789, that puts the trailing P/E for the index at a lofty high of more than 28. Considering there are no signs of an economic recovery in 2009, the forward P/E could be much higher (remember, the long-run average P/E for S&P 500 is about 15).

That’s just one realization the market has to go through yet. However, another, potentially bigger problem exists.

California Leads the Way

We’ve talked before about how state government’s are in deep trouble before. Now the whole world is quickly learning how bad it’s going to get for free-spending states.

For example, excluding pension plans for former employees (which would make at least a dozen states technically insolvent), 44 states will face budget deficits this year. The average deficit across all states is 15% (that’s considering fairly rosy estimates on the revenue side too). This can’t go on. And, to see what happens when it stops, just look at California.

The world’s eighth largest economy has the biggest budget deficit of all. It’s so bad there, that the government has been forced to cut back. Over the weekend, California announced it would be laying off 20,000 employees - that’s a little less than 10% of the state’s employees.

What’s the reason for such drastic measures? Well, the Golden State couldn’t get a budget passed. The state’s Democrats wanted to raise taxes to fill the void, and the Republicans wouldn’t budge. (I’m sure it’s just political posturing from a party that seems to be marketing itself as the “low tax, small government” party once again – both parties have proven they can squander money as well as the other.)

Of course, California has faced budget shortfalls before, but this time around, no one will lend money to California. The state is already too deeply in debt, and it has the worst credit rating of any state in the U.S. Now that regulators and economic constraints are forcing banks to look at the creditworthiness of borrowers once again, California just isn’t making the grade. The pension funds aren’t stepping up either.

It’s a stalemate and the consequences are good and bad. Over the short term, there are another 20,000 people to add to the ranks of the unemployed, and over the long term, it could mean (dare we hope!) smaller government.

But you have to remember; we’re focused on an increasingly shortsighted stock market here, so this news is bad - all the way around.

An Undeniable Pocket of Strength

There’s no side skirting this one. It’s ugly out there and it’s getting worse, with state budget deficits and a federal stimulus package doomed for failure, slowly but surely, the market is realizing the seriousness of the situation. There is, however, a good side to it all.

Remember a few weeks ago when we talked about how Barometer Capital’s little known, but highly successful David Burrows focuses on finding strength and buying it.

Well, we’re seeing a pocket of strength emerge right now. In the chart below there is a clear separation between the S&P 500 - gold line and iShares Dow Jones Medical Devices (IHI) – black line.

click to enlarge

Both have had a rough year, but the IHI is showing some life. Meanwhile, the S&P 500 is testing its November lows. That proves there’s a lot of interest in healthcare, and more specifically, it shows there’s a lot of interest in medical device companies.

IHI is made up of the leading medical device companies. The IHI is dotted with great companies with great products and facing many great years ahead. For instance, Intuitive Surgical (NASDAQ:ISRG), maker of the Da Vinci robotic surgery equipment, makes up about 3.5% of IHI. And Covidian (NYSE:COV), which is a company so strongly positioned it’s safe to say that every hospital in the U.S. has at least one Covidian product in it, makes up more than 7% of the IHI.

Right now, there is a lot of strength in medical device stocks. They will likely do well in the face of more market sell-offs, and will likely do great in the event of a recovery. That’s why you stick to pockets of strength. That’s the only place where you’ll find safety and upside potential in a market like this.

Remember, days like today are what we’ve been waiting for, and they’re why I’m terribly excited about the months and years ahead. Every so often, you can get in on a big trend pretty early, and when this happens, there is nothing like it.

I bought my first oil stock in 1999. When the tech market crashed, I loaded up on water utilities (sounds boring I know, but I cashed in a three-bagger in water a few years later), and I moved into agriculture in 2006. Healthcare is shaping up to be one of those opportunities.

Disclosure: None

Comments

[lemoneater:]

Read ISRG's last earnings transcript. Doctors are finding Da Vinci an extremely useful tool to help them do more and more tricky surgical procedures allowing more of the patients' organs to be repaired reducing the need for transplants. Disclosure ISRG and TNH are the only stocks I have that are currently in the green.

Feb 19 10:01 AM

[User 348251:]

A win win for isrg. The best of the best and its cheap.

Feb 19 03:14 PM

[PauvrePapillon:]

If you’re attracted to medical device stocks that have performed well lately, why not take a look at Accuray (ARAY)?

When the market (correctly) understood that CyberKnife was a truly unique and revolutionary technology, investors bid Accuray’s post-IPO shares up to an intraday high of $31.09 (9 February 2007). As Varian and others made repeated claims, in numerous press releases, interviews and conference calls, that their gantry-mounted machines could do the same thing as the robotically controlled CyberKnife, Accuray’s market cap shrank even though its economic fundamentals actually improved.

On 6 December 2008, Accuray, finally, fired back with the release of two animated videos that effectively demonstrate what CyberKnife is and why it is fundamentally different from gantry-mounted radiation sprayers. You can see them for yourself at www.accuray.com.

Since then, Accuray shares have gone up 22 percent (as of close of market Friday 20 February 2009) while Varian’s shares have gone down 12 percent while Tomo and ISRG are both down 23 percent against the backdrop of a NASDAQ index that has lost 4.5 percent.

Are investors now beginning to rethink this space and conclude that Accuray really does have something?

From Breakthroughs That Will Change Lives in 2009…

“Cyberknife has the potential to replace surgery as the first form of treatment for cancer,” says Dr Nick Plowman, director of clinical oncology at St Bartholomew's Hospital.

www.dailymail.co.uk/he...

Is CyberKnife just now being discovered by, and moving into, a huge market?

See WSJ’s Is CyberKnife Ready for Prime Time in Prostate Cancer?

blogs.wsj.com/health/2...

And it’s making waves in Europe and Asia as well…

From ABC News London…

www.abcnews.go.com/Vid...

And most CAPS players like it…

caps.fool.com/Ticker/A...

You might still be able to make some money with Intuitive Surgical but with Accuray you have a serious candidate for a multi-bagger in the making whose underlying technology is still in the early stages of its adoption curve. Peter Lynch would be all over this one.

Feb 22 10:15 PM

[PACS:]

people have to invest more in medical technologies

Apr 27 07:57 AM