5 Defensive Superstars In Medical Products

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 |  Includes: ABT, BCR, BDX, JNJ, STJ
by: Paul Franke

Since we are in the middle of football season, let's review some football words of wisdom and translate them into successful stock market investing suggestions. "Defense wins championships!" was an idea popularized by University of Alabama's famous football coach, Paul BEAR Bryant. For stock investors, when the market is going nowhere fast or declining in price during a bear raid or recession, keeping your capital whole is a paramount concern. Truth be told stock gains come and go for long-term investors in any given multi-year stretch.

Maintaining stock market gains may be the most difficult part of the investing process to master for the average person. Often investors in hot stocks and sectors during a bull run, end up giving back those profits or even taking losses on the round-trip, as equities turn cold. How can investors hold onto their gains or even outline new profits in a market downturn?

A football truism popularized by Green Bay Packer coach Vince Lombardi is likewise a great focusing tool for investors to consider in late 2013. "The best defense can be a good offense!" Similar terms regarding an attacking defense have permeated game playing and war philosophy throughout history, including the works of Machiavelli and Sun Tzu. Can we have both as investors - a defensive juggernaut of holdings that hold their own in a market dive, and are also so strong and desirable they actually are able to climb in value/price?

Historically, the answer is YES! There are sectors and companies running business operations that either survive recessions just fine, or see yet more revenues and profits as a side effect of weak consumer confidence. Often these sectors are referred to as recession proof. While not true in every instance, for every stock, throughout a myriad of economic slowdowns the last century, consumer staple, brand name, high profit margin, strong balance sheet companies in the health care, food, and consumer product categories have performed much better than the S&P 500 average in bear markets and recessions. The trick is selecting the best situated for the current down cycle.

For example, during the worst years of the 1929-1933 stock market crash and depression in economic activity, only a handful of stocks like gold/silver miners and Coca-Cola (NYSE:KO) were able to outline gains against a crushing (financially and spiritually) 80% stock market decline generally. During the 2000-2003 technology bubble bust drop of 50% in the S&P 500, most every pharmaceutical and medical products stock was flat to higher in price. The recent 2007-2009 real estate bubble bust cycle proved an incredible headwind to rise into, but a long list of defensive selections, including many listed later in this article, outperformed the 60% market price shellacking by only dropping 10%-30% during the same span? Every cycle is different, so what should be on our radar screen?

I would rate companies like General Mills (NYSE:GIS), Coca-Cola , Procter & Gamble (NYSE:PG), Kimberly-Clark (NYSE:KMB), McDonald's (NYSE:MCD), Pfizer (NYSE:PFE), Merck (NYSE:MRK) and others as having sound value and defensive characteristics. However, as we transition into the next bear market and recession, one group appears to have the strongest foundation for price appreciation going into 2014.

Medical product companies have been the clear price performance winners the last twelve months out of the defensive sectors, and are typically leaders during bear markets for stocks the last 50 years. My momentum screens highlight this sector as showing the greatest current buying interest by investors, while maintaining above average fundamental value characteristics.

Abbott Labs (NYSE:ABT)

Abbott Labs just completed spinning off its pharmaceutical division in early 2013 as a separate publicly-traded company, AbbVie (NYSE:ABBV). In an effort to slash research and development expenditures related to a long list of higher risk prescription drug trials, and release itself of some drugs coming off patent, Abbott split into two organizations. Most all the pharmaceutical business and some debt went into AbbVie, while the rest of pre-split Abbott remained with the namesake traditional organization. The new Abbott has about 70,000 employees and $22 billion in annual sales. So far, both company stocks have performed well in 2013, as renewed management focus on operational results and investor attention on each unit have unlocked the real value of the pre-slit Abbott businesses.

The remaining Abbott assets are lower risk, stable demand health care products, ranging from leading brand name Similac infant formula at your local grocer, dog/cat medical items used by veterinarians, medical diagnostic tests and tools found at every hospital in the world, to iLASIK eye surgery products, and more. Literally, Abbott manufactures and sells hundreds of products sold all over the world (with better than 60% of 2013 sales originating outside the U.S.), and this diverse mix of items and marketplace geographies creates one of the most stable revenue streams, in good times and bad, of any company on the planet. Abbott is perhaps my single best, high "margin of safety" idea in the defensive stock sectors. Abbott's operational restructuring and rationalization effort in 2013, diverse product line-up, strong fundamental value at the current $38 stock price, and stable growth-based business future should be considered by all long-term investors as a core holding going forward. Abbott announced a large new share buyback program in June and just weeks ago raised its dividend payout. Both efforts should help support buying interest going forward.

Based on numbers in the September quarter earnings statement released in October, and Wall Street analyst consensus forecasts for GAAP EPS in 2014 [available on Yahoo! Finance and numerous other websites for free] the company should generate about $2.75 in free cash flow per share next year. We are adding 50 cents per share in amortized intangibles expense to the EPS estimate of $2.25 presently. The extra $800 million annually in accounting expense for amortization is a non-cash charge on the cost of previously businesses purchased, and is actually kept by Abbott to reinvest or pay out to shareholders. Abbott's tried and true expansion strategy over the decades has been to take income earned to purchase similar yet smaller sized, strategically fitting product lines. I fully expect the company to continue this successful growth strategy, as they are recognized year-in, year-out as one of the top dealmakers in healthcare. A combination of regular and digestible acquisitions, a slowly expanding economy, and share buybacks should allow for future growth rates in free cash flow per share of 7%-12% annually.

Today's 2.3% dividend yield, 14x multiple on 2014 estimated yearly free cash flow, high GAAP net profit margin of 12% after taxes, ultra-conservative balance sheet (with its current liquid assets roughly equal to the company's total in liabilities, long and short-term), diverse product mix, plus ongoing manager reassessment of its business risk profile in favor of sensible growth, in unison, argue for a much higher stock price in coming years. On a simple scorecard of fundamental and technical trading criteria vs. the S&P 500 average large capitalization alternatives, Abbott's present business and stock position looks better in nearly every category. The added kicker for shareholders is the potential for above average growth in profits, simply from the spin-off refocus of management, in my humble opinion.

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Charts courtesy of StockCharts.com

Johnson & Johnson (NYSE:JNJ)

Johnson & Johnson is a close second choice to Abbott in medical products from my thinking when reviewing the whole stock investment picture. The company is actually much larger in sales size and individual offerings than Abbott with a year-to-date 55% total from international sales, and 120,000 employees globally. Johnson & Johnson's amazingly vast pharmaceutical and over-the-counter health care divisions provide an even stronger and more regular revenue stream, beyond the basic medical products niche Abbott is trying to carve out. Ranging from Band Aids, Listerine and Tylenol, to heart implants, popular contact lenses, and a long list of the biggest prescription drugs on the market, the organization is awash in name brands and oversized profit margins. Johnson & Johnson is estimated by Wall Street to earn $15 billion in profits for 2013, after taxes, on $70 billion in revenues, for a sky-high 20%+ net margin!

Investors buying at $95 a share get a current annual dividend yield of 2.8% that will likely rise over time. Based on 2014 Wall Street consensus estimates, Johnson & Johnson is trading at 15x forward free cash flow. The balance sheet is ultra-conservative, just like Abbott's, earning an A+ score for safe-minded investors. The company has nearly the same total of liabilities as short-term assets, and has annual cash flow of roughly $20 billion vs. $32 billion in long-term liabilities at the end of September 2013.

Remember, health care products and pharmaceuticals are not entirely risk-free businesses. High profit margins come with the occasional flop in demand for an item, patents ending, or a real catastrophe like a product recall. Johnson & Johnson has encountered more than its share of safety and liability issues from offerings in 2010-13. Just this week they announced a $2.5 billion settlement for a hip implant discontinued for causing major health problems in patients. For safety minded portfolios, it is a critical you employ capital into diversified medical/health related companies, to mitigate the risks involved in trying to help sick patients get better. Truth be told, human beings are fallible and product inventions have side effects.

I give the investment edge to Abbott from its slightly better valuation at present quotes, smaller size allowing better growth rates into the future, and refocused management after the spin-off providing an extraordinary boost to results in 2014-15. For well-heeled and more diversified thinking investors, owning both Abbott and Johnson & Johnson makes plenty of sense. Why not have two all-stars on defense, in case one gets hurt?

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CR Bard (NYSE:BCR)

CR Bard is one of a large number of businesses in medical products selling surgical, patient care, and diagnostic devices directly to physicians and hospitals. As a group this sector saw stock prices held back first by the 2007-2009 bear market generally, then the negative effects of Obamacare's confusing and not entirely predictable rollout since 2010. A 2.5% excise tax on medical devices is still in place going into 2014, and has been a major reason Wall Street investors have drifted away from medical products as a group in 2010-2013. The odds of its repeal seem to be fading in 2014 or 2015 after the latest government shutdown fight failed to galvanize political opponents of the tax.

Bard is best known for its vascular, urology and oncology products, but literally has hundreds of items for sale and under patent in a variety of fields and body care emphasis. The company had better than 12,000 employees at the end of 2012, and held a first or second place position in market share across 80%+ of product sales. In business for over a century, and publicly traded for 50 years, Bard is a leading health care name for investors, on numerous metrics.

Despite a relatively modest climb in its stock price since 2005, Bard's operations and underlying business value have grown to a point where Wall Street has started to bump up the share quote in 2013. Bard's diverse product line and high level of overseas sales should limit any short-term headwinds caused by the new Obamacare tax and related demand issues from health care delivery changes in America. Compared to ending 2004 results nearly a decade ago, a rough 200% jump in earnings per share projected by Wall Street consensus for 2014, alongside a similar 150% rise in revenues per share, have translated into a much lighter 80% price climb to $137 per share currently. Bard's stock price has increased a strong 35% during 2013, as pent up value is rising to the surface. Investors appear to be discounting the Obamacare tax situation, and looking forward to even better results by Bard in 2015 and beyond.

Bard just recently announce it was selling its stagnate growth electrophysiology business to Boston Scientific (NYSE:BSX) for $275 million. I like the fact that management is willing to liquidate slower moving businesses to focus on the higher margin, stronger positioned ones. The company will use the proceeds to pay down debt, repurchase shares and invest in brighter outlook product lines.

Taking into account the sold business for cash, continued share buybacks reducing the float of shares, Wall Street estimates of GAAP EPS for 2014, and the extra cash flow available to owners from the non-cash amortization of past business acquisitions, Bard is today priced at a relatively modest 15x free cash flow annually. The company's steady revenue stream, high net profit margin after taxes approaching 18% of sales in 2013-14, and stellar balance sheet argue for a premium valuation of Bard's assets and organization. Since Bard could pay off all liabilities on the balance sheet from liquid assets on hand, plus one year of operating cash flow, the free cash flow calculation for owners is an even more realistic, repeatable number compared to other leveraged companies. The 6.5% projection in yearly free cash flow, after taxes, at the current share price stacks up quite favorably against zero at the bank for savings, 3.8% (before taxes) on the static yield for 30-year Treasury bonds, plus thousands of alternative "higher risk" stock and bond investments putting less money in your pocket currently.

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St. Jude (NYSE:STJ)

St. Jude is a leading developer, manufacturer, and distributor of cardiovascular and implantable neuro-stimulation medical devices worldwide, with 15,000 employees and $5.5 billion in sales annually. The company has done quite well against its larger competitors of Medtronic (NYSE:MDT) and Johnson & Johnson with innovative new heart related products. A bonus catalyst for oversized gains in both St. Jude and Bard is their tempting takeover size. It would be quite easy for a big competitor to snatch up either at current quotes and fold their businesses into a larger organization in the same business. Accounting for the newly created goodwill write-off each year as amortization expense, and synergies in function and distribution, St. Jude and Bard are tempting targets right now.

St. Jude is priced with a 1.7% dividend yield annually at a $57 stock price. The company is valued around 14x free cash flow for 2014 estimated by Wall Street consensus numbers. St. Jude has a strong balance sheet with total liabilities equal to short-term, liquid current assets, plus one and a half years of cash flow. A 15% net profit margin, after taxes, highlights the desirability of St. Jude's products by physicians and patients alike. While the new Obamacare tax will take a bite in 2014, it will be the same headwind as competitors experience. In addition, St. Jude's devices are more of the emergency and life-saving demand that may not be greatly affect by the excise tax of 2.5%. We will have to see how demand changes over time from the battling forces of a growth in aging baby-boomers seeking implants vs. a desire by Uncle Sam to reduce government outlays for such.

From a technical pattern perspective, St. Jude was a $50 stock in 2005. The 2013 breakout above the $50 level after an 8-year basing period is quite positive historically. The odds of a stock price outperformance span in St. Jude during the next 2-3 years appear to be expanding for long-term investors. The combination of decent valuations, defensive business characteristics and stock trading history, real takeover potential and a technical stock price breakout higher argues for serious consideration in low risk - high reward portfolio creation.

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Becton Dickinson (NYSE:BDX) has experienced perhaps the most stable management style and regularly conservative financial leverage of any company I have watched the last three decades! Steady reinvestment in research and development, small acquisitions, and stock buybacks have put a constant breeze behind the growth in per share results at Becton for many years, without extending massive leverage or operational risk for owners. I marvel at this company's competency and success at managing its long-term financial ratios, including revenue and income per share growth. The basic accounting structure and business risk for this entity have not changed much in any given year, and this consistency has not been properly rewarded by Wall Street evaluators, in my opinion.

Becton is a global leader in medical devices, instruments and reagents. Everything from needles, syringes, intravenous bags, blood collection and testing equipment, to laboratory automation and diagnostic equipment are the company's specialties. Like other medical equipment mentions in this article, Becton has been in business for better than a century, with 30,000 employees and a solid $8 billion in annual sales. So what is Becton worth?

At the present $108 share quote, Becton Dickinson enjoys a 1.8% dividend yield and is valued under 15x projected free cash flow for 2014 according to Wall Street consensus numbers. The company has a super strong balance sheet holding enough liquid current assets, in addition to needing just one year of operating cash flow to pay off its total of liabilities at the end of June. The net profit margin, after taxes, on total sales is tracking around 15% during 2012-13.

Becton's regular dividend and business growth trend in good times and bad has encouraged several high profile investors and hedge funds to acquire big stakes in Becton during 2010-13, including the legendary Michael Price. Like our other favorites in medical products, Becton's stock quote rise above $90 during 2013 represents a breakout move, after basing in price for a 7-year period in the $60-$90 range. To give you an idea of the power of compound interest on a solid long-term investment, if you had invested $1,000 in Becton Dickinson in 1986 (the year I started investing) you would have in excess of $25,000 today, including dividends! Honestly, I have had trouble holding Becton for more than a few years - so that wasn't my return, darn it. Becton generated this super-sized return from one simple buy and hold decision, while the equivalent S&P 500 gain the last 27 years proved a not too shabby $12,000 either.

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Mini-Portfolio

My Seeking Alpha articles are going to concentrate on stocks that show a combination of strong fundamental valuations and technical momentum buying. As a group Abbott Labs, Johnson & Johnson, CR Bard, St. Jude and Becton Dickinson have outperformed the market averages on the respective 1-month, 3-month, 6-month and 1-year charts pictured below. Each stock has outlined a unique pattern in price gain and volume buying interest, while they have taken turns leading the pack. In my research, these five defensive superstars in medical products historically and currently look primed to rise further in 2014, with only a market crash scenario potentially slowing them down.

1-MONTH

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3-MONTH

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6-MONTH

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1-YEAR

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Charts courtesy of Yahoo!

Conclusion

Typically at the end of a bull market run defensive sectors start to witness increased buying by experienced investors. We have seen defensive stocks performing better in 2012-13. Another late cycle trading phenomena is a move higher in move oil/gas stocks alongside defensive ones. As mentioned in my article 6 Top Blue-Chip Energy Stocks For Long-Term Investors, a large number of energy stocks have been rising strongly the last 6-12 months. With U.S. stocks generally trending higher in price over a very long period of two years without a 10%+ correction, and nearly five years without a decline beyond 20%, the odds of some sort of market meltdown or shakeout appear great, and well overdue in November 2013. Does the lack of a serious correction guarantee one will happen? No, but defensive stocks should be on the investigative front-burner and in the thought process of rational investors looking to diversify or hedge their stock market gains of late. Not holding some defensive sector stocks going into 2014 may prove a costly mistake in portfolios seeking a true risk/reward balance. Remember, "Defense wins championships!"

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ABT, JNJ, BCR, STJ, BDX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While I do not hold any shares of the superstars listed at the time of writing, I have targeted these companies for future near-term purchase in my own account given a market sell-off generally.