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From targeting inelastic demand to providing high dividend yields, biotechnology is an attractive hedge against an uncertain domestic economy. Takeover Analyst believes that the best risk / reward healthcare portfolio can be made through investing in a combination of emerging specialists and established firms. Investors who followed our advice here and here would have seen their holdings more than double in less than five months for ImmunoCellular (IMUC) and InVivo Therapeutics (OTCQB:NVIV). Many of our other recommendations have gone on to receiving considerable takeover chatter.

In this article, we will run you through a review of Abbott (NYSE:ABT) and Pfizer (NYSE:PFE), and will then compare it to one smaller healthcare company, Emergent Health Corp. (OTCPK:EMGE). We find that all three of these companies will outperform broader indexes in both the pessimistic case of a double dip and the optimistic case of a quicker-than-expected full recovery.

To assess the value of Pfizer and Abbott, we use a discounted cash flow analysis. Takeover Analyst rates both companies a "buy" - in-line with the Street's consensus (source: T1 Banker). We model Abbott conservatively growing revenues by around 8.3% annually over the next half decade or so. This is more than 200 basis points below what is expected for the S&P 500 and is thus a safe figure. We project cost of goods sold at 40% of revenue versus 28%, 10%, and 3% for SG&A, R&D, and Capex, respectively. Factoring in net increases in working capital and taxes while adjusting for non-cash depreciation charges evidences solid free cash flow beyond what the market appreciates.

Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8% yields a price target of $80.36 for Abbott. This bullish sentiment is reinforced by double-digit sales growth in a variety of segments: established pharmaceuticals, international and nutritionals, molecular and point of care diagnostics, international vascular, and global proprietary pharmaceuticals.

A DCF model on Pfizer similarly evidences a significant discount to intrinsic value. We find that investors are overly discounting the company due to its admittedly distressing patent cliff. Insofar as the company can unveil reasonably similar catalysts to what we have seen in the past, growth, however, should be many folds higher than the 2.8% annual rate analysts have modeled.

Even accepting this bearish projection and considering that operational expenses hover around their 3-year average levels as a percent of revenue (ie. no improvement), we still find that the company is significantly undervalued. Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9.3% yields a fair value figure of $30.10. Even if the WACC was as high as 11.7%, the company's downside would still be limited. Again, this bullish case is supported by the fundamentals: fourth quarter results were strong despite the $1.3B revenue decline stemming from exclusivity losses.

Moving onto Emergent, we have yet more reasons to be bullish about healthcare. Emergent specializes in regenerative medicine - a niche field within the healthcare sector that is well positioned to gain from the aging Baby Boomer generation. In the seminal report "A Future for Regenerative Medicine", the US Department of Health projects that "the population of senior citizens over the age of 65 in the US will… total… 70 million [by 2040]". The DoH then extrapolates that as much as a quarter of the US economy will be devoted to healthcare by that time. Stressing further,

"The majority of these projected costs stem from recurring treatments for diseases that arise from tissue failure commonly seen in the elderly. The baby boomer demographic… expects the best from healthcare and will have the greatest need for regenerative medicine".

With several products targeting unmet needs and an active pipeline that is complemented by solid IP protection, Emergent is well positioned to gain from these positive secular trends. In addressing the Stem Cell Nutrition market, the company launched its patent and patent pending Stem Cell JDI MultiVitamin-MultiMineral with added Stem Cell Nutrition. More than just securing a foothold in this attractive market, this has already showcased promise through sales momentum.

Emergent's JDI International member network has reportedly realized a monthly growth rate of nearly 25%. Management anticipates that revenue will hit more than $2M this year based on that growth rate. Towards driving accelerating growth, management has launched a variety of products, including Vita-Stim Stem Cell Nutrition Concentrate, Infinity Anti Aging supplement, and Hungarest Diet & Energy Aid, among others.

While all of these products will help drive meaningful free cash flow, Takeover Analyst is particularly bullish about Vita-Stim and Hungarest. The former is a phytoceutical dispensed through physicians that can enhance the immune system, thus aiding the natural healing process. Fortunately, the combination of ingredients has been patent protected. Diet product Hungarest, which is patent pending, is distributed through Health Food Stores and helps regulate the chemical mechanism behind hunger. By dually controlling appetite in the brain and stomach, Hungarest offers a strong answer to weight reduction. Distribution is key in the neutraceutical and phytonutritional market, so implementation of a direct selling method will further catalyze sales.

Lastly, we would like to emphasize the company's note that it is well financed with working capital in the range of $1M. We believe that this is stronger than what the market acknowledges and will thus help drive in higher-risk adjusted returns. Many of the rising healthcare companies that we have worked with were in a comparable position until takeover chatter ensued.

In conclusion, we recommend healthcare investors consider building a portfolio that takes long positions in both emerging and large firms. Takeover Analyst sees that these two fields will "blend" through sector-wide consolidation. M&A activity will enable larger players to dissipate investor anxiety over patent cliffs by catalyzing revenue while enabling the smaller buyout targets to instantly gain access to broader patient populations. It's a combination worth implementing to both (1) hedge against an economic double dip and (2) ride the wave of a full recovery.

Source: How To Build A Winning Healthcare Portfolio

Additional disclosure: The distributor of this research report is not a licensed investment adviser or broker-dealer. Investors are cautioned to perform their own due diligence. We seek business relationships with all of the firms in our coverage, but research covered in this note is independent and prospectively commissioned. Always discuss investments with a licensed professional before making any financial decision. Statements made within this report may include “forward-looking statements” as stipulated under Section 27A of the Securities Act of 1933, Section 21E of the Securities Act of 1934, and the Private Securities Litigation Reform Act of 1995. All information was taken from corporate communications and public information. Since these statements are uncertain, actual results may be materially different from those expected. Please contact us for corporate notes and data.