'Non-Cyclical Consumer Healthcare': How This Sector Will Create Long-Term Wealth

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Includes: ACN, AKRX, ANTM, AZN, CNC, EW, FICO, GILD, GSK, JNJ, LLY, MCK, MOH, MRK, NVS, ORCL, PFE, RMD, SNY, SRCL, VRSK, WCN
by: Peter Mantas

Summary

Demographic trends in the healthcare space could create margin expansion and value creation for certain names over the long-term.

Consumer healthcare will continue to be a very important macro-trend over the next few decades.

Companies like McKesson (MCK), Edward Lifesciences (EW) or ResMed (RMD) should see faster growth than traditional big pharma.

Allow me to provide you with a hypothetical portfolio containing only 5 stocks. This portfolio is somewhat diversified in that each company operates in different markets with different threats, competitors and opportunities, but all 5 companies have one thing in common - they all operate in what I like to call the "non-cyclical consumer healthcare" sector.

Let's look at the specifics of the portfolio: Company A operates in bio-hazardous waste removal at your local doctor's office or blood clinic, Company B provides sleep apnea equipment and humidifiers for the home, Company C is in drug retailing and distribution, Company D manufactures heart valves for critically ill patients, and Company E manufactures ophthalmic medications and OTC products (i.e. eye drops) for consumers. The main characteristic of the 'sector' is this: it involves companies that create healthcare products that are integral to the lives of consumers or make the delivery of family medicine more effective but without the incredibly large cap-ex or intense R&D expenses involved with your typical pharma giant or biotechnology firm (i.e. typically 20% of sales goes to R&D for large pharma or biotech compared to less than 10% for companies in this 'sector').

Rethink Pfizer (NYSE:PFE), Sanofi (NYSE:SNY), Gilead Sciences (NASDAQ:GILD), AstraZeneca (NYSE:AZN), Eli Lilly (NYSE:LLY), Merck (NYSE:MRK), Novartis (NYSE:NVS), GlaxoSmithKline (NYSE:GSK) or Johnson and Johnson (NYSE:JNJ). These businesses are elephants in the pharma jungle and have massive purses focused on their R&D. Huge cap-ex, huge investments, potential for write-downs and losses. Their business model is chasing their never ending patent expirations and occasionally anchoring certain brands to broaden their portfolio (i.e. Neutrogena for JNJ or Sensodyne for GSK). Moreover, rethink biotechnology. The volatility in some of these names can be difficult to stomach and the cash flows generated by these businesses is much less predictive than the pharma giants.

There is no question certain biotech names have done very well over the last 5 years, some giving investors over 10x return in that timespan, but this sector requires specialized knowledge and productive research pipelines so that companies may create joint ventures with the big pharma giants to achieve mass production. To be clear, none of the aforementioned sectors or businesses are bad investments. An investor with thorough research who is confident in these businesses and has a long-term outlook can do very well, sometimes beating the market by very large percentages. However, this third sector, the "non-cyclical consumer healthcare sector", has much more predictive business models (lower beta), strong organic growth, large margins and goes to the heart of what is necessary to the successful mass consumption of medicine. They are businesses that have recession proof portfolios and their 'moats' are created by scale, acquisitions and affordable innovation leading to quality products, services and brands.

Back to our hypothetical portfolio for a moment: how has this portfolio performed and what are these mysterious companies?

Over the last 10 years, this portfolio has performed 545.69% versus 83.39% by the S&P 500 (see Figure 1). What's more, this portfolio has a beta of just 0.56, indicating pretty impressive risk-adjusted returns compared to the 2+ beta commonly seen in many biotech names. The companies in this portfolio are: Stericycle (SRCL - Company A), ResMed (RMD - Company B), McKesson (MCK - Company C), Edward Lifesciences (EW - Company D), Akorn (AKRX - Company E).

Figure 1:

It is evident that these leaner, smaller and growing enterprises within this sector have had a great run, but will this performance continue and will this sector outperform in the future?

It is predicted that on a macro-level, consumer healthcare will grow by at least 50% over the next 5 years. Highly specialized players focused on niche markets (like the names in our hypothetical portfolio) may outperform the broader market over the long-term for a number of reasons, including but not limited to: increased demand on individual well-being due to aging, growing and shifting populations; governments seeking to control administrative healthcare costs; continued innovation leading to new products and markets; continued international expansion into "pharmerging markets"; healthy margin expansion; potential consolidation within the sector.

Concomitantly, prudent management and sound corporate strategy play a central role in the success of these companies. For example, Stericycle has a very focused corporate strategy which propelled them out of their struggles in the early 1990s to the strong cash flow operator it is today. Rather than targeting large pharmaceutical giants as clients, SRCL decided to establish itself piece by piece in very small markets (i.e. providing waste disposal for family doctor's offices and small blood banks where the contracts are smaller but the margins and switching costs are higher) which later created the cash flows necessary to expand into new markets (i.e. retail bio-hazard waste removal, manufacture recalls).

This strategy of has been hugely successful for SRCL: the company has made over 350 acquisitions domestically and internationally since 1993 and this grassroots approach to bio-hazard waste removal has made them vital for millions of medical professionals around the globe. It has cemented their brand with that of 'quality waste removal', 'safety' and 'compliance' which has led to very large contracts with hospitals, pharmaceutical firms and international organizations (i.e. SRCL acquired a special permit for Ebola waste removal during the West Africa outbreak in 2014).

Unlike SRCL, Waste Management (WM) did not have a strong presence in bio-hazard removal and only recently (2009) decided to compete with SRCL "head-on". However, WCN knows one thing: they can only go after the large hospital and pharmaceutical contracts. Why? Because the footprint that SRCL has created for 'micro' waste disposal market is very deep: SRCL has too much scale and brand equity in this 'mass medical' market which leaves WCN with the unenviable task of competing with SRCL through a market with lower switching costs, lower margins and more internal competition.

There are many examples of solid strategic initiatives by companies in this sector (i.e. ResMed's core growth strategy is to focus and promote sleep testing equipment for the home and enhancing communication between primary care physicians and the patient) but it is important to note that we are not suggesting a blanket 'outperform' rating by every single company in this sector. Business always has winners and losers, and there will certainly be some 'losers' in this sector if companies are not focused, lack hunger and innovation or do not adapt or prepare to the dynamics of changing global markets.

Another way to get exposed into this sector is to look at technology. Big data is changing the way healthcare companies of all levels (hospitals, pharmaceutical companies, medical supply companies and biotech companies) are able to recognize and meet the demands of patients. It is estimated that big data will contribute at least $300 billion in value to US healthcare every year.

Names like Anthem Inc. (NYSE:ANTM), Fair Isaac Corp. (NYSE:FICO), Verisk Analytics (NASDAQ:VRSK), Centene Corp. (NYSE:CNC) and traditionally large tech players like Oracle (NYSE:ORCL), Molina Healthcare (NYSE:MOH) and Accenture (NYSE:ACN) will all benefit from this growing market as productivity demands for healthcare analytics continue to rise.

Overall, as long-term investors seeking value, we will continue to monitor this sector and allocate capital to select names. At minimum, a long-term investor should carve up a portion of their portfolio to this sector if he or she wants to see above average returns over the next 25 years.

Disclosure: The author is long SRCL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.