IHI: Medical Device Stocks Have Outperformed, But Now Appear Expensive

Summary

• IHI invests in U.S. companies that manufacture medical devices, instruments, and equipment or involved in diagnostics testing.
• IHI has significantly outperformed the broader healthcare sector and the S&P 500 in recent years supported by strong growth of its underlying companies.
• This article looks at trends in the performance and valuation of the underlying portfolio holdings.
• I do much more than just articles at Core-Satellite Dossier: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

The iShares U.S. Medical Devices ETF (NYSE:NYSEARCA:IHI) invests in companies that manufacture a wide range of instrumentation and equipment for the healthcare industry along with companies involved in diagnostic testing. This has been a strong market segment over the past decade supported by multiple fundamental tailwinds including higher healthcare spending, adoption of more complex technologies, and trends in an aging demographic. The ETF is up over 65% in the past three years, impressively outperforming the S&P 500 index which is up by 35% over the same period. Recognizing a still overall positive outlook for the group, greater macro uncertainty in early 2020 coupled with some emerging valuation concerns lead us to a more cautious view on IHI.

(Source: finviz.com)

IHI Background

The Medical devices ETF is a relatively concentrated portfolio including only 56 underlying stocks. The fund uses a market capitalization methodology and only includes U.S.-based companies. Keep in mind that some of the companies in the ETF like Medtronic PLC (MDT) and Steris PLC (STE) are technically headquartered in other countries for tax purposes, but are included in the ETF based on their operating profile and exposure to the U.S. Healthcare system. Overall, this is a large-cap fund with most of the companies recognized as leaders in their respective segments while others may be direct or indirect competitors of each other.

(Source: iShares)

As mentioned, one of the themes supporting the growth outlook for medical devices is the increasing adoption or transition towards more complex and high-tech treatments in healthcare. By this measure, the companies here are often interconnected with other healthcare industries like pharmaceutical and biotech which represent important customer segments.

While medical device companies often face strict product-level regulation, in some ways the businesses here are less exposed to political policy uncertainty that has pressured other areas of healthcare like drug makers and health insurance plan companies. Nevertheless, the 2020 U.S. presidential election is a monitoring point for the industry with implications for certain companies and particular products.

IHI Performance

IHI is down about 5.4% year to date in 2020 consistent with the current episode of market volatility and significant macro uncertainty related to the ongoing Coronavirus outbreak. We note that IHI has outperformed by the S&P 500 and the larger Healthcare Select Sector SPDR ETF (XLV) over the past decade. In the last 3-year period, IHI has returned 67.% on a total return basis compared to 36.5% for SPY and 35.3% for XLV.

The outperformance of the medical device group is related to its higher growth tilt benefiting from overall positive economic fundamentals over the period and the strong bull market in stocks. Notably, the yield on IHI is only 0.35% compared to 2.25% in XLV given its value tilt. The expense ratio of IHI at 0.43% is consistent with other industry-specific ETFs but above the 0.13% for XLV.

(Source: Data by YCharts/table author)

The table below highlights the performance data for the top 25 holdings of IHI. Abbot Laboratories (ABT), Medtronic PLC (MDT), and Thermo Fisher Scientific (TMO) are the largest holdings of the fund with a 12.7%, 12.2% and 11.5% weighting each respectively. With the 2020 year to date returns highlighted, we note that results are mixed given the wide market volatility.

(Source: Data by YCharts/table author)

Among the top 25 holdings, DexCom Inc. (DXCM) representing 2.7% of the fund has been the big winner up 29.9% in 2020 and up 100% over the past year. The company produces an innovative glucose monitoring system for diabetics and last reported earnings in February that beat expectations with a positive outlook. The company is expected to grow revenues by 20% in 2020.

At the other end, Boston Scientific Corp. (BSX) is a laggard in 2020, down by 14.9% year to date. In this case, BSX missed its Q4 earnings estimate and also offered soft 2020 guidance which has pressured the stock.

IHI Holdings Valuation

The table below highlights valuation and revenue growth estimates for the top holdings of IHI. We highlight the on-average large valuation premiums attached to most of the constituents of the fund.

(Source: Data by YCharts/table author)

Just considering the top 10 holdings which represent 70.4% of the fund, we calculate an average forward P/E multiple on the year ahead EPS consensus estimates at 26x. An average P/S ratio of 7.3x across the top 25 holdings also demonstrate what we consider to be expensive valuations for the group. The fund sponsor, iShares for its part, calculates an even higher portfolio P/E ratio on trailing twelve months results at 33.2x.

(Source: iShares)

To be clear, there is a case to be made that these companies deserve a premium valuation as leaders in their segment. On the other hand, the other trend we are looking at is generally decelerating growth with several companies among the top holdings with revenue growth estimates for the year ahead in the low to mid-single digits compared to higher rates in recent years.

We prefer to see multiples expansion driven more by top line acceleration reflecting organic growth momentum. High valuations for the group overall simply adds to the risk profile of the fund should cyclical conditions deteriorate requiring a deeper correction in the stock prices to reset expectations. This is a dynamic we explored in a recent article on Danaher Corp. (NYSE:DHR) and our coverage of Intuitive Surgical Inc. (ISRG).

Analysis And Forward-Looking Commentary

The current market environment has been defined by historic volatility and uncertainty related to the ongoing global COVID-19 outbreak. The potential that the public health crisis results in a deeper disruption to the global economic outlook represents a key risk to the medical device industry that is not immune to a cyclical downturn.

We expect continued volatility going forward but think a deeper correction could eventually result in a more attractive valuation level across the underlying holdings. At the ETF level, we see $220-$230 as an important support price with a potential move lower signaling more concerning macro trends. To the upside, a faster than expected containment of the current coronavirus outbreak and recovery to global growth will be required to improve sentiment in the group.

Takeaway

We like this ETF because of the quality of the companies supported by positive fundamental and structural growth tailwinds. That being said, we take a more cautious view of the fund at its current level considering the ongoing economic uncertainties and our opinion of stretched valuation. We think there are some interesting opportunities in some individual components but look at the momentum trend in IHI as useful to establish sentiment and market direction.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Comments

[Awayk]

I'm long IHI and appreciate the author's POV regarding valuation. Thank you! On some level think the real question is if Covid-19 will change the near-term trajectory of the market or not. If the virus effects are bad you probably don't want to be in equities and if it passes with warm weather or whatever then this ~12% dip is a buying opportunity. No plans to sell.

[Big Louie]

IHI is the a good way to invest in healthcare.
Thanks B/L

[Balance sheet guru]

IHI is a great ETF that I hold.. I'm sticking around. Medical devices and equipment will be more needed as population increases.

[Augustus]

It is not so much the increase in population as it is the aging of the population. Joint replacement is getting pretty common. Also the insulin delivery systems are getting common. Of courses, most cases of arthritis and diabetes are self induced illnesses due to diet choices. That over 60 aged population % will be really expanding. And Medicare covers the equipment so it is very little out of pocket. When devices have new models they can avoid some attempts at price controls.