IHI: Overvaluation Offsets Bullish Health Care Fundamentals For Medical Devices ETF
Summary
- Medical Devices ETF (IHI) has handily outperformed broader markets over the past 10 years.
- Weighted average price-to-book ratio on IHI's top 10 holdings surpassed the most expensive level since 2004 just ahead of the virus-driven correction.
- Subpar revenue growth and return on equity along with overvaluation suggest upside potential in IHI is limited.
- We expect health care ETF (XLV) to outperform going forward considering XLV's more moderate multiples and robust earnings.
iShares US Medical Devices ETF (NYSEARCA:IHI) crumbled alongside broader markets on an escalating global Covid-19 contagion, with a roughly -10% year-to-date performance which is mostly inline with S&P 500 (SPY) and health care sector (XLV). On a longer-term basis, IHI has been a stellar outperformer, particularly since 2017 when IHI took off and has been ahead of the pack:
Source: WingCapital Investments
Rich Valuations & Slowing Earnings Growth: 2 Headwinds Facing IHI
Ever-increasing demand for new technologies and products due to aging populations in developed countries as well as health care expansion in emerging markets has certainly led to the tremendous gains in medical devices companies. While macro fundamentals will undoubtedly continue to be favorable for IHI, overvaluation warrants caution as the price-to-book ratio of its top 10 holdings had turned most elevated since 2004 as of end of last year:
| Symbol | Name | % Weight | P/B as of 3/31/2004 | P/B as of 12/31/2019 | P/B as of 3/2/2020 |
| ABT | Abbott Laboratories | 12.75% | 4.92 | 4.83 | 4.54 |
| MDT | Medtronic PLC | 12.33% | 6.73 | 3.09 | 2.66 |
| TMO | Thermo Fisher Scientific Inc | 10.85% | 2.0 | 4.37 | 4.1 |
| DHR | Danaher Corp | 7.96% | 3.85 | 3.72 | 3.66 |
| BAX | Baxter International Inc | 4.65% | 5.35 | 5.35 | 5.69 |
| SYK | Stryker Corp | 4.63% | 7.74 | 6.14 | 5.77 |
| ISRG | Intuitive Surgical Inc | 4.46% | 1.99 | 8.26 | 7.81 |
| BDX | Becton, Dickinson and Co | 4.37% | 4.07 | 3.48 | 3.14 |
| EW | Edwards Lifesciences Corp | 4.35% | 3.34 | 11.76 | 10.73 |
| BSX | Boston Scientific Corp | 4.07% | 11.26 | 6.5 | 3.84 |
| IHI Top 10 | 70.42% | 4.91 | 5.11 | 4.66 |
Source: TIKR.com, WingCapital Investments
A correspondingly high profitability certainly would justify the increase in price-to-book ratios, though that does not appear to be the case for IHI. Specifically, return on equity on the top 10 holdings collectively is a mediocre 15%, which in fact is no higher than 2004 albeit rising steadily the past few years:
Source: TIKR.com, WingCapital Investments
To put it in perspective, below compares the IHI's weighted median ROE and P/B ratios to several S&P sectors as well as S&P 500. We observe that IHI's ROE is lower even than the financials (XLF), but has a P/B more than 3 times higher than that of XLF. Similarly, health care (XLV), industrials (XLI) and S&P 500 (SPY) all boost substantially higher ROE while having lower P/B ratios:
| Fundamentals | IHI | XLF | XLV | XLI | SPY |
| Sector | Medical Devices | Financials | Health Care | Industrials | S&P 500 |
| Weighted Average Price to Book Ratio | 4.803 | 1.455 | 4.211 | 4.421 | 3.399 |
| Weighted Median ROE | 12.82% | 15.43% | 24.24% | 29.21% | 26.51% |
Source: YCharts
Growth prospect does not look rosy neither, as revenue growth on most of the top 10 holdings has tailed off and been rising by only single digits. For instance, Medtronic (MDT), the 2nd biggest holding representing 12% exposure of IHI, has beaten earnings estimates in the last quarter but missed revenue targets. As Zacks further pointed out, "escalating costs and expenses persistently put pressure on its margins." which reaffirms above observation on ROE.
| Symbol | Name | % Weight | 2014 Revenue | 2016 Revenue | 2018 Revenue | 2019 Revenue | Revenue Growth | 5-Yr | 3-Yr | 1-Yr |
| ABT | Abbott Laboratories | 12.75% | 20,247.00 | 20,853.00 | 30,578.00 | 31,904.00 | 57.57% | 52.99% | 4.34% | |
| MDT | Medtronic PLC | 12.33% | 16,893.00 | 28,833.00 | 29,953.00 | 30,557.00 | 80.89% | 5.98% | 2.02% | |
| TMO | Thermo Fisher Scientific Inc | 10.85% | 16,889.60 | 18,274.00 | 24,358.00 | 25,542.00 | 51.23% | 39.77% | 4.86% | |
| DHR | Danaher Corp | 7.96% | 12,866.90 | 16,882.40 | 17,048.50 | 17,911.10 | 39.20% | 6.09% | 5.06% | |
| BAX | Baxter International Inc | 4.65% | 10,719.00 | 10,163.00 | 11,127.00 | 11,328.04 | 5.68% | 11.46% | 1.81% | |
| SYK | Stryker Corp | 4.63% | 9,675.00 | 11,325.00 | 13,601.00 | 14,884.00 | 53.84% | 31.43% | 9.43% | |
| ISRG | Intuitive Surgical Inc | 4.46% | 2,131.70 | 2,706.50 | 3,724.20 | 4,478.50 | 110.09% | -65.47% | 20.25% | |
| BDX | Becton, Dickinson and Co | 4.37% | 8,446.00 | 12,483.00 | 15,983.00 | 17,290.00 | 104.71% | 38.51% | 8.18% | |
| EW | Edwards Lifesciences Corp | 4.35% | 2,322.90 | 2,963.70 | 3,722.80 | 4,348.00 | 87.18% | 46.71% | 16.79% | |
| BSX | Boston Scientific Corp | 4.07% | 7,308.00 | 8,386.00 | 9,823.00 | 10,735.00 | 46.89% | 28.01% | 9.28% | |
| 70.42% | Weighted Average | 62.39% | 23.03% | 6.56% |
* In Millions USD. Source: TIKR.com
Hence, considering earnings growth has not been keeping up with the steep rise in valuations, we reckon downside risks outweigh upside potential for IHI going forward even as macro fundamentals continue to be constructive for health care in general.
XLV: A More Compelling Long-Term Health Care Play
Given the fact that health care spending will only be heading higher against the backdrop of aging demographics across the globe, the long-term growth prospect will remain bright for health care sector. As such, we have been bullish the biotech sector (IBB), which has seen its valuation normalize to the cheapest level in a decade as discussed in another article.
Meanwhile, the health care sector ETF (XLV) is another compelling play considering its higher dividend yield, relatively moderate valuations and robust profitability:
| Fundamentals Comparison | IHI | XLV |
| TTM Dividend Yield | 0.35% | 2.27% |
| Weighted Average PE Ratio | 40.93 | 24.26 |
| Weighted Average Price to Sales Ratio | 5.524 | 1.772 |
| Weighted Average Price to Book Ratio | 4.803 | 4.211 |
| Weighted Median ROE | 12.82% | 24.24% |
| Weighted Median ROA | 6.35% | 8.93% |
Technically, after oscillating in a decade-long horizontal range, IHI's relative performance to XLV has been on a breakout mode with a steep linear uptrend since late 2015:
Source: WingCapital Investments
That said, the uptrend is on the verge of coming to an end, which suggests XLV could be the outperformer relative to IHI going forward. Over the long haul, we anticipate IHI/XLV ratio will revert back towards the mean, which is about 10% from the current level.
On that note, XLV certainly received a jolt from Biden's resounding victory over Sanders on Super Tuesday and is expected to continue its long-term bull trend as long as the worst-case scenario is averted. Per MarketWatch:
Waning sentiment regarding Sanders being the Democratic nominee is helpful to XLV because the Vermont senator is a Medicare-For-All champion, a thorny issue for XLV because the fund allocates over 7% of its weight to Dow component UnitedHealth UNH, +10.72% and 19.56% of its total weight to managed care providers
In summary, while IHI has delivered exceptional gains especially over the past 3 years, we expect further upside potential to be limited by rich valuations as well as relatively weak revenue growth and margins. We prefer XLV as a long-term investment vehicle on the health care sector which will continue to be supported by favorable demographics picture.
This article was written by
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