IHI: COVID-19 Will Harm The Medical Device Industry

Summary

• Despite extreme valuations, medical device companies have all-time-high valuations and exuberant investor sentiment.
• Most analysts expect COVID-19 to slow the long-term EPS growth for most medical device companies.
• The decline in elective procedures and increase to hospital bankruptcies will lower demand for expensive medical technology.
• IHI's relative performance and relative fundamentals signal a high probability of negative alpha over the coming 1-2 years.
• IHI appears to be a solid short opportunity, potentially overvalued by 50%.
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Last year, I wrote "IHI: Medical Device Bull Market To End Soon," which detailed the fund's high valuation and the decline in its long-term bullish fundamental trend. Since then, the iShares U.S. Medical Devices ETF (NYSEARCA:IHI) is about 10% higher, having risen with equities as a whole, but it did decline a staggering 33% peak-to-trough during the March crash.

The ETF is now back near its all-time high and has seen significant inflows over the past few months. The valuations of its holdings have reached extreme levels despite the fact that many of its constituent firms will see a large earnings slowdown this year due to a decline in elective producers.

The primary goal of my previous article was to highlight the lack of opportunity for investors in IHI. Now I believe the fund has become a solid short trade as numerous downside catalysts have appeared. Additionally, the ETF has seen a decline in relative momentum compared to benchmark index funds, which imply it is headed for secular decline.

COVID-19 Has Led to a Decline in Growth Estimates

IHI is a very expensive ETF with richly valued companies. The weighted-average TTM "P/E" ratio of its holdings currently stands at 40.5X. This means it would take the fund 40 years of the past year's profits in order to repay its equity.

As I've said before, there is nothing inherently wrong about high valuations as long as earnings growth expectations can justify them. It is true that most of these firms have very high EPS growth over the past decade due to regulatory changes and an aging population, however, that does not mean future earnings growth will continue.

In fact, COVID-19 has resulted in a substantial decline in the long-term growth expectations of most of these IHI constituents. As you can see below, most of the top six firms in IHI have seen LT growth estimates decline about 2-3% this year:

Data by YCharts

These companies make up 52% of IHI's AUM and are mirrored in the majority of its other holdings. As you can see below, this has also resulted in an increase in forward P/E ratios to new all-time-highs:

Data by YCharts

There are numerous reasons for the decline in these firm's earnings expectations, and it seems the market is not accounting for this trend. Most of the bullish sentiment surrounding medical device firms relates to investor hopes that these companies will become industry leaders for COVID-19 testing. However, COVID-19 testing, treatments and a possible vaccine (someday) are likely going to be a "winner takes all" scenario where the company with the best product wins the entire market. Given the rise in valuations, it seems many investors believe all major healthcare technology companies will gain equally from this demand.

As one example, Goldman Sachs recently downgraded Abbott (ABT) (13% weight in IHI) to a "Sell," saying, "We think the stock currently implies a likely overreaction to current testing opportunity." In fact, Abbott's ID test is believed to miss at least a third of positive cases and nearly half using dry nasal swabs.

Obviously, Abbott is just one of many stocks that are in IHI. However, problems seem to be growing for many of the firms. Hospitals are the major customer of products made by firms in IHI, many of which are used in surgeries. COVID-19 has resulted in a decline in elective procedures and most hospital visits. Most counties in the U.S currently have hospital traffic that is 50% less than it was last year. Depending on the state, 25-50% of hospitals are seeing negative net income. Personal healthcare spending has also declined from $2.5 trillion to $1.5 trillion.

While many investors seem to believe the COVID-19 crisis will boost medical device firms, the opposite seems to be the case. The crisis has harmed the healthcare industry more than most. In the short run, sales of surgical devices will be significantly lower. In the long run, an increase in hospital bankruptcies and a decline in hospitals' financial stability will cause demand for new (expensive) healthcare technologies to lower.

While EPS growth expectations have declined by 2-3% for many of these firms, I believe the resulting declines maybe even more significant. Quite frankly, I do not believe investors should account for an increase in long-run earnings for most of these firms.

Technical Signals Suggests IHI's Steam is Gone

If you've read my articles, you may know that I use price ratios as a preferred way to measure market momentum in ETFs. When one ETF is rising faster than a major index, its ratio increases and will often continue to do so. Personally, my goal is to short funds that will underperform the S&P 500 and buy those that are expected to outperform. The direction is less important when using a long-short strategy.

As you can see below, the ratios of IHI's performance against the S&P 500 ETF (SPY), the Healthcare ETF (XLV), and the Nasdaq 100 ETF (QQQ) are all either trending lower or are stagnated:

Data by YCharts

This is a signal that IHI's outperformance trend is now over. Going forward, I expect it to at best perform similarly to the S&P 500 but most likely underperform it. In other words, I expect the fund to generate negative alpha.

Even looking at IHI itself on a short-term basis, the fund's momentum seems to be clearly faded:

Data by YCharts

As you can see, IHI tracked SPY quite well during the crash and actually had a more aggressive rebound, as investors assumed its constituents would partly gain from COVID-19. However, that outperformance resulted in a period of stagnation. IHI is at a slight trend higher over the past week, but it seems to have very poor momentum.

Bottom Line

Overall, I believe IHI is a relatively low-risk short opportunity. Essentially all of its holdings have extremely high valuations, which imply a 50-100% increase in EPS over the coming years. By that, I mean it would take a 50-100% increase in EPS for the firms in IHI to be at a fair market value similar to other equities today.

However, COVID-19 has resulted in substantial declines to most firms' EPS forecasts due to the increase in hospital bankruptcies and vacancies. Even more, considering U.S healthcare spending has reached extreme levels, it is hard to justify a continued increase in spending that would benefit these firms. Despite this, investor sentiment for these companies is actually at an all-time high due to potentially irrationally exuberant beliefs surrounding COVID-19 testing and treatment products.

I do not expect the EPS of IHI's constituents to increase more than that of the S&P 500's over the long run. The S&P 500 currently has a weighted average P/E of 21X, while IHI's is 40X. Given this, the fund is overvalued by around 48%, giving me a price target of $142.

If there is a substantial increase in hospital revenue, IHI's rally could be justified, but this seems highly unlikely. The current borrowing rate for IHI shares is a low 1.8%, and I believe it is unlikely to return to a new all-time high. As such, if I were short, I would place a stop-loss right above its ATH at $280.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in IHI, ABT, MDT, TMO 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.