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Health Rules:

Earlier this summer I posted an overview of the approaches I use at times to evaluate stocks. I thought I would take some time to give better insight into my Health Portfolio since some fellow investors have expressed confusion for why certain companies are included in this mix. The portfolio currently holds 28 stocks with an emphasis on exposure to general segments of the healthcare field. Included within these twenty-eight stocks are 6-7 specialty niche companies that offer an element of diversification within the industry or considerable promise related to current products in development. The stocks held can largely be divided into three major categories: a consumer component, pharmaceutical component and medical supply/device component.

If you are an investor with a traditional view of healthcare, you need to recognize that I’m investing in companies that aren’t solely in the business of selling drugs. I understand that it appears as the only promising or lucrative element of healthcare from the constant analyst and media attention drug companies receive, but there are many other areas that offer equal or greater opportunities for investment over the long-term. The importance is knowing where to look and examining what you’re looking at to see the potential value for that investment.

Since this portfolio has a time horizon beyond 10-15 years the first acknowledgement I made as I constructed this portfolio was: Dividends Matter. I don’t base any buy decision exclusively on a stock paying a premium dividend such as PFE or JNJ, but a stock that consistently pays a dividend and has raised it twice in the past 36 months likely receives a higher weighting within the portfolio than a competing option. This not only provides stability to the purchase, but also generates tax-efficient cash flow for new purchases.

Quality management is included as one of the main focuses for any company I own or track for this portfolio. When I assess a company I want to see strong, decisive and experienced leaders who focus on the ability to deliver results. Most investors are aware of how exposed drug companies can be to expiring patents, failed/stalled drug trials or negative publicity of lawsuits against potential side effects; we simply need to look to recent news of Biovail or Labopharm to see this impact. A competitive advantage can be lost in the blink of an eye if management is reactive to a situation versus being proactive in their strategic execution. I not only look for a company with long established history of quality management, but proactive and ambitious leaders who recognize their corporate core competencies and establish initiatives that strengthen their position in the market.

Cash flow is also a very important area for a company to concentrate on in this industry that is often overlooked. Earnings only tell a portion of the story on a company and as with any sector, examining the cash flow of a company in relation to its peers will help you to better understand the demands experienced from an operational standpoint. Research and development (R&D) is a capital intensive process that requires a company manage their cash flow properly in order to avoid debt as much as possible. Generally I look for a Price/CF ratio of 12-18x as an entry or accumulation position in a company in this sector. My experience has been that under 10x and over 20x tend to indicate relative weakness in the performance of a stock vs. competitors.

An increasingly important component of this portfolio over the past year has been a requirement that each pharmaceutical company has a stable portfolio of mature products as a base for providing cash flow for sustained/increased R&D activities. With the erosion of revenues from many generic products as patents continue to expire, companies are concentrating on shifting their marketing activities towards mature stages of the product life cycle in order to maintain/grow market share or minimize losses. Both Tylenol (made by McNeil – JNJ Company) and Acetaminophen are the same product competing against one another in brand and generic form. While the generic versions find their ways into homes of frugal shoppers, the majority of Acetaminophen taken by consumers is from a bottle with Tylenol written on it. There’s absolutely no difference between the two, but McNeil does a spectacular job of marketing this mature product against generic competition by continuously referring to the drug only by the brand name and creating an emotional response to the product (see commercial). Although this strategy can’t work as well for all generic versions of drugs, these drugs are important revenue drivers for large pharmaceutical companies. There is obviously no replacement for a drug that previously provided billions to the bottom line of a company and is now under direct attack from generics, but making something out of nothing can make the difference between a company’s ability to provide cash flow to R&D programs and finding yourself stumbling to create value or a new vision moving forward.

Speculation is NOT a component of any of the objectives of this portfolio. I don’t speculate on juniors or small-cap healthcare firms with negative earnings and no current products that hold the “potential” stated by analysts or management to create the “next healthcare revolution.” I find that investors almost NEVER take the time necessary to understand the required phases & processes of research that is required for a drug or medical technology to gain approval by the FDA or other authoritative organizations. Their mandate is to protect the public at all costs and any suspicious results or activities can send a company back to the drawing board for years. A new technology, drug or medical device is likely to have been tried once before or other companies are currently selling variations of the same technology that are in practice by healthcare professionals today. Instead of speculating on unknown factors I’ve chosen to concentrate on companies who have positive and growing earnings that position them to expand their scope of business to established target markets. This not only eliminates the rampant speculation and volatility of many small capitalization stocks, but ensures that value is established within the portfolio in comparison to the abundance of health care mutual funds offered by professional investment services.

Other elements include:
– Looking for companies within specific market capitalizations for each segment (Consumer, Drug & Equipment)
– Price/Earnings ratio within 15-20x range
– Debt/Equity less than 0.65
– Payout ratio (for dividends) between 30-35%
– Determining an AAV

Concentrating on the fundamentals of product lines in relation to changing demographics is also a very important element of the investing objectives of this portfolio. MG asked in a previous posting why PG & CL were included with such large weightings since it didn’t appear that they were considered traditional healthcare companies. To most investors it would appear that neither company has a meaningful pharmaceutical division and should not therefore be considered as healthcare investments.

The Three Fundamentals:

A reader of the blog emailed:

Q – How much more of these products can/will baby-boomers really buy? Does there not come a point where they consume as much as they can without these companies experiencing zero growth?
A – I should make it public that I’m not invested in CL, JNJ & PG for exposure to the baby boomers; I could actually care less to be honest. Although I do have exposure to this demographic through holdings such as NADX, it is not the main motivation for why I hold these three large companies. It is true that as we age we tend to increase our brand loyalty to specific products, but I’m invested heavily into CL, JNJ & PG for a very specific reason.

There are three major discoveries that drastically improved the health of our species and increased our longevity (ability to increase lifespan). The first was fire – cooking our food to eliminate parasites, bacteria and harmful microbes. The second was immunizations – childhood diseases that were virtually eradicated allowing more children to reach adulthood. The third was proper sanitation systems – separation of drinking water and human waste.

While each may come across as something we take for granted in our daily lives, the true impact of each is immense. Imagine 25% of a population dying each year from complications of improper food preparation, 3 out of every 10 children dying from a common bacterial infection (such as H. Influenza) or epidemics of monumental scale due largely to improper management and removal of human excrement. We often take for granted the struggles that our society struggled to deal with only 500 years ago. We brush our teeth, groom, wash our hands, use toiletries, receive our recommended immunizations and cook our food without really considering the “WHY” component. Personal and oral care might appear as a boring or mundane ritual in our lives today, but remember that we are no long the majority of the world’s population, simply the wealthiest. Countries, communities, cities and populations around the world struggle today with these same vital health issues that we take for granted.

When I set out the objectives of this portfolio, I wanted to accomplish some very specific goals over the long-term. Not only is the population in Canada and the US ageing as baby boomers get older, but the barriers of international trade are also collapsing with alarming speed. We are now a globalized national.

With a combined population over 2 billion people China & India have companies salivating at the mouth. Each company’s regional market share is miniscule in comparison to their established mature markets in Europe & NA. It’s the purchasing power of the emerging middle classes in these two nations, which has yet to peak, that holds my interest.

I’m not targeting just the health of people here at home, but those all around the world.

There is an impressively high correlation between economic status and overall health that researchers find in almost all situations; in nursing we refer to this as the socioeconomic model. As these populations become more educated, more productive, spend more, consume more and demand more in terms of their health they will look towards improving their health on their own as well as through healthcare professionals. What we are about to see is an explosion of growth for companies who are properly positioned to take advantage of this boom.

The Indian division of Colgate earns just over 85% of all its revenues from oral care products. With a distribution and supply chain management proficiency in all other mature markets, CL stands to gain considerable growth from both emerging giants with products as simple as toothbrushes and deodorant. No better can you see CL’s vision than in their slogan “World of Care”. Providing proper infrastructure is only one of the solutions or investment opportunities; providing access to proper health products and services is completely another. Both PG and JNJ are in similar situations when it comes to providing healthcare products to varying segments of the population of China & India. These companies are flush with cash flow, payout a moderate amount of earnings in the form of dividends and will expand, acquire and competitively protect any inroads they make into this new frontier.

I anticipate that once brand loyalty is created by consumers in these markets, growth accelerates and they adapt marketing strategies to better penetrate consumer barriers each of these major companies will look to expand through acquisitions in order to gain a competitive edge over all other competition. When you look at the number of consumers they serve worldwide currently and add even a conservative percentage of nearly two billion people…they start to look cheap at their current P/E’s.

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