A Checklist for Medical Technology Investments

Would you be interested in investing in a sector that boasts above-average historical returns, strong returns on capital, government-enforced restrictions on competition and products that can be essential to maintaining people's quality of life? Would you still be interested if you knew there were huge upfront development expenses, a high failure rate, a constant stream of would-be rivals and a federal regulatory body that enforces strict, and sometimes arbitrary, standards?

There is no doubt that medical technology offers all of the above to investors. The question, though, is what investors need to know to best avail themselves of the opportunities in the sector. While there are no surefire guarantees and no shortcuts around due diligence, there are some pointers that can help you make better investing decisions in this dynamic sector. Read on to find out what they are.

Look for an Innovator, Not a Follower

When considering a potential medical technology investment, it's generally better to look for a company dedicated to new technologies and innovation. New products typically offer better performance (better outcomes for the patient, easier for the doctor to use and so on), and those improvements typically command a premium price and drive market-share shifts to the new product.

The best way to assess whether a given company is focused on innovation is to look at the company's product pipeline and research and development (R&D) efforts. Small companies are generally very upfront about the projects currently underway (often it's the only thing management has to talk about with investors), but large companies don't often disclose as much information. In those cases, try this rule of thumb—if a company is spending less than 10% of its revenue on R&D, be suspicious.

Don't Sweat the Details

There is no need for expert-level medical knowledge in med-tech investing. In fact, even the smartest medical minds have a mixed record when it comes to seeing the future in medical technology, so investors should never feel intimidated by a "medical expert" opining on a given stock or therapy.

It is certainly worthwhile to read up on the conditions that a company's products treat (or intend to treat), and the internet offers a wealth of information on almost every medical condition that constitutes a viable market opportunity. From peer-reviewed journal papers to individual patient blogs, any investor can get a sense of the driving factors in the treatment of any medical condition.

Understand the Life Cycle

There are several key points in a med-tech company's life cycle, and each stage has certain ramifications for an investor.

Startup companies often face years of losses and cash outflows as management tries to lead new products through clinical trials, through regulators and onto the market. Here, the amount of cash on the balance sheet, the efficacy of the product and the candor of the management team are crucial. Assuming that the clinical data is positive, the company will eventually face the FDA and the thumbs-up/thumbs-down decision that follows.

If a company secures FDA approval, the next stage is the marketing launch and sales ramp. Here it is critical for the company to have a solid marketing team (or partnership) in place. Look for strong initial sales growth, but don't expect profits just yet.

Once a company achieves profitability, the game changes. Simply put, very few med-tech companies ever mature into large, independent players. For the most part, companies are acquired or try to bulk themselves up by turning to acquisitions. That means investors should keep a careful eye on deals and watch out for companies that overpay in their attempt to grow through acquisitions.

For those companies that do establish themselves as large, independent players, the life cycle here is a familiar one to investors: it is a continuous process of managing the existing business, introducing new products and shepherding the growth of shareholder value.

Don't Forget the Government

If there is a risk factor to medical technology that's not common to other companies, it is the significant role of the government at multiple levels of the businesses.

For starters, the FDA effectively determines whether a company can do business in the U.S. Before a device can be legally sold, the FDA has to approve its sale. While not all product approvals require expensive clinical trials, most of the products that drive significant revenue growth for the sector do require significant data on efficacy and safety before the FDA permits their sale.

It is also worth noting that approval does not end the story; the FDA requires ongoing monitoring and reporting and can order devices off the market if hidden dangers reveal themselves in subsequent years.

While that might seem straightforward, the FDA has a mandate that requires it to be sensitive to a variety of factors. The agency must protect the safety of the general public, but the proper tradeoff between the risk and reward of a new device or therapy is subjective. Complicating matters, the attitude of the FDA regarding that tradeoff seems to ebb and flow over time. Investors can minimize the risks to their portfolio by choosing companies that either have a suite of approved products already on the market or that have very strong data for products under development.

The government also plays a role in determining if medical technology companies can get paid for their devices and therapies. Medicare is a major factor when it comes to how Americans pay for their health care, and if the government pulls back on how much it's willing to pay for various therapies or devices, that can have a major impact on the sector. In fact, private insurers will often take a cue from what Medicare decides when they form their own coverage policies.

Accept a Different Valuation Methodology

Simply put, the valuation standards in medical technology are a little different. If you look at many of the bellwether medical technology stocks, such as Alcon (ACL), Stryker (SYK), Boston Scientific (BSX) and Medtronic (MDT), you will see historical ratios above (and sometimes well above) the prevailing S&P 500 Index levels, including:

• price-earnings ratio
• price-to-book ratio
• price-to-sales ratio
• price-to-cash-flow ratio
• EV/EBITDA (EV = enterprise value)

Yet, over time, medical technology stocks have generally outperformed the S&P 500 and held up relatively well in periods of difficult broader-market performance.

It's not that there aren't arguments in favor of more-robust valuations; this industry sports above-average margins and return on invested capital, doesn't fear generic competitors and offers products with pretty inelastic demand. After all, a person may be able to delay buying a new car or TV until the economy gets better, but they can't delay treating a heart attack or broken hip.

Investors new to medical technology should also realize that, for better or worse, the price-to-sales ratio is a commonly used metric for these stocks (particularly at the small-cap and mid-cap levels). In fact, emerging med-tech stocks trading below a price-to-sales ratio of 4 may be regarded as a buy, and those trading above 8 or so may be regarded as overpriced or at least overheated.

The Bottom Line

Medical technology is a dynamic sector, with new technologies and products emerging virtually every year. Many investors shy away because they mistakenly think it's too complicated, and so there are often overlooked investment opportunities. There's no doubt that it takes a little work to get up to speed on medical technology companies and their stocks, but no more so than for any other industry. If investors take a methodical approach to researching and assessing the stocks in this sector, they should find that investing in medical technology is certainly within the capabilities of the individual investor.