Medical Devices: Investing Essentials

The constantly evolving medical device industry may offer investors significant opportunity by way of industry innovation and an aging global population.

Aug 5, 2014 at 6:21PM

Medical device companies drugmaker cousins tend to get more notice when it comes to investing, but that doesn't mean there aren't compelling investment ideas within the industry.

Much like pharmaceutical and biotechnology companies, medical device makers are knee deep in the hunt to revolutionize disease treatment. Medical devices are being used every day in surgery, primary care, laboratories, and other health-care provider settings. The industry includes a dizzying array of products that stretch from the simple (tongue depressors) to the complicated (laser surgical devices).

As emerging economies develop and developing economies mature, a larger, longer-living population is increasing demand for everything from pacemakers to insulin pumps. So let's take a closer look at how to invest in this dynamic industry.

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Source: Stryker Corp.

What are medical devices?

First, it helps to know what a medical device is and isn't. The FDA defines a medical device as a product that's already approved as a medical device, or is intended to diagnose or treat disease, or is intended to affect the structure or function of the body without relying on a chemical reaction or metabolism. Essentially, if it's used to diagnose or treat disease and it isn't a drug, then it's most likely a medical device.



But just because medical devices don't work exactly like drugs doesn't mean that they get a free pass from regulators. Regardless of whether a medical device is used in a primary care office or surgery room, it needs to have first been vetted through a classification and approval system, which I'll discuss more in a moment. 

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Source: Medtronic

How does the medical device industry work?

Medical device companies range in size from small, venture-funded start-ups to large multinational corporations like Medtronic or Stryker. These companies either innovate existing devices to make them more effective or develop new devices that address disease in a novel way. Either way, before a medical device can be sold in any market, it must pass muster with regulators.

In the U.S., for example, the FDA offers three classifications for medical devices. These classifications are used to categorize medical devices based upon their intended use, their intended indication, and their potential risk to patients.

Class 1 devices pose the least risk to patients and consist of basic medical devices like bedpans, while Class 2 devices can pose a slightly higher risk to patients and include devices like clinical mercury thermometers. Many class 1 or class 2 products qualify for exemptions that may offer an easier pathway to market, but in non-exempt cases, a 510(k) approval is necessary. Class 3 devices pose the greatest risk to patients and include devices like vascular stents. Since class 3 products carry the greatest risk to patients, the FDA requires a company developing a class 3 product to conduct extensive (and expensive) clinical trials to prove the device's safety and efficacy.

A similar approval system exists in Europe where devices are categorized as either class 1, class 2a, class 2b, or class 3. Devices are separated into these classes based on how long the device contacts the patient's body, how invasive the device is, what kind of energy powers the device, how the device affects circulation and the nervous system, whether the device has a diagnostic impact, and whether the device incorporates a medicine. Devices that pass muster within the EU are granted a CE mark, which certifies that the product has passed the necessary regulatory hurdles for approval and sale within the European Union. 

As you can imagine, designing, manufacturing, and complying with these regulatory rules means that medical device companies spend a considerable amount of time and money on research and development. In this way, medical device makers are like drugmakers; however, since it typically costs medical device companies more to build each device than it costs drugmakers to make each individual dose of a drug, medical device makers tend to offer investors lower margins than drugmakers.

What's driving demand for medical devices?

A number of key drivers are dictating demand across this constantly evolving industry.

1. Global demographics

Medical device manufacturers have historically relied heavily upon demand in developed markets including the United States and Europe; however, device innovation and sales are increasingly migrating to developing markets such as China.

Improving economies in these emerging markets are leading to increased health care utilization, which in turn is driving growing medical device demand as hospitals and other new health care infrastructure are built and modernized. As a result, medical device start-ups are no longer limited to developed markets and established medical technology companies are no longer focusing all of their attention on the U.S. and Europe.

And the potential patient populations are expanding as well. In the U.S., baby boomers will turn 65 at a rate of nearly 10,000 per day through 2029. These increasingly active and longer-living boomers will increase the cost and complexity of care and fuel significant medical device innovation. Meanwhile, large aging populations in other markets are also driving medical device use higher. For example, the average life expectancy in China has more than doubled since 1949.  As a result, a key consideration for investors is how much of a medical device company's sales are being generated overseas and how quickly revenue in those developing markets is growing.

2. Healthcare information technology

The widespread adoption of health care information services creates significant opportunities for medical device makers to innovate systems that communicate patient health directly into electronic medical records. These "smart" medical devices contribute valuable information to health care providers that can be used to treat individual patients or to track, monitor, and measure health across larger patient populations. Developing these smart devices isn't easy, but investors may find that those companies working on them will remain or become market share leaders. 

3. Government regulation

Government regulation that increases the patient pool by mandating insurance coverage impacts the industry in various ways. The Affordable Care Act, for example, led to millions of newly insured Americans who are increasingly consuming more medical devices.

But government regulation isn't always going to drive greater profitability. Since medical devices must win over regulators in their various markets, changes that hasten or slow the approval process can have a significant impact on a company's time to market and cost of development.

Additionally, government regulation can also impact industry profitability through either taxation or price negotiation. For example, the U.S. Affordable Care Act taxes medical device makers 2.3% of their total revenue. In other countries, medical device companies' pricing power might be hindered by single-payer systems that can demand steep discounts. That suggests that investing in medical devices requires investors to keep a close eye on political and regulatory shifts. 

Why invest in medical device companies?

The medical device industry looks poised to grow as global markets develop and people live longer, but the industry isn't without challenges, as noted above. Product innovation makes this one of the most intriguing segments of the health care sector, suggesting that investors who do their due diligence and focus on long-term potential growth may benefit from investments within this industry. 

Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may or may not have positions in the companies mentioned. Todd owns Gundalow Advisors, LLC. Gundalow's clients do not have positions in the companies mentioned.

The Motley Fool owns shares of Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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