How to Buy Great Healthcare Stocks

Not every investor interested in the healthcare sector has personal expertise in the field. Foolish Analyst Michael Douglass and Contributor Todd Campbell share some of the perks and pitfalls of investing in healthcare companies, from retail to big pharma.

Campbell spells out the role of pipeline and product cycle in the success of pharmaceutical companies, and points out the biggest mistakes investors make when evaluating biopharma stocks. What about marijuana stocks? Watch the video to learn why investors should be cautious, despite the hype.

A full transcript follows the video.

Michael Douglass: How to pick good healthcare stocks. This is Industry Focus.

[INTRO]

Hi Fools. Healthcare Analyst Michael Douglass, and I am here with one of our healthcare contributors, Todd Campbell, all the way in from New Hampshire. Todd, how are you doing?

Todd Campbell: I'm doing well. The wind was whipping 50 miles an hour last night, but it didn't blow me away, so I'm here!

Douglass: We're very grateful you're here! We're very glad you're here.

We wanted to just chat a little bit about what makes a great healthcare stock because this is, in a lot of ways, kind of an impenetrable market for a lot of people.

One of the benefits to that, of course, is that there are potential opportunities for mispricings where folks who don't really understand what's going on are overreacting or underreacting to news, and that does give risk-tolerant and savvy investors opportunities to invest in great companies, sometimes at valuations that might seem stretched by, let's say the S&P's standards, but less so when you're thinking Nasdaq, tech, healthcare.

Let's talk a little bit about that, Todd. What do you think is the first thing that people should be looking for in a healthcare stock? Let's say a biotech stock.

Campbell: Sure. There are basic ways that I approach any stock, and it doesn't really necessarily have to be biotech or big pharma. It could even be a retail stock. But in the healthcare space, what I like to see is first, top-line product. What are the products that the company already has on the market?

The reason I want to know that is I want to have confidence that the management team has been there and done that. I want to know that they can launch a product, have it make money, commercialize it. I want to know that that money then is coming in and being able to be used to help fund the next product cycle, the next things that are going to come down the line.

Douglass: I think that's a really good point. When we're thinking about the risks that healthcare companies -- or really all companies face, but I think it's particularly true in healthcare -- it's that you want to make sure that you have a management team that knows how to commercialize a product.

In healthcare, because so many companies are so reliant, often on one or maybe two products, it's really important to have a management team that's done that before, knows how to do it, how to get that product in front of the maximum number of doctors and, ultimately, patients.

Campbell: Absolutely. Celgene Corp (CELG) I think is a great example of a company that has a proven management that has products on the market that are growing. They've demonstrated they're able to basically control the market.

Just to riff on them for a couple seconds, let's talk about them as a great example of what to look for at a top-line company with a proven management team. They've built a great franchise around one indication, multiple myeloma, and that's an important indication.

They have a drug called Revlimid, and Revlimid is on pace to do $5 billion in sales this year -- and that's up 20% from last year, so you've got a big drug with the majority of the market, that's growing. That shows to me they know how to launch a drug, and they know how to make sure that doctors prescribe it, and that money's going to come in very handy.

Douglass: Right. One of the things that Celgene I think does really well ... For full disclosure, I am a Celgene shareholder, and The Motley Fool recommends Celgene.

One of the smart things that they do is they'll get a drug approved for an indication, and then they'll have trials for several other indications. They'll get it on the market, then they'll be reporting this trial data. That's how they're able to build that long-term, fantastic sales ramp. That's what they've done with Revlimid, and they've got other drugs that they're looking to do that with, as well.

Campbell: You know, Michael, just to jump in for a second, I'm also a shareholder in Celgene. On the Revlimid side, that's one of the reasons that I like the stock so much for 2015; Celgene has a dozen programs that are either label expansions or potential new drugs, ongoing right now.

One of those expansion programs is for Revlimid. In February, the FDA will make a decision on whether or not to approve its use as a first-line treatment in multiple myeloma. Currently, it's the dominant treatment for second line, so if they get that vote of approval in February, then sales could go a lot higher than the $5 billion run rate they're at now.

Douglass: Yes, there's definitely a lot of opportunity with expansion.

I think that brings us in very nicely to this second, really key thing that you have to look for in a biotech or a pharma stock, which is thinking about a broad and expansive pipeline. I usually use Celgene as an example when I'm talking to new analysts here, as a stock that I think really exemplifies this.

What you're looking for, to my mind, is a broad and deep pipeline. You want a pipeline that isn't totally reliant on one drug, necessarily -- although, of course there are other examples -- but we're talking beginning stuff here.

You want a pipeline that has assets in Phase III, in Phase II, and Phase I, so that you know that they're going to keep that pipeline well stocked. Then, also, you've got incoming data, so that you've got drugs that can get on the market and expand that market share into new indications.

Campbell: Yes. The second thing that I like to look for in any company -- specifically in healthcare we would be talking about the pipeline, but you could apply that to any healthcare stock. You could apply it to an insurer or whatever. What is the next product cycle going to be?

Like you said, the way that drugs are developed is, first you do all the pre-clinical work on them, then you've got to bring them into the clinical trial phases. You go through Phase I, which is usually, "Is this drug safe?" Phase II, "What should the dose be, and does it show signs that it's going to work?" Then Phase III, "Let's roll it out to a lot of different people and see how it goes."

It's important for investors to understand that, because 90% of the drugs that go into Phase I never see the light of day when it comes to commercialization. Only 10% or so actually make it all the way through FDA, so you want to find pipelines that are diverse enough where you're not reliant solely on the success or failure of one drug in the pipeline.

It can be label expansions, like we see a lot with Celgene. Celgene's got Abraxane, which is a cancer drug. They just got that label expanded in 2013 to include pancreatic cancer. They've got Otezla, which just came out of their R&D through clinics, and just got approved for psoriasis in September. That drug theoretically could be a billion-dollar drug at some point. That's their first autoimmune drug.

Again, you want to have a pipeline that's going to provide you with the depth, either through label expansion or controlling one particular indication, or that spreads you out a little bit into some other indications using those product sales that we talked about in point one, to fund that development rather than, say, dilutive shareholder offerings or stock offerings, taking on debt, or giving away the house, if you will, in a partnership deal.

Douglass: Right. Speaking of that, in some industries you're going to tend to see balance sheets that are not quite fortress balance sheets. When you look at real estate investment trusts, for example, they tend to be highly levered.

You do see a lot of that in biotech, as well, where you've got a lot of debt; often, there's a fair amount of shareholder dilution going on. But I would argue, and I think you would, too, Todd, that it's really important to see a company that has a balance sheet such that it can weather these storms.

Again, that's not to say that healthcare stocks should never dilute. There are legitimate times to. That's not to say that they should never take on debt. There are legitimate times to do that. But you do want to know that this company has a fair bit of dry powder to throw into, let's say, additional phase 3 trials if a drug suddenly starts doing really, really well.

Campbell: Michael, you nailed it. I think that one of the biggest mistakes that healthcare investors make, especially when it comes to biopharma, is not looking at the balance sheet, not fully understanding just what kind of financial shape the company is in.

A Tufts study just showed that it costs -- I think it's indirect costs -- $1.7 or $1.9 billion to develop a drug. You include indirect costs, it's coming up on $3 billion. That's crazy money, so having a good balance sheet that can afford the inevitable stumble of a drug in trials is, I think, something that more investors should spend time thinking about.

Go back to Celgene for a second. Here's a company that has... I'm going to call it a rock-solid balance sheet. It's got $3.7 billion in cash. That's up from $3.2 billion coming out at December; so even with all the activity that is going on, it's still socking away more and more money for shareholder benefit later on down the road. All those expenses that it has, it's still seeing its cash hoard grow.

One of the ways that I like to look at the balance sheet really quickly is to look at the current ratio. The reason I look at the current ratio is it gives me a very quick and dirty look at whether or not a company can make good on its short-term financial obligations.

It basically takes a look and says, "Okay, short-term liquid assets, short-term financial obligations; what's the cover ratio, if you will?" On Celgene, you're talking about a cover ratio that's above six. You really don't have to worry about whether or not, if debtors come knocking, Celgene can come up with the money to take care of that.

I think that you want to know what products they have, you want to know what the pipeline looks like, and you want to make sure, like you said, that there's plenty of dry powder to take care of shareholders.

Douglass: Yes. Again, I think that, for someone with a Ph.D. in something healthcare related, perhaps it's a little bit different.

But for everyday investors, folks like you and me, it's really important to have those understandings, because a drug can look really good, and it can completely flop. Having these additional fallbacks gives you a lot of risk mitigation in what is perceived to be a pretty risky sector.

I think that's something that's really important for people to know about as they're getting into and thinking about their allocation in healthcare.

Campbell: Absolutely.

Douglass: Sounds good.

We've talked a stock we like. Let's talk a little bit about the anatomy of a healthcare stock we wouldn't like as much. Todd, what's one that comes to mind for you?

Campbell: I'd say one of the ones that makes me very nervous is GW Pharmaceuticals (GWPH).

Douglass: Wait, Todd. It's a marijuana stock, come on! It can't go down, right?

Campbell: They just go up to the Moon, and then they just keep on going to Mars! These marijuana stocks, they have potential; but they have far more potential than they have profit. Until they prove themselves, I think investors should be very cautious.

Again, product, pipeline, balance sheet. Now, GW Pharma has a product -- it's called Sativex. It's used to treat multiple sclerosis spasticity. It's only approved in Europe. But it only generates out a couple million dollars in sales per quarter. This is not a major drug for them. It's not generating a lot of revenue to finance the pipeline.

Now, you could argue, "Who cares, because the pipeline looks really good." You've got marijuana drugs that could be used to treat schizophrenia, that could be used eventually to treat maybe even diabetes. But the reality is that the programs that are closest to commercialization, they're treating very small patient populations, or they're for second-line use. They're not frontline drugs.

They're doing a study, for example, on cancer pain using Sativex. But they're partnered up with Otsuka, and Otsuka has the commercial rights to that drug; so even if they get approval for Sativex in cancer pain, it's going to be as a second-line treatment behind opiates, and Otsuka is going to get the money. GW Pharma's royalties are going to be about 20%.

You need to look at those kind of things and say, "Does this really justify a $1.2 billion market cap?" I get nervous when stocks start trading at more than, we'll call it five times sales, in the biotech and pharma space.

That would mean that you would need to be doing, we'll call it $200 to $300 million in revenue. I'm not sure that these drugs will get them there, and I'm certainly not confident that they'll get there in the next year.

Douglass: I assume that's five times either forward sales or peak sales?

Campbell: Yes.

Douglass: Okay, got you. I was about to say, "Wow, I've got a few in my portfolio that are trading a little bit more richly than that," but when you get into peak sales or forward sales, it's a little bit less, because, of course, these are off-and-on steep growth ramps.

Now to be fair, in GW's defense, they're not yet approved for Sativex or Epidiolex -- which is their other drug that could actually potentially have a fair amount of sales behind it -- in the United States, and they are in phase 3 right now for Sativex.

If FDA approval does come, then that should give them something of a better ramp, but I would agree with you that they still look pretty darn richly valued considering what we've seen thus far.

Campbell: Yes. I just want more proof in the pudding.

Douglass: Yes, I think that's very fair. At the end of the day, excitement about a drug is one thing. Potential of the drug is one thing. But commercialization is really going to be very key in terms of whether a stock actually pans out as a good investment.

People have called it the "marijuana bump," or something like that for these Cannabidiol biopharmaceuticals like GW. That has pushed their valuation such that I think they look pretty stretched to most people. I think a lot of us are saying, "Well, maybe." Let's give it a few more years, and we'll understand just how much of a disruptor these are going to be.

Campbell: Yes. They could eventually be great drugs, and it could be a great company. It's just that I think it's very speculative at this point.

Douglass: Absolutely, and especially for someone just dipping their toes into healthcare. We tend to prefer stalwart, proven companies that have really just done a great job at doing a return on investment, year after year; a stock like Celgene.

Turning from that, let's talk the retail end of healthcare, just real briefly. Rite Aid (RAD -27.27%) is reporting earnings next week. It's shocking to me, we're already almost in earnings season, Rite Aid being one of the first shots fired. What are we looking for?

Campbell: Rite Aid is a very interesting stock. Shareholders have really been rewarded in owning this stock since 2012. This was a company that a lot of people thought might go bankrupt. However, they've refinanced their debt, they've closed a lot of stores, and that's put them back into profitability.

That being said, this stock was trading around $8.00 and change earlier this year, and now it's around $5.50. That's happened because of a couple reasons. First, they have a drug distribution deal where they handed off their drug purchasing and distribution to McKesson. They thought that that was going to save them a lot of money; that hasn't happened yet.

They've said, "Okay, it's going to happen next quarter, next quarter, next quarter." So one of the things you're going to want to watch as an investor is, are we seeing any benefit yet from the McKesson deal?

If so, that would lead me to think that earnings could get a bump up next year rather than a bump down, which is something that we've seen in the last couple quarters, is them taking down their earnings estimate.

I also want to watch them to see what they say about potential growth in the future. Rite Aid has been consolidating. They're closing stores, not opening stores, so CVS (CVS 0.47%) and Walgreens (WBA -1.12%), they're expanding, expanding, expanding, where Rite Aid has been contracting, contracting, contracting.

I want to see them, now that they're profitable again, start to put some money back into it and start regaining some market share. They're conspicuously absent from two huge retirement markets, Texas and Florida. I want to see if they have any plans to start getting into those markets.

They've shown some signs of doing that when they bought RediClinic, an in-store healthcare clinic that operates in grocery stores in Texas. They did that acquisition earlier this year. I want to see more of that.

I also want to see whether or not there's any update on how that RediClinic strategy is progressing. Are they going to continue to open up new RediClinics within their pharmacies at the pace that they indicated earlier in the year?

Douglass: Yes, because frankly, let's face it... they're playing catch-up. Walgreens has, the last assessment I saw, was 400 -- probably more than that by now -- in-store clinics, and CVS has what, 800, 900?

Campbell: I think they're pushing 900 now.

Douglass: Yes. It's an impressive number, and these are really driving same-store sale because somebody comes in, let's say they need a vaccination, and they also have the sniffles. Fine, they'll pick up some Dayquil or something like that while they're there. Maybe they'll pick up a candy bar and a People magazine on their way out. That's a really big benefit.

CVS has just been showing that their same-store comps have really been partially driven by that Minute Clinic strategy that they've been doing. Then also, more broadly, by the strength of their pharmacy. Their front-end hasn't been as strong because of cigarettes.

To my mind, the only other thing I would add is, I want to see how their wellness format is progressing. They've been doing that in a lot of their stores, and they've been seeing a same-store sales bump from that.

To my mind, if you're looking at growth, the key first metric in something that's retail focused is looking at those same-store sales.

Campbell: Yes, and they're good, same-store sales.

One of the neat things about Rite Aid is it tells you how they've done before they actually report earnings. They're one of the few companies that still reports monthly data, so we already know that the same-store sales at Rite Aid during the last quarter were up 5.4%.

That's pretty impressive, and you're right about wellness. This is a reformat of their stores that is designed to do exactly what you were saying before, which is to encourage more sales, to be able to provide more services for each person that's walking in through the door.

With an aging population, with more people getting healthcare insurance, either through Medicaid or the exchanges, prescription volumes are climbing. What was the big driver of same-store sales growth was prescription sales. I think they were up 7%, same-store sales.

Douglass: Yes, that's pretty impressive.

I'll tell you, actually there's a Rite Aid that's been just recently redesigned at a shopping center near where I live, and the other day, I spent a little time wandering through it. The only reason I didn't buy anything was because I didn't have my wallet with me. Otherwise, I probably would have, so at least, in this anecdote, it appears to be working, and certainly the data would seem to bear that out.

Definitely something we'll want to watch very closely with Rite Aid. Any other final thoughts on them, Todd?

Campbell: No, but it will be a very interesting week to go through and dig through that earnings report, and see what's said on their conference call.

Douglass: Sounds good. Thank you, Todd.

Before we sign off, I just want to let folks know. We talk a lot about high-growth stocks on Industry Focus here at The Motley Fool and, particularly, as you can imagine, healthcare, where we're talking about these stocks with these incredible growth ramps.

Motley Fool Co-founder David Gardner actually has a checklist of six different things he looks for in the growth stocks he invests in. If you want access to David's checklist, just send us an email at [email protected]. Again, that's [email protected], and we'll shoot over that checklist and you can take a look. It's totally free, so please feel free to. Once again, that's [email protected].

As always, check back to Where the Money Is and Fool.com for all of your healthcare and other investing needs, and Fool on!