Are These Winners Worth the Risk?

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Having performed extremely well this year, several small-cap stocks in the medical device and supply industry are drawing attention from investors seeking the next big trend. But are these companies seeing enough improvement in their fundamentals to justify the big move?

Despite being highly competitive and fraught with regulatory obstacles, health care is generally seen as recession-resistant. But certain subsectors of health care do better than others. Growth in discretionary medical spending on orthodontics and cosmetic surgery should decline throughout the downturn, for instance, but companies that make tools for more critical procedures could continue growing steadily for years to come.

Just look at some of this year's winners among small-cap medical device and supply manufacturers, compared with the losses of a few key market performers:

Stock	1-Year Performance	EPS Growth Estimate This Year	EPS Growth Estimate Next Year
Orthovita (Nasdaq: VITA)	143%	64%	280%
ICU Medical (Nasdaq: ICUI)	43%	0%	17%
Thoratec (Nasdaq: THOR)	40%	26%	21%
Haemonetics	3%	14%	11%
ev3	9%	123%	263%
SPDRs (NYSE: SPY)	(23%)
iShares Russell 2000 Growth ETF	(25%)

Source: Yahoo! Finance, as of July 21.

While losses have been the norm for every class of stock, these companies have seen their shares rise over the past year -- in some cases, quite substantially. So what's driving this performance, and what's in store for these stocks going forward?

Down to the bone
Orthovita develops and markets synthetic, biologically active tissue products for orthopedic and neurological applications. Despite its big rise recently, its shares have actually fallen by about 14% from their IPO in 2000, and the company has never posted an annual profit. But the market seems to think that situation may be changing.

In June, Orthovita received FDA clearance to market its Cortoss bone augmentation material for treatment of spinal compression fractures, and shares have been showing signs of life. If research and development costs, as well as general expenses, stay relatively constant while sales continue to increase, then 2009 could mark the first year that Orthovita earns a profit. As a speculative play, investors could do worse than Orthovita.

Stick it to the man, not to me
ICU Medical makes and sells disposable needleless IV connection devices. Needle-free technologies have gained favor with hospitals, in part because they reduce the overhead costs tied to sterilization, as well as the mandatory testing after employees accidentally prick themselves with steel needles. ICU has done remarkably well this year in the niche, which is highly competitive.

But ICU Medical's long-term success hinges on two things. First, it has a close relationship with its top customer, Hospira (NYSE: HSP). Second, as company reports point out, nearly all of its innovations have come from its founder, CEO, and board chairman, Dr. George Lopez. At 61, Dr. Lopez is no spring chicken, and with nearly 70% of revenues coming from a single buyer, ICU is particularly vulnerable if something happens to Hospira. ICU Medical sports a valuation that leaves little room for error, with a forward price-to-earnings ratio of around 21 and a PEG ratio of close to 2.

And the rest ...
Thoratec manufactures circulatory support devices and diagnostic testing systems for patients with heart failure. Like the others mentioned here, it faces relentless competition. But Thoratec also has some balance sheet problems: It owns illiquid auction-rate securities valued at $30 million, and it carries another $100 million in goodwill on its books. It's also expensive, with a trailing P/E of more than 50 -- so if you're betting on it as an acquisition target, you may be waiting a while.

Haemonetics and ev3 have both produced fair results in their respective core businesses, plasma systems and peripheral vascular disease treatment. But potentially big growth from Haemonetics' blood-bank product line has yet to fully realize itself. And as for ev3, its recent acquisition of Chestnut Medical closed less than a month ago, so we'll have to wait to see how it pans out.

The brass tacks
Staying ahead of the curve in equity markets involves vigilance, forward-thinking, and plenty of lessons learned. Well-disguised traps can ensnare even the most experienced investors. Small-cap stocks have more room to grow, so it's not uncommon to see them perform a little bit better than their larger cousins.

But are you willing to accept the risks presented by these small-cap companies in exchange for the possibility of multibagger returns? For more conservative investors, you might prefer to invest in a mix of small caps like these, as well as more established large-cap companies such as Medtronic (NYSE: MDT) and Johnson & Johnson (NYSE: JNJ), which can provide stability while giving you exposure to the industry.

At reasonable prices, adding risky stocks to your portfolio can provide you with the oomph needed for above-average returns. However, many of these stocks have already seen big gains and may be getting ahead of themselves. While the medical device and supply industry should continue to do well as a whole, ignoring high valuations may turn the gains these stocks have seen into future losses.

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