The past nine-plus years has been an incredible time to be a stock market investor. Since hitting their lows in March 2009, all three major U.S. stock indexes have at least quadrupled in value. Mind you, stocks historically gain about 7% per year, inclusive of dividend reinvestment and when adjusted for inflation. This means the gains over the past nine-plus years have been well above the historic norm.
Yet, even after such impressive gains, some sectors still look to be underappreciated.
For instance, the healthcare sector trades at a forward price-to-earnings multiple discount relative to the broad-based S&P 500, according to data from market analytics firm Yardeni Research. Though the discount appears modest (a forward P/E of 15.7 for healthcare vs. a forward P/E of 16.5 for the S&P 500), it's particularly notable for some of healthcare's larger industries, such as biotechnology and pharmaceuticals, which have respective forward P/Es of just 12.9 and 14.7 as of Aug. 2, 2018. Presumably, investors willing to put in the time to find these healthcare gems could walk away with some incredible bargains.
13 of the cheapest healthcare stocks, based on the PEG ratio
With this data in mind, I screened the entire healthcare sector, minus companies with a market cap below $300 million, for one metric, and one metric only: a PEG ratio below 1. The PEG ratio compares a company's price-to-earnings ratio to its expected five-year earnings growth rate. This helps eliminate low P/Es with negative or very low long-term growth rates from the equation, so we're left with only the most promising, and potentially most underappreciated, value stocks.
Traditionally, a stock with a PEG ratio below 1 is considered undervalued. Comparatively, a PEG ratio above 2 is often considered overvalued, with the middle ground between 1 and 2 representing a somewhat reasonable valuation. Of course, investors should keep in mind that these figure aren't concrete. A "cheap" or "pricy" stock based on the PEG ratio could vary by industry. Within the healthcare sector, though, the traditional measurement described here tends to work well.
After running a screen for healthcare stocks with a PEG ratio below 1 (courtesy of Yahoo! Finance), the following 13 were all that remained:
- Innoviva (NASDAQ:INVA): 0.42 PEG ratio
- Celgene (NASDAQ:CELG): 0.54
- Mallinckrodt (NYSE:MNK): 0.59
- Exelixis (NASDAQ:EXEL): 0.60
- Global Cord Blood Corp.: 0.72
- AbbVie: 0.75
- Vertex Pharmaceuticals: 0.80
- DaVita: 0.80
- Supernus Pharmaceuticals: 0.80
- Mednax: 0.82
- MiMedx Group: 0.88
- CIGNA: 0.93
- Medpace Holdings: 0.95
The PEG ratio isn't perfect
Before you run to your online broker and even consider entering buy orders, keep in mind that the PEG ratio is just one piece of a very big puzzle that investors need to solve when analyzing a business. Even though it offers more detail than a simple P/E ratio, it still has its faults.
For instance, the PEG ratio takes into account earnings growth over the next five years. A lot can change over a five-year period, meaning these estimates could prove stale sooner rather than later. Investors need to regularly assess growth prospects for the businesses they're invested in beyond just relying on the PEG ratio.
Likewise, the PEG ratio doesn't factor in variables that could add or subtract value from a business, such as a company's cash on hand or legal issues that could result in settlements.
For example, Mallinckrodt, despite rising by 32% year to date, has lost about 75% of its market value since July 2015. The reason is that Mallinckrodt's top-selling drug, Acthar Gel, has come under fire. Acthar Gel is approved in well over one dozen indications, but it carries close to a $40,000 a year price tag, and the company can't prove beyond a shadow of a doubt that the medicine actually works. During the second quarter, Mallinckrodt reported an 8% decline in Acthar Gel sales to $293 million, with the weakness blamed on patient withdrawals. Considering lawmakers' and patients' disgust with drugmakers hiking prices on key medicines, Mallinckrodt could continue to face backlash.
The PEG ratio doesn't factor in these intangibles, which means investors have to do the extra homework themselves.
"Cheap" healthcare stocks to consider buying
However, the PEG ratio has helped us hone in on what look to be a number of great deals in the healthcare sector. Of the companies listed above, three look particularly inexpensive and potentially ripe for the picking.
First, there's Exelixis, a cancer-focused drug developer I've held for years in my own portfolio. Driving Exelixis' growth is cancer drug Cabometyx, which is approved in first- and second-line renal cell carcinoma (RCC). After hitting the trifecta in second-line RCC of a statistically significant improvement in overall survival, progression-free survival, and objective response rate, a midstage study known as Cabosun showed that Cabometyx ran circles around the first-line RCC standard-of-care treatment.
Now, Exelixis stands on the verge of benefiting from the anticipated approval of Cabometyx for advanced hepatocellular carcinoma (liver cancer). With sales on track to potentially triple between 2017 and 2021, it's clear that Wall Street could be underestimating this gem of a biotech stock.
Staying within the biotech arena, blue-chip drug company Celgene (also a personal portfolio holding) looks to be a bargain. Celgene's stock has swooned since October, following a slight reduction to the company's 2020 sales and profit outlook, as well as the mishandling of its new drug application for multiple sclerosis drug ozanimod.
Nevertheless, Celgene has secured a path forward to keep generic versions of its blockbuster drug Revlimid off the market until the end of January 2026. By early next decade, multiple myeloma drug Revlimid might be the world's top-selling drug, and one major source of operating cash flow. Add in eventual blockbuster ozanimod, along with anti-inflammatory blockbuster Otezla and dozens of ongoing collaborations, and it's easy to see how Celgene could surprise Wall Street and investors.
Last, but not least, biotech royalty company Innoviva looks every bit a value as the cheapest healthcare stock based on the PEG ratio. Between 2014 and 2016, Innoviva struggled as it took on debt to pay a dividend to shareholders. The expectation was that a number of next-generation, long-acting asthma and COPD medicines developed in collaboration with GlaxoSmithKline (NYSE:GSK) would launch out of the gate. Unfortunately, it took longer than expected to get these new medicines covered by insurers and in patients' hands, leading to a rough ride for investors.
But things are much different today. GlaxoSmithKline's second-quarter report showed constant currency sales growth in Anoro, Arnuity, Incruse, and Breo Ellipta of 48%, 38%, 54%, and 4%, respectively. As GlaxoSmithKline works on expanding coverage for these products, Innoviva's royalty revenue has begun to soar. And since we're talking about a royalty company with relatively minimal costs, its margins should be in excess of 90%. Innoviva could turn out to be an excellent bargain.
Sean Williams owns shares of Celgene and Exelixis. The Motley Fool owns shares of and recommends Celgene and Exelixis. The Motley Fool recommends Vertex Pharmaceuticals. The Motley Fool has a disclosure policy.