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Here's What Warren Buffett Looks For With Healthcare Stocks

By Alex Carchidi – Oct 2, 2021 at 7:15AM

Key Points

  • Warren Buffett is a fan of companies with repeatable business models and low costs.
  • Berkshire invests in companies with competitive advantages since they tend to have higher profit margins.
  • Consistent earnings growth is a must to make Buffett's portfolio.

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There's a reason why there are so few of them in his portfolio.

If you're stumped about how to find lucrative healthcare stocks, Warren Buffett might be able to help. As the value investing rockstar of the late 20th century, Buffett's patient and conservative approach should be a tool in every investor's collection.

Today, I'll be explaining the most relevant bits of Buffett's philosophy as they apply to a pair of healthcare stocks that you may have heard of. You might not see these two stocks in his portfolio anytime soon, but you'll get an idea about what Buffett's rationale for them might be either way.

A scientist examines a test tube in a lab.

Image source: Getty Images.

Moats and evergreen products can go a long way

For Buffett, companies with sustainable competitive advantages are particularly attractive. One of the best competitive advantages that a company can have is an economic moat, which protects market share from being eroded by other businesses. 

In the healthcare sector, there are many types of moats. For a company like Intuitive Surgical, (ISRG -0.82%) which makes robotic surgical units for general surgery use, one of its moats is in the form of customer lock-ins. Once a hospital purchases one of Intuitive's da Vinci surgical robots, surgeons need to spend a considerable amount of time being trained in its use.

Therefore, it's much less friction for the hospital to keep using the robots once surgeons are trained rather than switching to a competitor, which would require getting up to speed all over again. And, since hospitals purchase multi-year maintenance contracts for their robots, there aren't that many opportunities to switch without wasting money, which keeps them around for longer. 

Intuitive has more than one type of moat, which Buffett would definitely approve of. The da Vinci brand of surgical robots has widespread and positive recognition, and the company's intellectual property (IP) protections ensure that competitors will have a harder time developing similar systems. 

One thing that Buffett looks for that Intuitive doesn't have is a simple product with a highly repeatable business model. For all its merits, Intuitive is a technology-heavy company, and that means it spends more on research and development (R&D) with each passing year, which Buffett would not be a fan of. The more a company needs to spend on R&D to maintain its edge, the more pressure there will be on its profit margin when strong competitors are on the scene.

In contrast, Retractable Technologies (RVP -3.32%) looks like it'd be much more up his alley when it comes to the ideal Buffett product in healthcare. The company makes retractable safety needles for safely administering medicines and vaccines without the risk of needle-stick injuries for healthcare providers. This is an evergreen product as it will be perpetually in demand.

Retractable's R&D costs have actually trended downward over the last decade up until last year when its revenue exploded due to the need to vaccinate people during the pandemic.

Financial strength, expense control, and consistency are key

The Oracle of Omaha is a stickler for consistent earnings and a healthy balance sheet. For example, Retractable's $2.3 million in debt is puny when compared to its $151.7 million in trailing revenue, which would be another factor in its favor for Buffett. Likewise, Intuitive's complete lack of debt is something he'd find strongly appealing. 

Intuitive's earnings growth is far more consistent than Retractable's. One might assume that the steady level of demand for needles before the pandemic would lead to predictable gains compared to the rate of growth with less broadly distributed robotic surgical units, but that isn't the case.

Intuitive's quarterly earnings before interest, taxes, depreciation, and amortization (EBITDA) grew more or less without fail for each of the last five years. Whereas Retractable shifted between expansion and contraction before 2020.

RVP Revenue (Quarterly) Chart

RVP Revenue (Quarterly) data by YCharts

Finally, Buffett prefers companies that keep their expenses low as a percentage of their revenue. If costs get smaller in comparison to revenue over time, that's the icing on the cake.

And both of these stocks could fit the bill. Retractable's total expenses represent just over 70% of its quarterly revenue, and that proportion has fallen by more than 30% over the last three years. For Intuitive, the reduction has been a modest 1.4% in the same period, with total expenses reaching 65% of quarterly revenue. Still, Buffett would probably recognize that Intuitive's profit margin is more stable over time.

Would Buffett want to buy either stock?

Given that healthcare stocks only account for around 4% of Buffett's portfolio, it's important to recognize that they generally aren't his favorites. Of the healthcare stocks he owns, he seems to prefer drug developers like AbbVie and Biogen over hardware companies like Intuitive and Retractable.

Nonetheless, I think that both Retractable Technologies and Intuitive Surgical are candidates for being Buffett picks in healthcare. Between the two, Intuitive would doubtlessly be his preference, as it has a stronger track record of sustained growth.

Alex Carchidi owns shares of AbbVie. The Motley Fool owns shares of and recommends Intuitive Surgical. The Motley Fool recommends Biogen and recommends the following options: long January 2022 $580 calls on Intuitive Surgical and short January 2022 $600 calls on Intuitive Surgical. The Motley Fool has a disclosure policy.

Stocks Mentioned

Intuitive Surgical Stock Quote
Intuitive Surgical
ISRG
$272.25 (-0.82%) $-2.24
Biogen Stock Quote
Biogen
BIIB
$298.90 (-0.98%) $-2.95
AbbVie Stock Quote
AbbVie
ABBV
$163.66 (1.26%) $2.03
Retractable Technologies Stock Quote
Retractable Technologies
RVP
$2.04 (-3.32%) $0.07

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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