Did Morgan Stanley get it wrong on health care? The big investment firm recently published its "20 for 2016" report highlighting stocks that it thinks will perform the best over the next few years. Since health care makes up more than 17% of the gross domestic product of the U.S., you might expect that three or four stocks from the sector would be in this top 20 list. That wasn't the case. Only one health-care stock made the Morgan Stanley ranking: Gilead Sciences (NASDAQ:GILD).
Why weren't there more health-care companies? The biggest reason is that Morgan Stanley wasn't trying to balance its stock picks by industry representation. The company stated that its focus was on "sustainability -- of competitive advantages, business model, pricing power, cost efficiency, and growth."
That approach sounds reasonable. And Gilead was a great pick based on those criteria. However, I still suspect that health care was underrepresented. Here are three companies that probably should have made Morgan Stanley's list.
Express Scripts (NASDAQ:ESRX)
If we're looking for a sustainable business model, pharmacy benefits management, or PBM, stands out as a great one. With the Centers for Medicare and Medicaid Services projecting that annual prescription drug spending will increase nearly 75% by 2021, the demand for services to help control these costs should grow. As the largest PBM in the country, Express Scripts sits in the catbird seat for this flourishing industry.
Express Scripts' size gives it several competitive advantages. The company can use its heavy purchasing volume to negotiate better deals with pharmaceutical companies than smaller rivals can. Express Scripts' economies of scale allow it to drive down costs, particularly in process-intensive areas such as mail-order drug delivery. The company also benefits significantly from its accumulation of data garnered by processing 29% of retail pharmacy prescriptions. This data allows it to develop more effective programs to control drug costs for its customers.
What about growth? Express Scripts' revenue more than doubled over the past year and increased by nearly 50% over the last three years. Granted, much of that growth stemmed from the company's 2012 acquisition of Medco. However, Express Scripts also grew its bottom line by 4% and 5% over the past year and last three years, respectively, even with the big costs of the Medco deal. Those numbers are better than several of the companies included on Morgan Stanley's top 20 list.
Morgan Stanley picked a great biotech with Gilead. However, they omitted another impressive player in the industry -- Celgene. When it comes to growth, Celgene actually looks better in several metrics. The company's revenue jumped nearly 28% over the last three years compared to Gilead's 11% growth. Celgene's earnings per share likewise soared by 28% during this period, while Gilead increased earnings per share by 5%.
Celgene's primary drug, Revlimid, targets multiple myeloma and myelodysplastic syndromes, or MDS, both of which are bone marrow diseases. Revlimid is the top-selling drug for those indications and continues to experience solid double-digit annual sales growth. Celgene expects 2013 revenue for Revlimid to top $4 billion. The company also counts several other potential blockbuster drugs in its portfolio, including Vidaza, Abraxane, Apremilast, and Pomalyst.
With the high level of competition in the drug industry, are Celgene's current competitive advantages sustainable? I think they are, especially for the three-year period that Morgan Stanley used. AbbVie (NYSE:ABBV) and Bristol-Myers Squibb (NYSE: BMY) are partnering in development of elotuzumab, an experimental drug targeting treatment of multiple myeloma. However, the drug is still in late-stage clinical trials and is a few years away from presenting any potential threat for Celgene.
Intuitive Surgical (NASDAQ:ISRG)
Few companies can boast the kind of growth experienced over the past few years by robotic surgical systems maker Intuitive Surgical. Revenue surged more than 24% over the last year and higher over the past three years. Earnings growth looked even better, up nearly 33% last year.
Intuitive Surgical sells its da Vinci robotic surgical systems at a premium price to hospitals. It then promotes usage of the systems for a growing number of procedures. That's not the biggest source of revenue, though. Recurring revenue from sales of instruments, accessories, and services accounts for 57% of total sales -- and that number continues to grow. Intuitive doesn't view any other company as its primary rival. Instead, it sees the alternative of doing surgery the old-fashioned way, without a robot, as its main competition.
The company has certainly experienced a rough patch over the last few months, though. Short-seller Citron Research launched an attack on the stock in December, citing an increasing number of lawsuits, insider selling, and questions about the advantages of robotic surgery. Just last week, Intuitive had to explain why its numbers for device malfunctions were on the rise (the reason given was a change in reporting practices).
Another shoe dropped last week also, with the American Congress of Obstetricians and Gynecologists announcing that hysterectomies performed with robotic systems shouldn't be the first choice for women because of potential complications and cost. Intuitive Surgical shares dropped to their lowest point in more than a year on the news.
With all this negativity, why should the company be on anyone's top list of stocks? Mainly, because we're looking at a longer time period than the here-and-now. Like many, I expect Intuitive to move past these issues and continue its successful growth story through increasing training for surgeons (which will help minimize complications) and staying the course with its business model.
Getting it right
I think Morgan Stanley got it wrong with its top 20 list by not including more health-care stocks. However, they definitely got it right with a focus on sustainability. Companies without competitive advantages that endure aren't good alternatives for investors. I think all three companies I mentioned can sustain their competitive advantages. Did I get it right? Chime in with your top health-care picks in the comments below.
Fool contributor Keith Speights has no position in any stocks mentioned. The Motley Fool recommends Express Scripts, Gilead Sciences, and Intuitive Surgical. The Motley Fool owns shares of Express Scripts and Intuitive Surgical. 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.