You would think that the medical-device sector would be rife with big gainers thanks to an aging population, but it's not quite as simple as that. Just as we saw when we examined the biotechnology sector last week, there are pros and cons to investing in medical devices.
The pros and cons of medical devices
On the positive side, medical devices should make a logistically smart play for an aging population. As technologies and manufacturing processes improve -- and health-care insurance becomes a mandate because of the full implementation of the Patient Protection and Affordable Care Act, known loosely as Obamacare, in 2014 -- the demand for medical devices ranging from implantables to simply disposable-use products in hospitals is bound to increase.
Conversely, medical-device companies walk a fine line when it comes to product efficacy sometimes and must now deal with a 2.3% medical-device excise tax that comes straight off their total revenue to help pay for the Medicaid expansion under the PPACA. St. Jude Medical, for instance, has dealt with two recalls in the past three years because of the long-term durability of its implantable products. In 2010, it recalled its defibrillator leads known as Riata, and in February, it recalled its Amplatzer TorqVue FX Delivery System for fear of fracturing in the device over time. On top of this, St. Jude will fork over 2.3% of its revenue because of the medical-device excise tax.
The Buffett factor
Warren Buffett, as my Foolish colleague Brian Orelli has pointed out, tends to shy away from the health-care sector as a whole -- save for a few very large and diverse companies -- because he doesn't have the time or energy to follow the developing pipeline of a company, whether it be biotech or medical devices.
But, just as we saw with regard to biotech, I think Buffett and Berkshire Hathaway (BRK.B -0.38%) are missing a crucial component in their investment portfolio by predominantly passing up the medical-device sector. It's true that Buffett and Berkshire do have some medical-device exposure thanks to ownership in shares of Johnson & Johnson (JNJ -0.88%), which purchased Synthes last year for nearly $20 billion. Synthes has a large spinal implant operation, which will give J&J plenty of fast-growing emerging market exposure and will probably put big smiles on Berkshire shareholders' faces. But overall, J&J is a diversified conglomerate with only partial exposure to medical devices.
Instead, I propose we once again focus on Buffett's key investable points -- sustainability, growth, and income -- to deliver the best possible medical-device company for Buffett's and Berkshire's portfolio.
When talking about sustainability, I'm hitting on Buffett's penchant for seeking out well-established product lines that can essentially run themselves. Buffett's set-it-and-forget-it investing philosophy requires that cash flow and profits remain relatively consistent. In this category, I'd say there's only one pure-play example and two other companies that somewhat fit the bill.
The pure play, as I see it, is Medtronic (MDT -0.42%), which is a global leader in cardiovascular and spinal implants. This device maker can claim annual revenue growth in every year over the past decade, along with gross margins that have moved within a tight 180-basis-point range and hit a decade high in 2012. In the company's third-quarter results, announced in February, it demonstrated growth across all regions -- domestic, international, and emerging markets -- while delivering free cash flow of $1.4 billion. It's definitely a company whose product line can be set on cruise control.
The other two I'd throw into the sustainable column are Johnson & Johnson and Abbott Laboratories (ABT -0.77%). J&J, as I noted, is a pharmaceutical and personal-products behemoth as well, so it can offer an investor a lot more diversification beyond just medical devices. But for the sake of argument, I'm focusing strictly on medical devices here. The same goes for Abbott Labs, which can offer investors the opportunity of mitigating some of their investing risk with the security of generic-pharmaceutical sales. In the fourth quarter of 2012, for example, the company's pharmaceutical and nutritional operations contributed to 76% of total sales, leaving its diagnostic and device business on the back burner.
Sustainability isn't enough for Buffett and Berkshire. Buffett also likes to see the companies he invests in constantly innovating and adapting to changing times. Because Buffett prefers to invest in companies that are going to "move the needle," as my colleague Brian Orelli put it, I've excluded many of the faster-growing but smaller device makers. The result is that only one company truly meets what I'd refer to as the high-growth and Buffett-investable threshold: Intuitive Surgical (ISRG 0.91%).
Intuitive Surgical hits on a key point that Buffett should love -- it holds a veritable monopoly over soft tissue robotic surgery with its da Vinci surgical system. Robotic surgery, according to the company, has been shown to be just as effective as traditional laparoscopic surgery, with less time spent in the hospital recovering and smaller scars. Intuitive's growth rate definitely would suggest this to be case, with the company delivering a compounded annual growth rate of 37.3% since 2003. Furthermore, its surgical machines continue to maintain their high price point because of a lack of any viable competition.
However, Intuitive's growth also comes with a hitch, in that the Food and Drug Administration is investigating it regarding mounting complaints from patients who've undergone a robotic-surgery procedure. Conflicting data studies from multiple sources and a growing population of people treated is going to make any investigation of this nature long and drawn-out.
Unlike the biotech sector, which devotes almost all of its free cash flow to further research and development, medical-device companies are a bit more liberal with their free cash, and many can be found to pay out reasonable dividends. Counting J&J in the mix, there are seven $10 billion-plus medical-device makers that pay out in excess of a 1.1% yield. Specifically, the three highest-income producers for investors are J&J, with a 3% yield, Smith & Nephew, which yields 2.7%, and St. Jude Medical, at 2.4%.
As I noted previously, J&J isn't really a medical-device pure-play -- and Buffett already owns shares in the company -- so we can easily exclude it. Likewise, St. Jude Medical's rash of recent recalls (there's a tongue twister for your next party) is enough cause for concern not to chase after its 2.4% yield. Smith & Nephew, an orthopedic-implants maker with its 2.7% yield, and Medtronic, with its 2.2% yield, appear to be the safest bets to deliver steady income to investors. Even with a smaller yield, I'd give the nod here to Medtronic, which has boosted its dividend in 35 consecutive years.
The medical-device company Buffett should buy
Unlike last week's biotech scrum, this is a cut-and-dried case of outperformance that should have Buffett and Berkshire Hathaway knocking on Medtronic's door to take a position in the company.
From a sustainability perspective, it's hard to argue against Medtronic's global appeal, as emerging-market sales grew by 21% in its most recent quarter. In addition, Buffett loves a company whose management takes care of shareholders. Medtronic has boosted its payout in 35 straight years, with that annual payout jumping by an average of 15.3% per year since 2003.
Even though I failed to mention Medtronic in the growth section, CEO Omar Ishrak has a multifaceted plan to keep Medtronic growing. Ishrak's strategy involves focusing on its emerging-market presence, with a 20% long-term growth target; shifting its device focus to cardiovascular, neuro and orthopedics, and diabetes; and launching Resolute Integrity, its next-generation drug-eluting stent. There is plenty of reasonable mid- to high-single-digit growth potential for Medtronic, which makes its forward P/E of 12 seem like a steal.
Warren Buffett would be wise to take note of Medtronic's growing potential.