Mascot
introduction
iShares American Medical Devices Corporation (NYSEARCA:IHI) is an exchange-traded fund that provides investors with exposure to US companies that manufacture and distribute medical devices, while the portfolio has been created to be aligned with its benchmark index, the Dow Jones Index. US Select Medical Equipment Index.
The last time I covered IHI was in December 2021, at which time I thought IHI would underperform. This has already happened; While 2022 has been a bad year for almost all stocks, we have seen all-time highs safely breached across major indexes since the end of 2022 (i.e. a very strong recovery, at least in the US). When I last covered IHI, the ETF’s share price was $63.18 (at publication; or $61.78, which is the price I used in my model). Today, the stock is priced at $56.63, so it makes sense to reconsider it, especially in light of a different macroeconomic environment.
I thought before that I was probably right that flows into ETFs were excessive, and were driven by sentiment built on a higher-than-reasonable probability of an extended pandemic with higher demand for medical devices over the long term. I would reconsider IHI, in case sentiment swings in the opposite direction, creating an opportunity in terms of valuation. As can be seen in the chart below, inflows are now negative on a 12-month basis (worth around -$921 million, which is almost $1 billion).
ETFDB.com
Periodic positioning
In theory, Healthcare as a sector exposure is considered “defensive”, as demand is likely to be strong over the long term, in a way that it is not as dependent as most other sectors on the cyclical situation or the health of the economy. Logical. However, medical devices can be at least partly sensitive, with the potential for reduced spending in economic downturns, even in health care. I often look to Fidelity’s business cycle positioning chart to see where we are, because it’s fairly accurate. As of the second quarter of 2024, Fidelity estimates that the United States (along with a few other major geographies) is in the early part of the “late phase” of the current US business cycle.
Ikhlas.com
The United States has been behind China for some time. However, so far, it seems that the United States has admirably managed to avoid recession fears, and has continued to move forward. Barring a “black swan” event, it is likely that over the next 12 to 18 months we may see a gradual increase in interest in so-called defensive sectors such as healthcare, but not necessarily with an outright stagnation in earnings. Topically, this could support IHI as a general (cyclical) investment thesis.
evaluation
For reference, we can use the most recent IHI fact sheet (as of May 31, 2024) to construct the starting values. It’s also worth noting upfront that the fund’s expense ratio is 0.40%, which isn’t cheap; Meanwhile, the bid/ask ratio is 0.02%, which is fair (the shares are liquid and traded regularly). In the referenced fact sheet, the price-to-earnings ratio was 52.8x, while the expected price-to-earnings ratio was 27.89x. This implies an approximately 89% jump in next year’s profits; This is likely a result of a decline in the earnings base, and the expectation that earnings will return to normal in the future at the portfolio level.
The price-to-book ratio was 4.54 times, with an indicative dividend yield of 0.87%. Taking the data into account, the data suggests a forward return on equity of 16.28% and a dividend payout ratio (to dividends) of around 40%, retrospectively. Meanwhile, Morningstar gives us a three- to five-year earnings growth rate, based on analyst consensus, of 8.04%. Aside from the near-term “jump” in earnings basis, I will keep this 8% forecast in mind as I prepare the valuation.
Looking beyond the next first year, in which case I will take the analyst consensus according to the IHI Benchmark Fact Sheet (as above), I will then assume that the forward return on the equity matures/matures within year 6 in my analysis, as reasonable ( I think) and a conservative assumption. I’ll assume earnings growth actually hits 5% per year for the first two years, before falling to around 2%, in order to support the weaker return on the stock trend (from 16.28% in year one, to about 12.5% in year one). % in the sixth year). This helps build a margin of safety compared to agreed estimates.
Incorporating all other information, including dividends, expense ratio, and bid/ask spread, and assuming a constant forward P/E ratio of 27.89x (as is the case at present), we arrive at a headline IRR of 6.18%. . With the current US 10-year yield (“risk-free rate”) of 4.43%, the equity risk premium (or “ERP”) is 1.75%.
Author’s calculations
The implied IRR is low. The implied ERP is also low, especially since although healthcare stocks are considered more defensive, the fund’s beta (on a three-year monthly basis, with respect to the S&P 500) is 1.13x (i.e. 13 times more volatile % of the S&P 500 on average).
There were only 51 holdings as of June 6, 2024, a tenth as many as the S&P 500’s constituents, which perhaps helps drive the fund’s beta. The largest holding is Abbott Laboratories (ABT) with 16.21%, an American multinational corporation that sells medical devices, diagnostics, generic drugs, and branded nutritional products. The second largest holding is Intuitive Surgical (ISRG) at 13.19%, a large medical robotics company. The third largest holding is Stryker (SYK), 10.58%, another large and profitable medical device company with a relatively diversified product portfolio. While these companies are sound, these three stocks represent just under 40% of IHI’s total assets under management, so there is a fair amount of concentration risk, and one wonders if it makes sense to buy these three stocks outright at the time Present. (Instead of investing in IHI).
At the portfolio level, what happens if you adjust the average forward earnings growth rate and return on equity? If you allow the forward ROE to hold above 14%, with an earnings growth rate between year one and year three of 7.5%, the implied IRR and ERP will rise to 8.97% and 4.45%, respectively. Raising the earnings growth rate to 8% raises the IRR and ERP to 9.57% and 5.14%, which is about where we need these numbers to be to justify saying IHI is “at fair value.”
Judgment
I think IHI is probably in the realm of fair value at present, albeit without much margin of safety, and thus potentially provides investors with a reasonably good entry point. Long-term shareholders, unlike at the end of 2021, will likely achieve a healthy long-term return by holding IHI at current prices (about $56-57 per share).
However, risks include concentration risk, and there is little margin of safety in earnings growth numbers.
Perhaps one supporting factor alongside the valuation is that a slowing economy and perhaps a recession in 18 to 24 months (or longer, as the case may be) could lead to increased demand for more defensive sectors like healthcare, thus pushing up the IHI share price. However, the valuation is already in the fair range, and the portfolio is not well diversified (given only 51 holdings). It is also always possible that earnings will decline slightly in a slowdown, offsetting any valuation improvement effect.
I like the defensive stance of investing in healthcare companies, and I think IHI offers good value, especially relative to the last time I covered the fund. However, I believe that with recent outflows and the update in market perception of IHI, the fund is now likely to achieve headline returns (with dividends reinvested) of 6-10% over the next five years, which is close to fair value. Arch. Therefore, I will take a neutral position.
