Market Observations with Chris Puplava

Chris Puplava

Health Care Macro Investment Theme

By Chris Puplava, January 17, 2007

In support of health care as an investment theme I wanted to start with the obvious: the upcoming retirement of the baby boom generation, and then move into detailed fundamental drivers for health care out-performance.

For 2006 the number of people aged 60 years or more is estimated at 688 million and is projected to increase by 190% to nearly 2 billion by 2050. This corresponds to one out of every nine persons aged 60 or over currently, and one out of five by 2050. This will be an historic event where by 2050, the population of older persons (>60) will be larger than the population of children (0-14) for the first time in human history!

Figure 1

Figure2


Source: Population Ageing 2006, United Nations (UN)

One of the main reasons for the ageing population is an increase in life expectancy. Since 1950 the life expectancy at birth increased by 20 years to the current level of 66 years. The UN reports that of those living to 60 years, men can expect to live an additional 17 years and women an additional 21 years.

The above figures show a major shift in the population demographic of the world with many countries moving into the 30%+ category of their population aged 60 years or more. This forecasted shift to an older population will put a major strain on the health care systems of the world and require vast sums of capital investment into hospitals, drug manufacturing facilities, health care equipment manufacturing facilities, and managed care facilities and so on. This backdrop does not necessarily make health care an attractive investment now, as the aging baby boom generation has been discussed for years and the health care sector has underperformed the broad market since late 2002.

Figure 3. S&P 500 Health Care Sector Index Relative Performance


Source: StockCharts.com

However, there are several industry developments that point to strength within the health care sector that may translate into relative out-performance in share prices in the months and years to come, which are discussed below.

Real Estate Slowdown? Not in Health Care Construction

Since peaking in 2006 residential real estate has been in a tailspin with the National Association of Homebuilders (NAHB) housing market index, approaching levels not seen since the last housing recession back in the late 1980s and early 1990s.

Figure 4


Source: Moody's Economy.com
Data: National Association of Home Builders: Builders Economic Council Survey

In stark contrast to residential real estate construction is health care construction which is currently booming. Below is a figure that shows the broad based spending within the health care sector on hospitals, medical buildings, and specialty care facilities, with the bulk of total health care construction coming from hospital construction which has jumped since 2005. Current health care construction is nearly at a 20% year-over-year rate of increase as hospital construction increases to meet increasing demand as the baby boom generation reaches retirement.

Figure 5

Figure 6


Source: Moody's Economy.com
Source: Census Bureau: Value of Construction Put in Place - End Usage classification

Trickle-Down Economics

The increase in hospital construction has a trickle-down effect that translates into increased investment spending in medical equipment as more health care facilities means more procedures, which in turn boosts demand for devices and equipment. What drives health care equipment maker sales are hospital profits, hospital construction, and the value of the dollar. Increasing hospital profits (Health Care Facilities earnings per share [EPS], bottom of Figure 7) correlates with an increase in medical equipment and instrument investment spending (middle of Figure 7) as the chart below illustrates.

Figure 7


Source: BCA Research, U.S. Equity Strategy

What the bottom of the above figure also shows is that there is an (approximate) one-year lag between health care facility profits, as measured by EPS, and the translation of those profits into profits in the healthcare equipment industry. As health care facility profits (solid blue line in bottom of Figure 7) rebounded at the end of 2005 and into 2006, health care equipment EPS (dashed black line in bottom of Figure 7) will likely rise as an increase in investment spending in medical equipment and instruments is already underway.

Increasing Drug Demand

Health care equipment makers aren't the only industry in the health care sector with favorable economic conditions. Pharmaceutical companies and the pharmacy service industry are benefiting from rising drug demand with whole sale trade drug inventories rising at double-digit rates after drug inventories had been contracting since 2003, which led to declining drug sales.

Figure 8


Source: Moody's Economy.com
Data: Census Bureau: Wholesale Trade Survey - NAICS version

Rising wholesale drug inventories as seen in the above figure may be a cause for concern unless demand is able to keep pace with the supply of drugs. Looking at Figure 9 below shows the supply and demand for drugs in terms of the inventory-to-sales (I/S) ratio. From early 2001 to late 2004 the I/S ratio fell due to falling inventory build up rather than increasing sales as can be seen by a dramatic plunge in the YOY rate of change in wholesale drug inventories from roughly 30% in early 2001 to a nearly zero growth by late 2001.

Figure 9


Source: Moody's Economy.com
Data: Census Bureau: Wholesale Trade Survey - NAICS version

However, since 2005 there has been surge in drug inventory build up (blue line) yet the I/S ratio (orange line) remains flat, indicating that sales must have picked up at the same relative growth rate as inventories to keep the ratio constant. This is indeed the case when looking at the monthly retail sales report which shows pharmacies and drug store sales rebounding sharply in 2005 after briefly reaching negative territory on a YOY basis, with sales approaching double-digit territories not seen since 1997 and 1998.

Figure 10


Source: Moody's Economy.com
Data: Bureau of the Census: Estimated Monthly Retail Sales

Rising consumer demand seen in the strength of pharmacy and drug store retail sales is trickling down within the industry from pharmacy chain stores to pharmaceutical companies who manufacture the drugs. With demand for drugs in a solid uptrend without supply overshooting demand, pharmaceutical companies should continue to surprise on the upside. This has been the trend in pharmaceutical companies last year with Pfizer Inc. beating earnings estimates for five straight quarters with its 3rd quarter 2006 earnings coming in 19.73% above analyst estimates and Merck also beating estimates for five straight quarters. Positive earnings surprises has been broad-based within the AMEX Drug Stock Index (DRG), with the average earnings surprise for the index's 15 members beating analyst estimates in each of the past five quarters as the figure below shows.

Figure 11


Data: Bloomberg

Foreign Currency Translation

Another fundamental driver for health care equipment makers and the pharmaceuticals is a falling dollar that makes their devices and drugs cheaper overseas and increases demand for them. The dollar index has plunged from a high of 92 in late 2005 to roughly 85 currently, a decline of more than 8%. Further dollar weakness is likely as a major support to the dollar--rising interest rates--has been suspended by the Federal Reserve's recent pause in rate hikes. The Federal Reserve may potentially lower rates later in the year in an attempt to stabilize the housing market and increase economic activity as GDP growth has slowed to 2.0% in the 3rd quarter of 2006.

Figure 12


Source: BCA Research, U.S. Equity Strategy

Not only does a falling dollar boost demand for companies who sell their products overseas but it also adds to the bottom line via foreign currency translation, as sales in foreign currencies are worth more when translated back into the dollar if the foreign currency appreciates relative to the dollar. Since late 2005 the dollar has been declining as many currencies have strengthened against it.

Figure 13


Source: StockCharts.com

Dollar weakness has a significant contribution to the health care sector which has a considerable amount of sales outside the United States. For example, the average percentage of sales outside the U.S. for the AMEX Pharmaceutical Index (DRG) is 40%.

Table 1


Data: Bloomberg

The 8% slide in the dollar since late 2005 would add roughly 3.2% (8% x 0.40) to total sales from foreign currency translation for the average company in the DRG index for those who do not use currency hedges. A falling dollar clearly benefits those with a significant portion of sales overseas.

Value

Like the energy sector which I commented on last week, the health care sector is currently undervalued and is an attractive long-term investment from these low valuations. Last week I showed several valuation multiples for the energy sector, and for the health care sector I am showing a composite valuation chart of the price-to-earnings ratio (P/E), price-to-cash flow ratio (P/CF), price-to-book value ratio (P/BV), and price-to-sales ratio (P/S). The figure below is the average for the deviations from the mean for each individual price multiple.

Values greater than one are more than one standard deviation above the mean and represent overvalued territory while values less than negative one or more than one standard deviation below the mean and represent undervalued territory. When looking at Figure 14, it can be seen that the health care sector has remained undervalued since 2004 and still represents an area for value investors as earnings, sales, and cash flow have increased faster than share prices as valuations continue to be compressed since reaching their peak in 1999 and then again in 2000.

Figure 14


Data: Bloomberg

The investment concept of mean reversion is defined by Investopedia as �A theory suggesting that prices and returns eventually move back towards the mean or average.� This concept can be applied to a sector's relative performance to the broad stock market as measured by the S&P 500. Below is the twelve month relative performance of the S&P 500 health care sector relative to the S&P 500. Values greater than zero represent periods of excess returns over the S&P 500, and values less than zero indicate periods of underperformance.

The red lines indicate two standard deviations above and below the mean, with values falling within the two redlines approximately 95% of the time. Values near or beyond the red lines indicate statistical extremes of value, either undervalued (lower red line) or overvalued (upper red line), where values should fall outside these limits only 5% of the time.

Figure 15


Data: Bloomberg

The figure above shows that the health care sector outperformed the S&P 500 in the first two years of the 1990s when the economy was coming out of a recession, not surprising as health care is seen as a defensive sector due to its stable earnings. As the economy recovered, money rotated out of health care and into technology and other areas, leading to the performance of the sector to decline and under-perform the S&P 500 from early 1992 to 1994, when the economy entered into a mid-cycle slowdown. Not surprisingly, money rotated back into the sector as the economy slowed and the sector continued to outperform until 1998, when the tech bubble moved into full swing and money rotated back into technology. The sector then regained its desirability as the NASDAQ crashed and the economy went into a recession in 2001, where the sector began a period of out-performance from 2000 to 2003, the year the bear market ended. With the end of the bear market, money then rotated back out of the sector and health care has continued to under-perform since then except for a brief period in 2005. To summarize, Figure 15 shows that the health care sector outperforms on a twelve month relative basis when the economy is in either a recession, or undergoing a mid-cycle slowdown due to its stable earnings.

As many are calling for a mid-cycle slowdown for this year, a review of historical returns during previous mid-cycle slowdowns is in order. Mid-cycle slowdowns were seen both in the 1980s (1985-1986) and the 1990s (1995-1996). The historical returns for different industries before and after the mid-cycle slowdowns are presented below.

Table 2


Note: Industry returns reflect relative performance versus the S&P 500
Source: BCA Research

Notice in Table 2 that industries within the health care sector put in strong performances during the mid-cycle slowdowns, with the health care equipment industry putting in the best performance during the 1980s mid-cycle slow down, and pharmaceuticals putting in a respectable 33% gain. During the 1990s mid-cycle slowdown pharmaceuticals put in a stronger showing than health care equipment makers, though both put in strong returns.

In summary, with booming health care construction, increasing investment in medical equipment, rising drug inventories coupled with an even greater rate increase in pharmacy sales, cheap valuations, and a possible mid-cycle slowdown for 2007, the health care sector has many tailwinds that could propel this group to be a star performer over the next year.

TODAY'S MARKET - Economic Reports

Producer Price Index (PPI)

The PPI numbers released for December surprised on the upside, with finished goods rising by 0.9% against expectations of a 0.4% rise. The principal cause of the rise was from food and energy as core finished goods rose by 0.2% in December. In terms of stage of processing, core crude goods rose 1.0%, core intermediate goods declined 0.1%, and as mentioned above, core finished goods rose 0.2%.


Source: Moody's Economy.com
Data: U.S. Bureau of Labor Statistics

Industrial Production

Industrial production surprised on the positive side, with production rising 0.4% in December against the consensus call for a 0.1% rise. Utilities were the greatest drag on production with a 2.6% decline in December due to the unseasonably warm weather. Manufacturing industry production rose 0.7% last month with the mining industry production rising 0.8%.


Source: Moody's Economy.com

MBA Mortgage Applications Survey

Mortgage demand fell 0.6% last week as purchase applications declined 7.0% and refinance applications increased 6.3%. Mortgage demand likely fell from rising mortgage rates which were up last week. The contract rate on the 30-yr FRM increased 6 basis points to 6.19% with the 1-yr ARM also rising 6 basis points to 5.85%.


Source: Dismal Scientist
Data: Mortgage Bankers Association of America

NAHB Housing Market Index

The National Association of Home Builders (NAHB) Housing Market Index (HMI) rose 2 points in January to 35 after reaching a low of 30 in September of last year, though the survey measuring single-family sales for the next six months remained at unchanged from December at 49.


Source: Dismal Scientist
Data: National Association of Home Builders

The Markets

The markets opened up lower on the surprise increase in the PPI numbers and news from Intel that its gross margins will narrow in 2007 after its fourth quarter gross margin came in at 49.6% after declining from 61.8% in the year-ago period. Cisco Systems also weighed down the tech-heavy NASDAQ as well as the general markets when it was downgraded for the third time in two days.

The markets broke into positive territory in late morning trading though they fell to finish in the red. The Dow posted a small loss of 5.44 points to close at 12,577.15. The S&P 500 was down 1.28 points to close at 1430.62, and the NASDAQ put in the largest decline resulting from the above mentioned news, falling 18.36 points to close at 2479.42. Investors sold Treasuries today with the 10-year note yield rising to 4.787%, rising 3.6 basis points. The dollar index was also down on the day, falling 0.11 points to close at 84.95. Advancing issues representing 51% and 41% for the NYSE and NASDAQ respectively, with up volume representing 55% and 26% of total volume on the NYSE and NASDAQ.

Energy commodities were mixed with spot Henry Hub natural gas rising sharply on the change from warm to cold weather in the eastern part of the U.S., rising 14.53% on the day. Precious metals were up on news from the PPI report with gold rising $7.0/oz to $631.80/oz and silver rising $0.24/oz to close at $12.795/oz. In contrast to precious metals, base metals were mostly down on the day with zinc and lead leading the pack down, falling 4.38% and 3.15% respectively.

Overseas markets were mixed down with Asian and Latin markets mostly up with the U.S. and European markets mostly down. Taiwan's Taiex index put in the best showing, up 0.54% while the Korean Kospi index was the greatest decliner, falling 0.74%.

The mixed breadth in the markets in terms of only 51% of issues advancing on the NYSE was also reflected in mixed sector performances. The energy sector put in the greatest performances today in advance of the inventory report due tomorrow, rising 1.21% with technology shares down the most, falling 1.29%. The health care sector put in a decent showing, rising 2.93% followed by materials and utilities, up 0.21% and 0.08% respectively.

Chris Puplava

© 2007 Chris Puplava

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