A rare chill for healthcare favourites

Investors are faced with a difficult decision as two of the market’s favourite healthcare stocks suddenly catch cold.

Woman doctor using tablet computer in hospital

Two of the market’s favourite healthcare stocks are suddenly on the nose. Both CSL and Cochlear are for the first time in years displaying what might be described as “relative value”

But the operative word here is relative. After losing nearly 20 per cent of their entire market capitalisation in the fall since August, the two behemoths of the local medical device market are still on a price earnings ratio of more than 30 times with (31 at CSL and 36 at Cochlear). That’s a very high price to pay for any share anywhere.

Yet, it’s a rare chance for retail investors who are notoriously over-committed to locally focused income stocks such as banks to get a slice of action in outwardly focused, globally competitive Australian companies that tick all the boxes — rising profits and dividends that are set to grow rather than shrink.

Blood products specialist CSL is now a massive company with a market cap of $85 billion. It is already bigger than two of the four major banks: ANZ and NAB. Cochlear is considerably smaller than CSL with a market capitalisation of $10bn.

But a swing in sentiment suggesting CSL’s share price had run way too far ahead has seen the stock fall from $227 to $188. Against this backdrop, CSL has a consensus price target among local brokers of $215, while broker recommendations range from hold to outperform.

Similarly, hearing technology specialist Cochlear has dropped from $218 to $171 against a consensus target price of $180 with recommendations ranging from a ‘sell’ to ‘buy’.

Earlier this week Cochlear got hit with a second wave of selling pressure after a surprise legal decision in the US which means the company is facing a $371m damages claim (which it will appeal but the process will take years).

With the share prices of both device makers enduring exceptional sell-offs, the problem for local investors is not so much regarding them as an opportunity, rather the dilemma is how expensive they look compared to those traditional favourites, the banks.

The P/E ratios at the bank’s suggest the medical device company shares are on another planet. Here’s the P/E numbers: ANZ 11 times, CBA 12 times, NAB 12 times and Westpac 11 times — that’s textbook cheap when you know the long term average ratio for the entire market is closer to 15 times.

What’s more, the device companies might have rising dividends but they are rising from a very low level — the one year forward dividend yield estimate at both CSL and Cochlear is less than 2 per cent.

The banks meanwhile continue to dish out the dividends — the yields (before taking into account a post tax lift from franking) are as follows: ANZ 6.1 per cent, CBA 6.3 per cent, NAB 7.5 per cent and Westpac 7 per cent.

But the issue with bank stocks is clear — the growth of recent years is not going to happen in a climate of re-regulation and a downturn in lending.

Moreover, there is the important question of whether the banks can actually afford to keep paying these sort of dividends if they have profits dropping fast — it is worth noting that dividend payout ratios across the sector are now more than 80 per cent with NAB managing to stretch itself to a dividend payout ratio of 94 per cent in its latest set of results.

For investors the choice is on the table — powerful global medical device companies that tick all the boxed on growth but remain at prices that are roughly double the market average or bad banks which tick few boxes and deliver yields more than double what you might get inside those banks from term deposits. It’s not easy, but the window of opportunity to buy either CSL or Cochlear at anything other than sky high prices rarely remains open for long.