The Australian Health Care sector has had another stellar year, with the S&P/ASX 200 Health Care Index providing a substantial 43.5% total return over 2019. This was substantially higher than the still impressive 23.4% return provided by the broader S&P/ASX 200 Index. These strong health care returns were largely due to impressive earnings growth being recorded by some larger names such as CSL Limited (CSL) and Resmed Inc (RMD), up 50.8% and 39.3%, respectively. In addition, recent interest rate cuts globally in the face of a more challenging economic outlook has added fuel to the rally as health care is seen as having structural growth drivers that have a lower correlation to the economic cycle.
However, consistent with such a strong rally in share prices, valuations in the sector now appear full versus longer-term trends. This confluence of strong earnings performance with full valuations should provide investors with a reason to pause and assess the risk-adjusted returns available to them going forward. But to do so, it is critical that investors develop a deeper understanding of the bottom-up fundamentals of the health care companies themselves. While the outbreak of the Coronavirus is unlikely to have a direct effect on Australia’s health care names, a risk-off environment could see investors attracted to the defensive characteristics of the sector.
A review of consensus estimates on a 12-month forward basis quickly establishes that the market is firmly of the belief that the fundamentals for the Health Care sector remain robust. Current consensus estimates are for top-line sales growth of 7.7% and even stronger earnings growth of 16.4% due to the operating leverage inherent in these companies. These top and bottom-line estimates are well ahead of the broader market, with the S&P/ASX 200 Index consensus estimates being for both top-line growth and earnings growth of around 2.7%.
However, this above trend growth comes with a hefty price tag. The forward price-to-earnings (PE) ratio for the S&P/ASX 200 Health Care Index is 40.6x, well above the 17.3x for the S&P/ASX 200 Index. In fact, by our estimates the current PE ratios for both CSL and RMD are currently two standard deviations above their 10-year harmonic means, and Cochlear Limited (COH) is one standard deviation above. This is also reflected in the current dividend yield projections, with the consensus yield (pre-franking) being a meagre 1.4%, again well below the market yield of 4.3%.
Then again, with the sector return on equity (ROE) projections being a healthy 18%, there’s a strong argument that health care investors are well served by boards reinvesting capital rather than paying it out as a dividend.
Health Care Sector 1-Year Forward Outlook
Source: Thomson Reuters, Lonsec Research
The Australian Health Care sector is dominated by CSL, with its market cap of around $128 billion, making up over 60% of the Health Care Index’s $208 billion capitalisation. This concentration in CSL only grew stronger over 2019 as its performance outpaced most of its peers. CSL has benefitted from strong global demand for its plasma products, especially in the US and increasingly in China. CSL is benefiting from an ageing population, increased development and spending on rarer diseases, and a unique ability to source their own raw material ‘plasma’ via an array of collection centres throughout the US.
This has been complemented by the acquisition of flu vaccination supplier Sequirus, which CSL has transformed from a loss-maker into a business with an expected EBIT of $200 million in FY20. Given this backdrop, CSL is likely to continue to benefit from a prolonged earnings upgrade cycle as seen by its sector leading EPS consensus growth target of 19.2% for FY21. Investors, however, will be required to pay up for it with a forward PE of 46x.
The broader Health Care sector is rounded out by a range of large-to-mid-cap medical device and medical service companies as well as an emerging tail of bio-tech companies which have strong runways for growth but are at an earlier stage of their development. Medical device companies such as COH and RMD have enjoyed earnings upgrade cycles, benefiting from strong investment in R&D and increased market penetration.
These factors are expected to continue, with consensus estimates being for EPS growth of 10–20%. This compares to the medical service providers such as Ramsay Health Care Limited (RHC) and Sonic Healthcare Limited (SHL), which have more subdued growth expectations (4–6%) due to regulatory and consumer preference risks. Nonetheless, these providers are still expected to be long-term beneficiaries of an aging population. Despite this slightly different earnings profile, both these sub-sectors are trading on a forward PE well above the market. However, due to the relatively stronger EPS trajectory, the medical device entities are trading at much higher multiples which are more commensurate with CSL.
The Australian Health Care sector has provided investors with very strong investment returns over the last year driven largely by earnings growth above the broader market due to positive structural tailwinds. The Australian segment is also demarcated by companies such as CSL which have strong corporate cultures which emphasise product innovation and operational excellence, factors which continue to provide them with a competitive edge globally. However, the strong earnings upgrade cycle in a ‘low growth’ world has seen very strong investor interest leading to valuations being stretched. Also, the sector is not homogenous with sub-sectors having different earnings profiles and risks. This mix of strong fundamentals with stretched valuations will continue to make an investment in Health care stocks more suited for investors with longer investment horizons.