The Motley Fool

Fool’s Eye View: A Spoonful Of Medicine To Grow Your Wealth

I get disappointed these days if I can’t find a little pill or a gritty ointment that could be used to treat an ailment that is giving me problems. It doesn’t happen that often because there seems to be a cure for almost all known germs.

That is all thanks to the pharmaceutical and healthcare industry that has managed to cover most bases. They are even working on medicines for some of the more exotic diseases. Who would have thought that a vaccine for the frightening disease, Ebola, would be possible?

We have certainly come a long way since the days of Fleming, with his mouldy petri dish. The pharmaceutical and healthcare industry is now big business with hundreds of companies that we can invest in.

An investing minefield

The breadth and depth of the sector also means that there is probably something for everyone. We can choose from growth, income or value healthcare companies.

But the wide range of options also means that the healthcare sector can be a minefield. But that doesn’t mean we should avoid it. This can be a lucrative sector.

The median return on equity for 20 companies examined in this article is an appealing 16%. What’s more, the returns have been remarkably steady over the years. It means that these healthcare companies have consistently generated an average of $16 of net profit on every $100 invested by shareholders.

The best of breed

The steady double-digit returns are a testament of the attraction of the sector for long -term investors. But it is important to choose carefully. The secret to finding good investments is to look for the best of breed in each sector.

In general, companies tend to specialise in specific areas. Smith & Nephew (LSE: SN.), for example, is an expert in orthopaedic and wound care, while GlaxoSmithKline (LSE: GSK) and Merck (NYSE: MRK) are renowned for their vaccines. Both GSK and Merck have been instrumental in developing vaccines for Ebola.

Singapore’s Haw Par (SGX: H02) is an unusual healthcare company. Its return on equity, which is supported by its high margin Tiger Balm brand, is augmented by its investments in three Singapore companies.

Abbott’s (NYSE: ABT) return on equity is underpinned by its leadership in lifechanging diagnostics, cardiovascular and neuromodulation products. For example, its FreeStyle Libre continuous glucose monitoring system, which is used by 1.5 million people in 46 countries, represents just a fraction of the 425 million people who are living with diabetes….

….Its ease-of-use could spur rapid revenue growth by changing the way that people can manage the condition painlessly.

Limited window

The high return on equity at healthcare companies can be traced to their strong profit margins. On average, they make around $15 of bottom-line profit on every $100 of sales.

The profit margin at AstraZeneca (LSE: AZN) was as high 29% until patents on its blockbuster drugs expired. And that raises an interesting issue. The unique products developed by healthcare companies enjoy protection for only a limited period, after which they can be copied by generic drug makers.

That goes some way to explain why healthcare companies demand higher margins on their patent-protected products. They need to reinvest the profits generated now to develop new products that could replace the ones that are no longer protected by patents.

But developing new medicines is both costly and unpredictable. More developmental drugs end up in the bin than on the shelves at pharmacies. It is important to bear that in mind the next time we moan about the price of medicines.

Me-too products

Healthcare companies are also quite efficient, which also helps to boost their returns on shareholder funds. They generate around $50 of sales on every $100 of assets employed.

Some of the most efficient are generic drug makers, whose business model is primarily mass manufacturing out-of-patent medicines at lower costs. These include India’s Dr Reddy’s Laboratories (NASDAQ: RDY) and Sun Pharmaceuticals.

Roche, on the other hand, also has a high asset turnover. But its focus is higher-priced medicines at lower volumes.

Lend me some money

Another contributor to healthcare companies’ high return on equity is leverage. On average, healthcare companies have around twice as much in assets as liabilities.

Leverage can be a double-edged sword, though. But in a low interest rate environment, it could provide a welcome shot in the arm for some businesses. It could also benefit shareholders who look to stable companies for a robust source of dividends.

Show me the money

On that score, healthcare companies look attractive. The average yield is around 3%, with some European pharmaceutical companies offering some of the best yields. Reassuringly, the payouts are adequately covered by cash flow.

What’s more, the amount paid only accounts for 60% of profits. It means that some 40% of the retained earnings could grow at a return on equity of 16%. In other words, dividends could grow around 6% a year, which in a low-growth economy could be just what the doctor might order.

A versionof this article first appeared in The Business Times.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo owns shares in GSK.