Got Vision?

A couple weeks back we named the top ten trends that will likely affect orthopedic surgeons, hospitals, suppliers, and implant sales people over the remainder of this current decade.  This week we narrow our focus to the next 12 months and orthopedic company values.

And we have found some unexpectedly reassuring patterns.

Wells Fargo Security’s senior analyst, Larry Biegelsen, looked back at the 2008-2009 financial crisis (admittedly uncomfortably similar to today’s credit downgrade and EU economic turmoil), the recovery that followed (2009-2010), the 2010 correction, the 2010-2011 recovery and then today’s downturn.

Source:  FactSet and Wells Fargo Securities, LLC

And he wondered if there was any particular pattern for how medical stocks in general and orthopedic stocks in particular performed.  As it happens, there was a clear pattern.  If that pattern holds true, the next 12 months will likely be better for orthopedic company values than the last 12 months.

Between 2008 and 2009, when the global economy was free falling through the worst financial crisis since the Great Depression, all investors wanted to do was find a bottom.  A floor to stand on.  And all orthopedic executives wanted was a source of working capital and a healthy bank to lean on.

The one searing lesson we remember from those days is that public company execs worried more about their bank lines than they did about their stock prices.  Stock prices could swing all over the place, but with no bank lines, there was no business. 

Here’s how everyone did in those chaotic days of 2008-2009.

Table 1 – '08-'09 Financial Crisis

Source: Wells Fargo Securities

During the financial meltdown of 2008-2009, the S&P lost about 47% of its value (Table 1).  Orthopedic companies underperformed the overall market by losing 53% of their values which was 5.9% worse than the overall market.  Given the chaos of the time, most orthopedic company execs probably didn’t notice.

But executives certainly did notice what happened next.

On March 9, 2009 the S&P 500 hit a 12-year low.  Then it bounced for the next 13 months.  From March 10, 2009 to May 26, 2010^, the value of the S&P rose 68%.  Orthopedic stocks soared 79%. 

So where orthopedic stocks underperformed the overall market indices by 5.9% in the financial crises of ’08-’09, they outperformed the same market indices by nearly double that or 10.8% in ’09-’10.

Table 2 – '09-'10 Recovery

Source: Wells Fargo Securities

This pattern of worst to first continues for each of the next set of market swings.

The recovery ended in time for summer in 2010 and for the next four months what started out as profit taking grew to become a full blown correction.  With the economic recovery sputtering and the political leadership in Washington and Europe proving to be equally ineffective, investors started to look for safe capital havens again.  Again orthopedic companies took the brunt of the selling.

Table 3 – 2010 Correction

Source: Wells Fargo Securities

From first to worst.  After being whipsawed so thoroughly it may be hard to remember where the orthopedic values started and where they were at the end of the correction (August 31, 2010). 

Down 53% during the financial crisis, up 79% then down 23%—leaving the aggregate values of orthopedic stocks at 65% of their values before the financial crisis hit.  To simply return to, in effect, par as of 2008, orthopedic company values would need to rise by 54%.

For the next 11 months, orthopedic stocks tried to do exactly that. Several orthopedic companies dusted off their shelf registrations and tried to enter the market.  Tornier succeeded with a $166 million stock float on February 2, 2011. 

And, yet again, orthopedic stocks traveled the long road from worst to first.

Table 4 – '10-'11 Recovery

Source: Wells Fargo Securities

By July 22, 2011 the value of orthopedic companies was roughly 84% of their values from before the 2008 debacle.

And now we come to today’s eerily familiar financial crises.  There is anxiousness, a fear and a feeling that it’s 2008 all over again.  Where that crises was effectively an unraveling of the banking system, this time it is the economic dissolution of countries.  Is Greece too big to fail?  If not, then who saves it?

Sure enough, there go the orthopedic stocks.  Down.

Table 5 – Recent Downturn

Source: Wells Fargo Securities

The Trend is Your Friend

It may strain credibility to say that this pattern of first to worst and back again is positive. But for the next 12 months this may in fact be pointing to an unusually rewarding capital market for orthopedic company equities.

If, as most economists assume, the global community starts to pull itself out of this economic maelstrom by, say, December or January, orthopedic equities will almost certainly lead the market out.  How high could orthopedic stocks go?  If the past patterns repeat, orthopedic equities should outperform the overall market by between 500 and 1, 000 basis points.

Should capital flows move back in the direction of orthopedic companies, a new question emerges—what will they be able to buy?

The orthopedic industry appears to be in the middle of a consolidation phase.  Synthes is being purchased by JNJ.  Rumors have Smith & Nephew and Wright Medical disappearing as public companies into the folds of larger, more diversified firms. 

Whenever institutional stock buyers return, they will surely find fewer shares to buy.  That, in turn, would probably drive equity prices higher still.

2012 Is an Election Year

Of the last 20 election years, there have been only three years where the S&P 500 index had a negative return during an election year.  The last time was 2008—which, given the axiom of regression to the mean, sets 2012 up as a positive year. 

Marshall D. Nickles, Ed.D., wrote about the correlation of positive stock market returns and presidential elections in his paper called “Presidential Elections and Stock Market Cycles.”  He writes that a profitable investment strategy would be to purchase equities on October 1st of the second year of a presidential term and then sell on December 31st of year four.

Dean A. Junkans, CFA, Wells Fargo’s Chief Investment Officer and James P. Estes, Ph.D., CFP, Wells Fargo’s Senior Investment Manager conducted their own study and concluded that the average market return in the fourth year of a presidential term (that would be 2012 in Obama’s term) is twice that of the return in the first year of a president’s term (that would be 2009 in Obama’s term—when the recovery was underway).

Got Vision?

The period from 2008 to 2009 was, in retrospect, the perfect storm for orthopedic companies.  Both the capital markets and the banking system were unraveling.  The U.S. Government, which through CMS (Centers for Medicare and Medicaid Services), its military and VA systems, and Medicaid account for a majority of reimbursement for orthopedic surgeries in the U.S., was dealing with the orthopedic industry from a position of mistrust if not outright antagonism. 

Could it get worse? 

Sure, there could be a big fight over healthcare reform and a medical device products tax.  Which, of course, happened. In 2009.

But really, that probably was the worst period for orthopedic companies. 

Wall Street, as an industry, is roughly two and a half times older than the modern orthopedics industry of Zimmer, DePuy, Stryker, Biomet or Smith & Nephew.  The first trading desk was a table under a button wood tree beside the wall that formed the lower boundary of Manhattan in 1792.  Through booms and bust, Wall Street has tracked every single known industry.  There are charts of equity prices, interest rates and economic activity that go back two hundred years. 

Ortho in 2012

We’ve seen this movie before. 

Using past patterns as a guide, here’s how, we think, this orthopedic industry drama likely plays out over the next 12 months:

• Orthopedic company values will likely be higher than they are today

• There will be fewer independent orthopedic implant suppliers

• Both CMS and the FDA will endure budget constraints

• Strategic investors (large private equity companies and pharma companies) will be eyeing the comparatively strong operating profit margins for orthopedic companies and be looking for ways to add hips, knees, spine and extremity care to their portfolios

In short, the next 12months may well be a more positive, supportive time for orthopedic suppliers which is certainly the most optimistic vision we’ve had in about four years.