5 Steps to Investing in Orthopedics

Early in my Wall Street career with such firms as Craig-Hallum or Piper Jaffray, my boss, the Director of Research said to me: “Robin, I don’t care if your stock picks are right or wrong, just be consistent.”

My job was to identify mis-priced stocks. So I’d visit management, surgeons, hospitals and ask, essentially, about their jobs. How’s business? What’s working, what’s not? What changes are you seeing?

Then I’d boil whatever I learned down to a quantifiable set of numbers—sales and earnings forecasts—and put a price tag on the whole complicated enterprise. If my price was higher than the stock market’s collective estimate, then I’d say “buy.” Lower, then “sell.” Basically.

All my trading clients asked was….is Robin’s batting average high enough (right or wrong) to rely on to make a profit? If he’s consistently wrong, I can make money betting against him, for example. The key was consistency.

My first three years were awful. Couldn’t price companies if my life depended on it. I followed all the steps they teach you in MBA and CFA class. Create multi-layered spreadsheets. Interview absolutely everyone. But my stock picks were as good as any monkey’s in a zoo.

That was 1986.

Valuation Framework

So I studied the problem. Read Graham, Dodd, Drucker and Buffet. Talked to trading veterans at Piper. Read the Journals of Finance and paid close attention to statistical anomalies in the stock market. And I came up with a framework for looking at companies and their valuations.

A framework that worked.

Within one year of applying those principals, I was selected by Institutional Investor magazine as one of the top ten analysts in the United States. A few years later, the Wall Street Journal selected me as one of the top three medical technology analysts in the United States. And I’ve put together a string of successful medical technology calls that might seem pretty mystifying for a guy who only had one biology class in college.

Keys To Orthopedic Companies

I mention all of this because the orthopedic industry and certain companies in it are fitting very well into my framework. Meaning that there are some notably and tantalizingly mis-priced and inexpensive orthopedic companies around today.

So, in this article, I’m going to share five keys to looking at today’s orthopedic companies and mention one money manager, Kevin Kotler of Broadfin Capital, who posted a 26% rate of return in medical device companies last year and is putting in practice a lot of the same elements that I independently developed years ago. (Incidentally, Kotler’s compound rate of return over the past few years is 1, 700 basis points better than the S&P 500.)

1. Patients, not surgeons, know which new medical technologies will work.

The rank and file surgeon, who purchases about $6 million of orthopedic products each year on average, is expected to perform the same surgery thousands of times. It’s boring. To ensure consistently high outcomes, surgeons use what works best for them. Every time. There is precious little reward (and increased risk of punishment) for taking risks in the current system.

Patients on the other hand want change. They are in the physician’s office seeking change. History shows that patients are often the agent of change. Minimally invasive gall bladder surgery, for example, was driven by patient demand. Balloon angioplasty, which failed 70% of the time in those early years, was driven by patient demand. Stem cells are, today, being driven by patient demand. So, step one, watch what patients are saying and asking for.

When should you listen to the surgeon? When you want to know about handling characteristics in surgery. I know this is counter-intuitive. Many investors base their decision on what the surgeon/researcher/scientist says…but the business is driven by the patient. Again, balloon angioplasty failed 70% of the time. Virtually no heart surgeon recommended angioplasty in those early days. Today more patients receive balloon angioplasty than by-pass graft surgery. If there is any hope for disc arthroplasty, it lies with the patient. Longer term, patient demand will drive the business.

So, what are patient’s demanding in orthopedics? Hip and knee reconstruction is tried and true and rates highly among patients—but patients still want better intermediate treatments which would delay joint replacement. Also patients are fascinated with the idea of smart biologics (like stem cells and related products) that use signaling to clear out inflammation and lay a basis for regeneration.

2. Buy dollar bills for 40 cents.

Irwin Jacobs, one of my mentors in those early years, used to buy gunny sacks for pennies and then sell them for dollars when the Mississippi river flooded. Later he bought consumer credit card debt from bankrupt retailers for pennies on the dollar and then collected for years until he received dollars on the dollar. Early on I joined with an investor and we bought trade debt out of a railroad bankruptcy for 35 cents on the dollar. We were eventually were paid $1.15 for each of those $0.35 purchases.

This is another key lesson from Graham, Dodd and Buffett. Buy low, sell high. Look for the inherent value in an asset. The inherent value in orthopedics is, in fact, the ability to relieve pain and improve range of motion. That creates a low elasticity of demand for products and, therefore, a powerful economic model.

Surgeons, hospitals and suppliers have been using that inflexible demand to build a pricing structure that delivers great cash flow. So, if viewed from the perspective of cash flows, the current pricing for companies like Zimmer (28% return on sales), Stryker (25% return on sales), Smith & Nephew (23% return on sales) or Medtronic (33% return on sales) is, in effect, like buying dollars for 40 cents. What makes this even more interesting is that these valuations are available just in front of some historic changes—like Baby Boomers reaching 65 and the advent of trophic and regenerative implants.

3. Progress is always about efficiencies.

Wal-Mart became the largest retailer by driving logistics efficiencies. Tyson Foods became the largest meat processor by driving efficiencies. Remembering that patients drive change and that demand for pain relief and improved mobility is inelastic, the central challenge for suppliers is to find ever more efficient ways to deliver pain relief and mobility. Is that longer lasting implants? Is it off-shore manufacturing? Arguably, no. However, is it pain relieving injections? Site-specific drug delivery? New methods of tissue removal like ablation? Of course. Last year in the United States there were more than 100 million injections into joints to relive pain and improve mobility. One hundred million. No wonder they call these guys needle jockeys.

The central task of suppliers is to take control of treatment modalities that stretch out the continuum of care for chronic diseases like arthritis or other degenerative processes. An implant represents a near-terminal event in the disease cycle. Leading up to that point are dozens and dozens of treatment events.

If someone ever comes up with a pain relieving, cartilage generating, bone spur eliminating injection, they will own orthopedics because they will have set a new standard of efficient care.

4. Everything is a cycle.

To paraphrase Broadfin’s Kotler—can orthopedic manufacturers outmaneuver the macro cycle with product innovation and geographic portfolio management? Sure, assuming they know where they are on these cycles. The pricing cycle is going south right now and, in the absence of really new technologies, it will continue to behave as if most orthopedic implants are commodities.

Regulatory trends are likewise negative while payers are being squeezed by their funding sources (Congress is squeezing Medicare, companies are pushing back at Aetna/Cigna /United) and at the end of the line are hospitals, surgeons and suppliers. The prospect of paying for new Baby Boomer joints has CMS in a cold sweat. So the regulatory and pricing squeeze is on. That’s why orthopedic company stocks are cheap.

But there is one more cycle to watch. The system cycle. Remember, patients drive change and demand is inelastic. Patients are still going to be showing up for treatment. So if the current system can’t handle that, then we may be looking at a cycle of system innovation where new distribution patterns (like Physician-Owned Distributorships), new points of delivery (medical tourism) and new treatment modalities drive value and change.

5. Historic patterns are an accurate predictor of future patterns.

ArthroCare’s management built a great franchise in sports medicine, then made an accounting mistake—nothing particularly major—until they tried to cover it up. It’s the cover up that will always get you.

ArthroCare’s value broke down spectacularly. But the business didn’t. ArthroCare’s historic pattern was to effectively bring to market surgeon-friendly and effective MIS products. Broadfin’s Kotler figured this out and rode ArthroCare from $5 per share to $38 per share in space of about one year.

Orthopedic companies have an historic pattern of effectively solving pain and range of motion problems in the musculoskeletal system. This is the largest sector in all of medicine. What Zimmer, Stryker, Medtronic, Orthofix, Smith & Nephew, Wright Medical, NuVasive, Alphatec and other leading orthopedic companies have done in the past is an excellent predictor of what they will do in the future. So while valuations may be broken, the fundamentals in orthopedics are not. Note, for example, that three of the companies mentioned above have introduced a stem cell product.

Buy Low

Bottom line: the ability of this industry to solve patient problems is fully intact but the value of that as a business has never been as discounted as it is today. Which is a good thing if you are a buyer.