IHI: Medical Device Bull Market To End Soon – iShares U.S. Medical Devices ETF (NYSEARCA:IHI)

(Source – Pexels)

Healthcare has consistently been one of the top-performing sectors on a risk-adjusted basis throughout the current bull market. During its first half, biotechnology (IBB) and pharmaceuticals (XPH) were all the rage seeing 50% annualized returns per year until the bubble finally ended in 2015. Since then, biotechnology stocks as a whole have gone nowhere. Like a flying billiard ball hitting another, all of that momentum transferred into medical devices (IHI).

The overarching health care narrative is logical. Healthcare is typically less correlated to the general economy and has, and will likely continue to, see high top-line growth due to the aging U.S population. That said, it seems that investors may be far too unanimously believing the “aging population growth” narrative to a point of buying into extreme overvaluation. Indeed, that is exactly what happened in Biotechnology stocks only years ago.

I came across this idea after combing through valuations and risk statistics for the 200 industries in my database. Medical devices came it at the bottom of the “value for risk” list. Note, the risk is measured as annualized volatility and systemic exposure in a similar fashion to I showed in this article regarding European valuations. The result? Even with growth expectations used in the equation, medical device stocks are at least 40% overvalued.

Before we get into the weeds, I am considering a simple fact. Medical devices (IHI) and Pharmaceuticals (XPH) share roughly the same demand factors and both share relatively high political/regulatory risks. Given how similar the two are (compared to other non-healthcare industries) why does IHI have a weighted average “P/E” of 43X while XPH trades at 25X? Clearly, a dislocation exists.

The iShares U.S Medical Devices ETF

In my opinion, it is as important to know your product as it is to have an opinion on it. Many industry ETFs are overconcentrated, have poor liquidity, and/or have high closure risk. Luckily, that is not true for the iShares IHI ETF.

IHI is relatively old and has been trading since 2006. It tracks the Dow Jones Select Medical Equipment Index and currently has 57 holdings with none over 15% in allocation.

As I mentioned, it’s holdings have extremely high valuations with a weighted average “P/E” ratio of 43X. Valuations that high usually mean one of three things: risk exposure is very low, the companies are growing very quickly, or most of the companies do not make a profit. In the case of IHI, risk exposure is actually pretty high, the companies are growing (but not for long), and most companies make very high profits margins.

Speculation seems to be quite high for the ETF. One of my favorite ways to gauge speculation is by looking at AUM inflows. This lets us see what our fellow investors are doing. Specifically, if they are all doing too much of the same thing.

Data by YCharts

Here we can see that inflows were pretty much stagnant until 2015. What happened in 2015? This is what happened in 2015:

Data by YCharts

As you can see, as money finally poured out of pharmaceuticals it only rotated into medical devices. The question this is will the bull market in medical devices end the same as in pharmaceuticals and biotechnology? After looking closely at the fundamentals, the answer seems to be yes.

Low Growth at an Unreasonable Price

IHI is perhaps the “anti-GARP” investment. I know most will disagree with me, but I usually see the best results when most disagree. Medical device valuations are not supported by the fundamentals. That is not to say IHI will necessarily come falling down soon, but it is to say IHI and medical device investors may want to take their considerable profits.

Here is a table of my key fundamental statistics for most of the holdings in IHI. Together, they make up over 75% of the fund so are representative of it.

Data source: Unclestock

Note, “Typical” denotes median statistic for a given column

The typical firm here has a “P/E” of 52X and an “EV/EBITDA” of 27X. Most are also trading 20% above their five-year average on a price-to-revenue basis. This is a sign that growth expectations for the industry are very high.

That said, top-line growth is solid at around 8-11%, but nothing to ride home about. This is also true regarding the 9% median ROE, it is better than many industries but not a signal of high growth potential.

It is often said that healthcare is a “low risk” sector. It is not very capital intensive and has a stable and growing demand that is not subject to usual demand cycles. That said, IHI is not a “low risk” ETF.

To begin, the median debt to equity of the companies is 50%. This is not as high as many industries but does add cyclical risks. Secondly, the fund’s Beta to the S&P 500 over the past three years is 0.96, signaling that the fund has about the same systemic exposure as the S&P 500. Lastly, the ETF is quite volatile and currently has an implied volatility of 19% compared to the S&P 500 at 16%. In fact, IHI and the S&P 500 both fell just over 50% in 2008, and medical device stocks were trading at a much lower valuation back then.

Possible Growth Slowdown Suprise

A major factor that has been boosting healthcare stocks as a whole is the aging U.S population and growing demand for surgery and pharmaceuticals. It is well known that the United States has much higher drug and medical devices prices than the rest of the world.

This is a statistic you have probably heard, but just look at hip replacement prices in the U.S compared to its peers:

(Source – The International Federation of Health Plans )

While demand for products such as artificial hips and knees is growing, I expect that the political demand for lower prices may grow even faster. The assault on pharmaceuticals has been in play and hurting stock prices as I expected in June. It seems fitting that the discussion will expand into the next largest healthcare expense, medical devices.

Even Fitch reported that their 5% annual industry revenue growth rate to 2023 expectation could easily be cut short by more scrutiny of prices on behalf of the U.S government. Even 5% is not high, to begin with considering the valuations of these companies.

Remember too, if the U.S imposes tariffs on Mexico (which I see as unlikely) it will likely hit 17% of U.S medical devices that are produced in Mexico. The United States is also the leading global exporter of medical devices, other countries may choose retaliate against these U.S exports.

Regarding the aging population growth story. It seems that investors have all become far too decided on this narrative. Today, 16% of the U.S population is over 65 years old. By 2050, that figure is expected to rise to 20%. Given that life expectancy does not continue to fall, this implies a 0.19% rise per year. Thus, very little excess revenue growth can be expected by this slight demographic shift.

Trade-Ideas

In my opinion, healthcare and specifically medical devices is one of the last places I’d like to park my money. Valuations are far above reasonable levels, systemic risk is higher than many expect, and momentum is beginning to fade. Even if you’d like to invest in health care, there are much better risk-reward opportunities.

For example, if you really want to invest in an aging population. You may want to look at the Janus Henderson Elderly Care ETF (OLD) that invests in Health care REITs. While IHI has slowly been losing momentum, OLD has climbed very quickly. Perhaps the speculative rotation out of pharmaceuticals and into medical devices is now beginning to rotate out of medical devices and into healthcare real estate.

Indeed, a long OLD short IHI pairs trade looks like it may be a profitable low exposure opportunity. Take a look at the hypothetical performance of that trade as seen by its price ratio:

Data by YCharts

The trade is currently bouncing off of its long term support level. This is yet another sign that momentum maybe switching out of medical devices and into medical REITs. I would not be surprised to see this ratio climb to .14-.16 by year-end or a 20% return for the pair trade.

I am short IHI as of Wednesday with a price target of $200 by year-end. If the global economy continues to hurt stocks, that figure could be even lower as the fair value of the fund is probably around $160.

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Disclosure: I am/we are short IHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long XPH