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October/November 2009 Picks

Four offerings deemed to be right for right now.

Morningstar Analysts, 10/13/2009

Exchange-Traded Fund: iShares Dow Jones US Medical Devices IHI
After the massive stock market rally, it has become much harder to find undervalued corners of the market. Fear of potential cost controls in health insurance reform legislation has kept health-care stocks down during the current rally, but we believe medical devices face few of the problems holding down Big Pharma valuations, making these companies a very attractive bargain at today's prices.

Medical devices typically work on a faster product cycle than pharmaceuticals, keeping a steadier stream of innovative products. Thus very few of these firms face the patent losses that currently threaten profitability at the largest pharmaceutical companies. Furthermore, cost controls from U.S. health insurance reform legislation will likely not have much effect on revenues or profits at medical-device companies. Their customers are individual doctors and hospitals rather than the major distributors who buy pharmaceuticals, giving device companies greater pricing power due to their disaggregated purchasers. Also, the faster innovation cycle demands that each product update proves its cost-effectiveness to a degree that government procurers almost always find satisfactory. While pharma companies charge lower prices in other developed countries due to the bargaining power of government drug purchases, medical devices tend to command roughly the same prices worldwide.

The demand picture looks bright for these firms: An aging population demands more joint replacements and cardiovascular operations, continued innovation in diagnostic instruments creates whole new markets, and emerging economies trading up to Western best practices in medicine should provide a nice tail wind for years to come. (Bradley Kay)

Stock: Becton, Dickinson BDX
Becton, Dickinson's needle and surgical tool empire has provided investors with robust returns on capital for years. Now, largely because of the company's decades-long dedication to innovation and wise deployment of capital, its business is prospering and its investors remain amply rewarded even in this challenging economic environment.

Becton made a name for itself manufacturing basic surgical instruments: needles, syringes, and scalpels, among others. As the industry evolved, so did the company's products, with many significant technological innovations first introduced at Becton. The launch of safety-engineered products designed to prevent needle-stick injuries is among the firm's latest achievements; these products are now mandatory in most hospitals across the United States. Becton has also been advocating greater use of safety products overseas, and its push is paying off: The firm is seeing switching from traditional to safety-guarded sharps. This trend is particularly evident in developing countries, where the prevalence of infectious diseases makes Becton's single-use, safety-engineered needles and syringes valuable to both nurses and patients.

Our favorable take on Becton's prospects also stems from our confidence in the firm's management. Becton has a history of allocating its capital wisely and providing shareholders with solid returns on investment. The company's reputation for searching out pockets of growth, along with its sizable manufacturing and distribution infrastructure, convinces us that Becton will be able to fend off competition and continue to defend and widen its economic moat. (Haywood Kelly)

Separate Account: Champlain Small Cap Equity
This small-growth separate account does it all. It has generated topnotch long-term returns with below-average volatility. Manager Scott Brayman and team built a great record at Sentinel Small Company SAGWX before striking out on their own and founding Champlain Investment Partners in 2004.

Brayman and his team focus on a limited set of sectors they know best. They emphasize consistent and predictable growers with strong niche businesses over speculative fare. Take top-five holding Waste Connections WCN. The waste hauler has succeeded by countering industry norms. Rivals knock heads in congested urban markets with heavy competition but Waste Connections has built dominant positions in secondary and rural markets where it is the main player. It is also the industries low-cost operator. Brayman and his team been remarkably consistent over the years, topping the Russell 2000 Growth Index in nearly all calendar years. The separate account will lag a bit in such years as 2003 when the poorest-quality companies led the market, but expect it to continue to win out over time. (Michael Breen)

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