Nine Health-Care Stocks from Our Ultimate Stock-Pickers

By Alan Rambaldini | Stock Analyst

While most of our Ultimate Stock-Pickers have yet to file their second-quarter holdings with the SEC, we've had a chance to sift through the holdings, purchases, and sales of top managers  Amana Trust Growth (AMAGX),  Amana Trust Income (AMANX),  Aston/Montag & Caldwell Growth (MCGIX), and  Parnassus Equity Income (PRBLX), all of which provide monthly holdings data for their funds. Our inspection uncovered more than a few high-conviction purchases, such as  Accenture (ACN),  McGraw-Hill (MHP), and  Paychex (PAYX), as well as a spattering of health-care names that these managers were buying with a similar degree of conviction.

As you may recall from our last article, we noted that health care has been one of the three sectors that the management team at  Vanguard PRIMECAP (VPMCX) has been keenly focused on, given the impact that the aging of the baby boomers is expected to have on the industry longer term. We also noted that near-term concerns over a government-sponsored health-care plan have suppressed the stock prices of many of the firms operating in the sector. So it wasn't too surprising to see continued buying by some of the other top managers in our Investment Manager Roster.

The purchases of  Medtronic (MDT) and  Bristol-Myers Squibb (BMY) stood out because they were not only higher-conviction buys, but new money purchases for the managers acquiring them. Parnassus Equity Income purchased 1.25 million shares of Medtronic, with a position size equivalent to 2.6% of its equity holdings at the end of the second quarter. Meanwhile, Amana Trust Income purchased 550,000 shares of Bristol-Myers Squibb, with the position accounting for 2.0% of the fund's equity holdings. As you may recall from one of our previous articles, the average position size for our Ultimate Stock-Pickers is around 1.7%, and in the case of Parnassus Equity Income and Amana Trust Income it was 2.3% and 1.3%, respectively, at the end of the second quarter, so these would definitely qualify as above-average position sizes.

Nine Health-Care Stocks from Our Ultimate Stock-Pickers
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	Market Cap ($ Mil)
Genzyme Corporation		Medium	Wide	48.81	0.55	13,167
Pfizer Inc. (PFE)		Medium	Wide	15.79	0.61	106,551
Novartis AG (NVS)		Low	Wide	45.15	0.62	102,260
Eli Lilly & Company (LLY)		Medium	Wide	34.42	0.64	39,549
Abbott Laboratories (ABT)		Low	Wide	43.63	0.64	67,428
Becton, Dickinson (BDX)		Low	Narrow	63.75	0.69	15,270
Medtronic, Inc. (MDT)		Low	Wide	35.58	0.74	39,824
Johnson & Johnson (JNJ)		Low	Wide	59.93	0.75	165,141
Bristol-Myers Squibb (BMY)		Medium	Wide	21.73	0.78	43,045
Data as of 08-06-09.

 Eli Lilly (LLY) and  Johnson & Johnson (JNJ) were both purchased by two of the four funds during the recent quarter, while  Genzyme ,  Pfizer (PFE),  Novartis (NVS), and  Abbott Laboratories (ABT) were all bought by at least one manager. A name that did not show up among the most recent purchases by these four funds, but which remains notable for the fact that it was a new money purchase for three of the four managers that were buying the stock during the first quarter, including Amana Trust Income, is  Becton, Dickinson (BDX).

As you may recall from a recent article on the top new money purchases by our Ultimate Stock-Pickers during the first quarter, Becton, Dickinson is the world's largest manufacturer and distributor of medical surgical products, such as needles, syringes, and sharps-disposal units, and it also manufactures diagnostic instruments and reagents, as well as flow cytometry and cell imaging systems. The company has built a narrow economic moat around its business by being the low-cost provider in the industry, as many of its customers make their purchase decisions based on price. Becton has also been an innovator in its field--being the first to launch safety-engineered products that are designed to prevent needlestick injuries, which are now mandatory in most hospitals in the United States.

Given the runup and subsequent pullback in the stock's price since we last looked at the firm, we decided to sit down again with Alex Morozov, the associate director of stock analysis for the Morningstar health-care team, to get his take on the firm's second-quarter results, as well as to talk about his future projections and see why our Ultimate Stock-Pickers have been so interested in the company.

Alex, you've been bullish on Becton, Dickinson for a while now, and the company has been a top new money purchase of our Ultimate Stock-Pickers this year. Yet the market didn't like the company's second-quarter earnings released on July 30, pushing the stock down about 13% to a two-month low. How did Becton, Dickinson do during the second quarter and what is it about its future outlook that pushed investors away from the company?

The company's stock took a beating following its second-quarter announcement, as investors were preoccupied in part with a nonrecurring $0.28 EPS currency hedge benefit that will provide tough comparisons for 2010 earnings. Becton's commentary regarding its 2010 prospects also contributed to the sell-off; the 7% earnings growth projected by the company appeared to be rather conservative for its investors who are accustomed to double-digit earnings expansion posted by the company over the last decade. Becton warned of a still-tough industry environment, with capital budgets remaining tight and international sales facing tough comparisons. While prudent in our opinion, Becton's cautious commentary didn't jibe with the public sentiment of easing recessionary pressures, sending its stock down sharply.

So excluding the benefits of the currency hedge, in the midst of one of the toughest external environments it's ever faced, Becton is still growing earnings at only a slightly lower rate than it has historically, even if management is being cautious in its forecasts. Can you explain how the company can continue to grow despite the harsh financial constraints faced by its customers?

The bulk of Becton's products should hardly be considered economically sensitive. Surgical consumables, given their essential and disposable nature, require constant replenishment. The inventory destocking phenomenon we witnessed in the previous quarter should only be viewed as an anomalous event, as hospitals are not likely to cut down their inventory levels even lower and face shortages of basic surgical supplies. It is also highly improbable that hospitals would attempt to downgrade from more-expensive safety products to basic needles given massive regulatory oversight and safety hazards such a decision would pose. Even in emerging markets, where regulatory requirements are less rigorous, the advantages of safety products continue to lead to growing adoption, providing a nice tail wind to the mature surgical business.

The area with some expected weakness is Becton's bioscience division, which relies on capital spending by pharmaceutical companies and research centers. Nonetheless, even if this business manages to eke out a low-single-digit growth (not an overly onerous task given a considerable boost expected from increasing levels of funding coming from the National Institute of Health), with mid-single-digit growth in its segments and some cost control, Becton should have no trouble getting to the 7% EPS growth it has promised to investors.

What are your own projections for Becton going forward, and where could you be wrong about the company's prospects?

I consider 7% EPS growth a rather conservative target. Once the impact of an unusually strong first quarter of 2009 in Biosciences is annualized, the remainder of 2010 should see very favorable comparables in virtually every product category. Top-line growth of 6% to 7% next year is hardly a stretch, and even with a reduced gross margin forecast due to unfavorable product mix, I believe Becton should post an 8%-10% earnings growth in 2010. Of course, if emerging markets come to a screeching halt, the NIH funding does not materialize, and capital spending remains at a very depressed level throughout 2010, my projections would prove to be overly optimistic.

On a valuation basis, how cheap is Becton's stock right now, and are there any catalysts on the horizon that the market would seize upon to close the gap with your fair value estimate?

The stock is presently trading at a 30% discount to my fair value estimate, a very intriguing entry point for an investor with a low risk-tolerance threshold. Management is forecasting 2010 EPS around $5, which means that at today's prices investors are willing to pay only 13 times forward earnings--well below the historical multiples for the firm. If the capital spending environment does not deteriorate any further, and NIH funding starts trickling through in the early 2010, Becton should see a decent pickup in revenue and free cash flows, giving its stock a well-deserved boost.

Finally, what's the worst-case scenario for investors who get in on Becton right now?

The floor on the stock is close to the level where it is trading currently. To reach $65 per share, we would have to stipulate Becton's pricing power deteriorates, its revenue grows at a below-market-average level, and its operating earnings increase at a meager 2% CAGR over the next five years--a highly improbable scenario in our opinion.

With little risk involved in holding Becton, Dickinson at the current market price, the decline in the company's stock post-earnings has given investors a great opportunity to add some health-care exposure to their portfolio at a cost similar to what many of our Ultimate Stock-Pickers thought was a worthy entry point a few short months ago. We still think that Becton, Dickinson is worth a look for investors looking to heal their portfolio after the pain inflicted in 2008.

Disclosure: Alan Rambaldini does not own shares in any of the companies mentioned above.