2 unloved healthcare stocks poised for strong returns in 2024

Small caps have had a very challenging period over the last couple of years. This has largely been driven by risk-off sentiment.

Investors gravitated to larger, higher quality, more defensive companies. This has drained the liquidity out of the micro-cap and small-cap parts of the market. In addition, small caps are more sensitive to downturns within their own countries and tend to feature higher concentration in the consumer, financial, and commodity sectors—sectors that have not performed well in this current environment.

However, the tide is now turning.

Small caps tend to perform best and, indeed, have outperformed large caps when the economic cycle entered a recovery phase. If we are in peak financial tightening conditions, with central banks pivoting, we are likely to see more expansionary conditions in 2024.

This is a positive set-up for most risk asset classes, but small caps in particular. Remember, the market leads, while macro conditions tend to be backward-looking. When a positive inflection point in economic growth has been reached, strong returns have historically been generated in small caps. Importantly, this trend has often engendered a multiyear cycle.

How about valuations? The charts below are of US equity indices (large, mid, and small cap); however, they are broadly indicative of other geographies, including Australia. 

It would appear the current set-up is favourable for small caps, and the valuation support is captured in the above charts.

Our top healthcare picks for 2024

Aroa Biosurgery (ASX: ARX) is an innovative New Zealand-based company that produces soft tissue regenerative products to help heal complex wounds. The company has delivered a 30% revenue CAGR in the past five years, from its clinically validated products. The company is now at an inflection point: new product launches, expanding into new surgical indications and channels to market, all in the very large US market.

Importantly, profitability is at an inflection point as the business begins to scale manufacturing, sales and R&D investments made in prior years. Management has guided to $1-2 million underlying EBITDA in FY24, which implies a strong profit contribution in the second half of the financial year which we expect will continue to scale rapidly into future years and support strong returns to shareholders. The company is founder-led, has a high level of cash on the balance sheet, and a well-controlled investment program at a critical inflection point.

Keeping within the Healthcare sector, but at the other end of the market cap spectrum, is Resmed (ASX: RMD). This global med-tech leader has had a very challenging 2023. Whilst they scored an own goal at their August result (missing margin expectations), by far the greatest impact on its share price has been the potential future risk of GLP-1 (weight loss drugs) on their business (sleep apnea). However, this “GLP-1 loser” we believe can bounce back materially in 2024.

Why? There are three reasons. 

Firstly, they are re-focusing internally on costs, broader efficiencies and driving a clear strategy to penetrate a massively under-diagnosed market. This should lead to margin expansion and an ability to maintain at least industry growth at the revenue line. 

Secondly, we feel the GLP-1 risk is over-done. The company has cited reports and data that corroborate the minimal impact so far. As to future disruption risk, there is a lot of data now being released on side effects and tenure of effective use of GLP-1s, so the jury is still out. 

Thirdly, the competitive environment is likely to remain favourable with Philips Respironics unable to resolve its product recall from 2021 and, in fact, receiving a new FDA alert on its main CPAP machine.

Tying this all together, whilst we believe there will be a negative impact on the sleep apnea market from GLP-1s long term (in terms of slower growth), there is plenty of internal opportunity that we believe is being under-appreciated by the market.

Risks for investors’ radars in 2024

Turning to risks. The main risk to our market is a material consumer slow-down, leading to a recession. Following 30 years of unbroken GDP growth, the recent extended rate cycle and high levels of household gearing are restricting consumption.

The two companies above, however, are examples of Australian stocks that we believe have clear idiosyncratic drivers, and could de-peg from a material slowdown, should that risk come to pass. Both provide non-discretionary, high-quality exposures, with what we believe to be a material valuation upside.