On the hunt for tomorrow's CSL

Grady Wulff: Hello and welcome to Livewire's Buy Hold Sell. I'm Grady Wulff, and if there's one sector that has captured the attention of Australian investors over the last 10 years, it's undeniably the healthcare sector. But with the likes of the powerhouses, like CSL, underperforming in recent times, I thought we'd take it to the experts today to see if there are hidden gems at the smaller end of the healthcare sector. To do that, I'm joined by Tim Johnston from Tyndall Asset Management and Tobias Yao from Wilson Asset Management. Gentlemen, thanks for joining me today.

Tim, I'll start with you. The healthcare sector has underperformed since the onset of COVID-19. What do you think the outlook is and do you think that they can come back from here?

Healthcare sector outlook

Tim Johnston: I certainly think there are opportunities in the healthcare sector, but on balance, I think the sector under-performs in the next 12 months, primarily because the valuation multiples that the sector's trading at still need to correct. If you go back to pre-COVID and the run-up to COVID - 2016 through 2019 - the valuation multiples in the sector expanded quite enormously. CSL (ASX: CSL), by way of example, went from a historic average of around 22x up to 45x at the peak of its valuation range and now it's trading back at about 30x. So still a fair way to correct before we're back to historic averages.

Grady Wulff: Tobias, what are your thoughts on this?

Tobias Yao: So we do see value in some of the traditional healthcare names. As Tim has touched on, COVID was a very disruptive period, initially, to the top line of many of these businesses. And then we've had a whole raft of cost issues, cost inflation, employee absenteeism, GP copay and availability issues, and even patient cancellations. That's really impacted the margins of many of these businesses and so the evaluation has come off. We believe right now a lot of that negativity is priced into the share prices. In fact, if you look over the last six months, we've had two takeovers in SILK Lasers (ASX: SLA) and Estia Health (ASX: EHE). So that's really highlighting the value in the space. So we are positioned that way, invested in many of these traditional names.

Is healthcare exposure important?

Grady Wulff: Do you think it's important for investors to have healthcare exposure in their portfolios?

Tobias Yao: Absolutely. If I focus on the traditional names, investors like the fact that these are structural growth stories. They're exposed to the ageing population, population growth and the regulatory backdrop is typically very, very stable. And if they have an offshore operation and succeed in their offshore strategy, then they could grow to be very large businesses like the ones in the ASX 100. So we do see a lot of value within the sector as a whole. It exhibits both growth and defensive characteristics, which should produce pretty good returns on a risk-adjusted basis over many years.

Grady Wulff: Tim, what are your thoughts? Do you think it's important to have exposure to healthcare of some form in your portfolio?

Tim Johnston: Ideally, I agree with everything Tobias said there. The fundamentals of the sector are very, very attractive to investors. As I said earlier though, you do need to be selective in the exposures you take because the valuation multiples are also important and the price you pay for exposure to that asset class is important.

How to assess small-cap healthcare

Grady Wulff: Tim, staying with you, do you think there are different ways of assessing small-cap healthcare stocks as opposed to small-caps in general?

Tim Johnston: I think you probably need to set aside the biotechs. They're a bit of a different beast, but beyond that, healthcare names are fairly much the same as other industrials. You need to get a good understanding of the company's earnings capacity, its growth potential, and the quality of the business in terms of its riskiness and reinvestment needs. To do that, you need to understand the competitive dynamic of the industry and the sources of value creation within the industry. So it's no different in healthcare than in other parts of the market. I would say though, that stocks that are in the US market, there has been a nuance there. Because of the archaic nature of the US healthcare system, there are quite misaligned incentives in a lot of instances and perverse outcomes as a result of that, not always easy to identify. So investors do need to spend a lot of time looking at that market in particular if they want to have success in healthcare.

Grady Wulff: The US is definitely a different beast, isn't it? Now, Tobias, are there any other metrics that you need to assess when looking at healthcare stocks compared to small caps?

Tobias Yao: So if I take a step back, at Wilson Asset Management our investment process is to look for undervalued growth companies with catalysts that could rewrite the share price. With healthcare names, it's the same. We are looking for those inflexion points. Specifically to your question, we do spend a lot more time on the regulatory backdrop and the funding environment. So as with Estia, when we first invested in the business over two years ago, we also spent a lot of time trying to work out the market share gains and losses. We get regular Medicare data that comes out, so you could see where the trends were going. You're just having to figure out why it's happening, why certain players are winning a share.

What about biotechs?

Grady Wulff: Tobias, I'll stay with you. When it comes to small-cap healthcare stocks, is it safer to play the traditional routes like aged care, blood testing, and imaging or do you see an opportunity in the biotech space?

Tobias Yao: We believe it depends on the risk appetite and the time horizon of the investor. Historically, we haven't really played in the biotech space as much unless we see a very clear catalyst and very attractive risk-reward trade-off, such as Neuren earlier in the year. We are a little bit boring, so we play more in the traditional healthcare names and things we can understand, we can track and that's not really relying on binary outcomes.

Grady Wulff: Tim, thoughts on this one? Do you think that it's important to have the specialist skills and knowledge before delving into this space or are you a more traditional investor in the healthcare space?

Tim Johnston: It's certainly safer to play, as Tobias said, in that established part of the market. Those early-stage biotechs are extraordinarily risky and very much a binary outcome. I think that in those instances, you need to lean on the experts in their field because there's no one who's got sufficient expertise across the range of biotechs that can have strong insights into all of them. So for that reason, when we are looking at biotechs, we do rely heavily on experts in the field.

Grady Wulff: It's my favourite part of the episode where I ask the experts to bring some stock picks and their different opportunities for us, for the audience here at Livewire. Tim, I'll start with you. Where are you seeing the opportunities within this sub-sector and can you provide an example of a buy?

Aroa Biosurgery (ASX: ARX)

Tim Johnston: A stock I would encourage investors to have a good look at is Aroa Biosurgery. It's a company, in very simplistic terms, that develops and manufactures surgical meshes and skin substitutes - very crudely speaking, given the science that's supporting these products. That said, the reason I like it is it's a very, very large market opportunity. In aggregate, its markets are in the order of one and a half billion US dollars. It's a company that's coming to market with products that are differentiated and disruptive on price, they're coming at a lower price point. And in addition to that, for the three key stakeholders in the market, it's beneficial for patients, it's beneficial for doctors and it's beneficial for hospitals. So you're basically giving everyone in the value chain a benefit by adopting these products. For that reason, we think the adoption will be relatively rapid and the market share gains should be very solid over the next three to five years.

Grady Wulff: Aroa Biosurgery. You've heard it here from Tim. Tobias, where are you seeing the opportunity and where's your buy rating for us?

Healius (ASX: HLS)

Tobias Yao: We quite like the pathology and radiology space. So Healius is a standout name for us. Now, it is a battleground stock. There's an ACL takeover in the background and they're sort of facing some of the industry headwinds with GPs currently. However, we believe the market's missed how hard they've gone in terms of cutting costs and fixing their balance sheet. So once some of the headwinds wash through, we believe the earnings on the other side are going to be a lot stronger than expected over the next two years. Healius is a buy for us.

Grady Wulff: Well, that's all we have time for today. I hope you enjoyed that special healthcare episode of Livewire's Buy, Hold, Sell. If you did, why not give it a like? Remember to subscribe to our YouTube channel, we're adding so much great content every single week.