Medical-Device Stocks: A Healthy Outlook

S&P thinks the group's long-term fundamentals are positive and features Medtronic and Stryker among its top picks

While flipping through the rolling 12-month relative strength charts for the nearly 140 subindustry indexes in the S&P Composite 1500 Index (consisting of the S&P 500, S&P MidCap 400 and S&P SmallCap 600 indexes), the S&P Health Care Equipment subindustry index chart popped out at me as a long-term turnaround candidate.

During 2006, the S&P Health Care Equipment index rose 3.4%, vs. a 13.3% advance for the S&P Composite 1500 index. The subindustry's relative strength, despite still being below one standard deviation from its mean, has improved ever so slightly and has broken above its moving average. Take a look at the accompanying chart. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500.

Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 17-year mean relative strength.

No Blockbusters on Horizon

Robert Gold covers this group for S&P, and he shares my interest in this subindustry. His fundamental outlook on the health-care equipment subindustry is positive, and he believes that early signs of a rebound in the implantable defibrillator market, combined with ongoing strength in the cardiology, diabetes, pain management, orthopedics, and oncology markets will help drive accelerating sales growth during 2007.

Gold remains concerned about a lack of blockbuster new product introductions anticipated for 2007, but he believes several important products may be launched during 2008 and 2009. In addition, he thinks merger-and-acquisition activity will continue to rise in 2007, providing some support to stock valuations and creating more powerful global competitors in categories such as orthopedics, vision care, interventional cardiology, and oncology.

S&P estimates that 2007 revenues will rise by about 11% to 12%, as improved pricing in orthopedics joins with slowing growth in the interventional cardiology category, particularly regarding drug-eluting coronary stents, which have, in Gold's view, saturated the market in the U.S. He continues to anticipate a rebound in the implantable defibrillator markets in 2007, and thinks growth will persist in the spinal surgery, pain management, robotic surgery, diagnostic imaging, and diabetes management product areas.

Strong in the Knees

Gold also looks for strong gains in the cosmetic surgery categories, with particular strength projected in the facial-aesthetics and breast-augmentation segments, although a weaker-than-expected level of consumer confidence in the U.S. could negatively affect demand for plastic surgery.

In orthopedics, S&P expects protracted strength in the knee-joint-replacement market in 2007, reflecting favorable global demographics and technological innovation. Gold sees spinal repair, including artificial discs, as another strong industry area. Although a broad investigation by the Justice Dept. into orthopedic-device pricing could result in additional headline risk for these stocks, Gold thinks the underlying fundamental drivers remain solid and anticipates that merger-and-acquisition activity will remain strong into 2007.

S&P sees positive longer-term fundamentals, including growing global demand for quality health care, an aging population, and rising R&D outlays, leading to a steady flow of new diagnostic and therapeutic products in areas such as cardiology, orthopedics, oncology, and minimally invasive surgery.

So there you have it. From both a fundamental and momentum standpoint, we believe the S&P Health Care Equipment group will begin to outperform the overall market over the longer term. S&P's 5-STARS (strong buy) picks in the group are Medtronic (MDT) and Stryker (SYK).

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry Company S&P STARS Rank Price (1/12/07)
Apparel, Accessories & Luxury Goods Coach (COH) 5 $46
Broadcasting & Cable TV Comcast (CMCSA) 4 $44
Casinos & Gaming Harrah's Entertainment (HET) 3 $83
Department Stores Federated Dept. Stores (FD) 4 $39
Diversified Metals & Mining Freeport McMoRan (FCX) 4 $55
Integrated Telecom. Svcs. CenturyTel (CTL) 3 $44
Investment Banking & Brokerage Merrill Lynch (MER) 5 $97
IT Consulting & Other Svcs. SRA Intl. (SRX) 5 $28
Metal & Glass Containers Ball Corp. (BLL) 4 $45
Motorcycle Manufacturers Harley-Davidson (HOG) 3 $73
Movies & Entertainment Disney (Walt) (DIS) 5 $35
Steel Carpenter Technology (CRS) 4 $104
Tires & Rubber Goodyear Tire & Rubber (GT) 3 $25
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