2023-07-31 15:29:54 ET
Summary
- It appears that the performance of iShares U.S. Medical Devices ETF isn't taking into account any expectations of long-term rates in bond markets.
- Long-term rates have an outsized impact on stocks whose value resides in the horizon.
- IHI is extremely high multiple, even relative to the tech-led US equity markets. Valuations do not acknowledge market expectations about LT rates, which are well-founded.
The iShares U.S. Medical Devices ETF ( IHI ) has a high valuation and a high expense ratio. While these businesses have large barriers to entry, and are growing, we still think that their performance ignores changes in the rate environment, especially as it interacts with the quality in the IHI. It doesn't seem safe to buy in at valuations that are still so high.
IHI Breakdown
There is no question that the medical device and general medical industry in the U.S. benefit both from favorable demographics for secular growth but also a lot of pricing power and barriers to entry afforded by the approval systems, required manufacturing expertise and high switching costs for physicians to get comfortable with alternatives. It is a growing industry with good industry structure that certainly deserves some premium in valuation.
However, there are several concerns. The first is that among some of the highest weighted exposures , since there is quite a lot of skew in this exchange-traded fund, or ETF, are companies that have actually had major earnings headwinds that have precluded a great performance due to the end of COVID-19. Testing revenues as well as other peripheries affected negatively the performance of Abbott Labs ( ABT ) and Thermo Fisher ( TMO ). The performance of the ETF might as well reflect those business headwinds considering the change in price.
What it doesn't reflect is the fact that this ETF is valued extremely highly at a 40x P/E on average, which is much higher than the general S&P 500 (SP500) which is around 23x, and therefore has a lot of its valuation baked into the long-term prospects of the companies. While the long-term prospects aren't in question from a business point of view, supported by factors like great U.S. demographics, the issue is how the rate environment interacts with those long-term cash flows.
All of the value of these companies is in the long-horizons for the modelled cash flows, and every point higher in cost of capital has an exponentially higher effect in discounting those horizon values. The fact that the ETF is doing so well relative to pre-COVID levels, which is arguably where all the stimulus that started the inflation we are seeing today started, is not consistent with what smart money is saying about long-term rates in particular , which concern those horizon values.
Bottom Line
Long-term rates have continued to be revised upwards, while short term rates less so, which reflects that bond investors are concerned with long-term rate factors like deglobalization. While higher long-term rates relative to short term rates also signal better immediate economic outlook, as part of a de-inversion of the yield curve, the fact that they are going up in absolute terms does reflect long-term rate concerns. Maybe there won't be a major recession but the last leg of inflation will need higher rates to deal with, especially when cost push factors remain.
The implied cost of capital on these businesses is probably barely at a premium to risk-free rates at this point. That's just not very appropriate considering that all equities have risk, at least volatility, and in the case of healthcare there is always the government and the matter of high healthcare costs in the U.S. to concern investors. IHI isn't interesting, especially when expense ratios are also pretty high on the ETF at 0.39%.
For further details see:
IHI: Too Expensive Considering Long-Term Rate Uncertainty