FNArena editor Rudi Filapek-Vandyck shares his views and insights on irregular basis with subscribers. Occasionally, these views are made accessible to non-paying members and readers elsewhere. This story was originally published on Wednesday, June 30, 2010.

By Rudi Filapek-Vandyck, Editor FNArena

It hasn't exactly received much airtime thus far, but Australia has led the rest of the world into this post-April downturn. Shortly after global equity markets peaked in April, I observed that profit growth expectations in Australia had stopped rising. That was weeks before corporate earnings forecasts in the US, Europe and Asia went into decline.

Two months earlier, during the interim results season in February, market expectations for healthcare stocks had received some significant downgrades. Not that anyone knew at the time, but in hindsight, healthcare stocks were showing the way forward for the broader market.

The February results season has had a material impact on how investors in general perceive the healthcare sector in Australia. Not every healthcare company is equal and investors have since again learnt the value of successful stock-picking.

This may well be lesson number one from observing the healthcare sector over the past four months: when things get tough the weak get separated from the strong. No mercy involved. This means stock-picking, rather than sector-allocation, becomes all-important.

Earnings risk has again become a major feature for the share market. Lesson number two from the February experience is that healthcare stocks are not immune.

The latter is more important than one would be inclined to think at face value. Despite healthcare often being categorised as “defensive” by stockbrokers, it is not always appreciated by investors the sector historically commands higher multiples than most other sectors.

The reason behind these above-market Price-Earnings (PE) multiples is simple: companies such as CSL ((CSL)), ResMed ((RMD)), Cochlear ((COH)) and Ramsay Healthcare ((RHC)) have long grown at much higher speed than other companies. If there's one thing the share market does very well, it is rewarding companies for high growth performances.

This easily explains why these stocks have been top of the list of favourites for many investors and stockbrokers: high earnings growth multiplied by high PE ratios makes for an almost watertight guarantee of high investment returns.

What is not always appreciated, however, is that high PE ratios become a time bomb when earnings growth stalls. This is what has happened to CSL over the year past.

I haven't exactly made myself popular with shareholders of CSL since I made the observation last year, and stuck by it, that the shares were too expensive. I do agree with almost everything that is being said and written in a positive sense about CSL, but I always end up adding: “but the shares are too expensive”.

CSL's underperformance since March 2009 proves my point. CSL's share price held up well during the 2008 share market meltdown, but what is seldom mentioned (and so easily forgotten) is that the company managed to grow its earnings per share by nearly 35% in fiscal 2009 – this at a time when most companies saw their profits plummet.

At $38 in March 2009, CSL's PE multiple had gone past 22, which by anyone's standards was more than appropriate. The problem that then arose, however, was that profit growth for the years ahead started to look bleaker and bleaker, especially after management had to give up on acquiring US competitor Talecris.

The combination of slower growth and thus a (deservedly so) lower multiple has made CSL one of the stand-out underperformers throughout what may well have been the strongest share market rally we will all witness in our lifetime.

I remain yet unconvinced the tide is about to turn for CSL. My motivation? At $32-something CSL shares are still trading on more than 17 times projected consensus earnings for fiscal 2010. While this is well below the multiple of 22 mentioned previously, one also has to appreciate that CSL -if it meets this year's consensus expectations- will only grow its earnings per share by 10% - less than a third of growth for the previous year.

What about fiscal 2011? Current consensus forecasts only assume 6.5% growth. One old standard rule for the share market is that investors better not pay for a higher multiple than what can be expected in terms of EPS growth. I acknowledge this is a rough rule, and it certainly not always applies to all companies under all circumstances, but CSL shares are valued at more than 16 times FY11 consensus EPS. That seems a whole lot to me for a company whose earnings growth seems in decline, and rather sharply so.

While many analysts are expecting major improvement from FY12 onwards, that is still such a long time away. In the meantime, dividend yield is around 2.5%. Sorry, but that's simply not enough for my liking.

My view on CSL is simply confirmed when I compare with valuations for other stocks in the sector. Ramsay Healthcare, for example, is trading at similar PE multiples but with projected EPS growth numbers of 12% and 10.5% for FY10 and FY11 respectively. Ramsay's anticipated dividend yield is 3% and more.

The real stand-outs, however, are Cochlear ((COH)) and ResMed ((RMD)). Both are trading on multiples well above 25, but have a look at what both should bring to the table in terms of EPS growth this year (FY10) and next (FY11): 19% and 12.4% for Cochlear; 33.1% and 20.2% for ResMed.

As things stand right now, Cochlear is slightly more expensively priced than ResMed, but the mentioned consensus growth projections suggest ResMed shares seem the better option.

At multiples above 25, however, I wouldn't be chasing any of these two, regardless of what future growth expectations might be. History shows that, in case of disappointment, the combination of weaker growth and contracting multiples can be devastating for the share price. Maybe the best strategy regarding both would be to wait for pullbacks and/or more certainty about future growth?

I note, for example, that Cochlear's present multiple seems high in relation to what is expected in terms of FY11 growth. Is this the next CSL in the making?

Glove and condom manufacturer Ansell ((ANN)) trades at a multiple not far below those for CSL and Ramsay, but at least earnings growth is expected to accelerate from 9% in FY10 to 15% in FY11.

Most other stocks in the sector, including Sigma Pharma (SIP)), Biota ((BTA)), Primary Healthcare ((PRY)) and Sonic Healthcare ((SHL)), are nowadays trading on lower multiples in line with sharply lowered growth expectations. The market is not expecting any growth from Healthscope ((HSP)) but take-over appeal is keeping the shares at relatively high multiples of 15-plus, indicating significant downside exists if nothing materialises.

All of the above are observations and conclusions based upon consensus forecasts, but we know from the February interim results that healthcare companies are not immune to profit disappointments. So where does this take us?

I believe the market has already made up its mind about which companies are more likely to disappoint and which ones carry less risk. This risk-assessment, I believe, is at present reflected in the triangle-combination of 60 days moving average, 200 days moving average and share prices for the companies mentioned.

For those not familiar with these tools: 60 M/A is usually used as a gauge for short term momentum, the 200 M/A marks the underlying, long term trend and if the first one breaks below the second one this is usually very bad news (it's called the “cross of death”).

As such I observe that: only ResMed, Cochlear, Ramsay and Ansell are still trading (well) above their respective 200 M/A, suggesting the market maintains the longer term outlook for these companies remains healthy. This is in line with what PE multiples and consensus forecasts are telling us.

Shares of Sigma, Biota, Primary and Sonic, however, are not only trading well below the 200 M/A, the 60 M/A is also below the 200 M/A. This at least suggests the market is either suspecting more troubles, or the risks are simply too high.

For CSL, the picture is rather mixed. The shares are below 200 M/A, but 60 M/A is still above the long term trendline (but approaching). I think this means not everybody has yet given up on the potential for a positive surprise.

Some investors will hold on because of “nostalgia” (which the company shares with the likes of QBE Insurance ((QBE)) and Woolworths ((WOW))), while others will be hoping management will come up with a game changing take-over.

The following ten stocks were included in the analysis above: Sigma, Biota, CSL, Primary Healthcare, Sonic, Ansell, Healthscope, Ramsay, Cochlear and ResMed. All consensus data are daily updated and available at all times for subscribers on the FNArena website. This includes price charts showing 60 and 200 M/A (see Stock Analysis).

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