For elite athletes, a health check following an intense period of training or competition is a standard part of the job.
As investors, we can use this strategy to evaluate the stocks in our portfolio that have experienced a period of high performance (or poor performance) to see if there is any further action required.
Displayed above is the three-year share price chart of the healthcare sector heavyweights CSL Limited (ASX: CSL), ResMed Inc. (CHESS) and Ramsay Health Care Limited (ASX: RHC).
During this period, CSL, ResMed, and Ramsay gained 107%, 108%, and 155%, respectively. After this stellar run, it's time for a health check to look for signs of stress or weakness.
The rules
For each category assessed, the strongest company will score 3 points, followed by 2 points and 1 point for the company showing the poorest health. Points will be tallied at the end to provide insight into the relative health of these businesses.
1. Debt
Debt can be useful for business when used in moderation, but the safest level is none. Companies that can grow with minimal external financing should be considered higher quality by investors.
All three companies carry significant amounts of cash. Therefore, the values in the table above are net debt (debt – cash holdings) and net gearing ([debt – cash] / equity).
ResMed is the most conservative of these companies and has more than US$500 million of surplus cash on hand. CSL has increased its gearing over the past three years, but Ramsay has piled on the debt and has a net gearing ratio of 155%!
Health: ResMed (3 points), CSL (2 points), Ramsay (1 point).
2. Revenue Growth
How quickly have these businesses grown revenue and what is the two-year forecast? The table below shows the compounded annual growth rate (CAGR) of revenue.
Health: Ramsay (3 points) just edged out CSL (2 points) while ResMed is further behind (1 point).
3. Return on Capital Employed
Due to the varying degrees of leverage used by CSL, ResMed, and Ramsay, we will look at the return on capital employed (ROCE). ROCE considers all of the capital being used to run the business, whether funded by debt or equity and will provide a direct comparison.
CSL and ResMed have delivered a consistent ROCE around 50%, while Ramsay is around 32%. Ramsay is a hospital owner and operator which explains the lower return compared to biotechnology companies CSL and ResMed.
Health: We have a tie – CSL and ResMed both receive (2 points) while Ramsay scores (1 point).
4. Dividends
With the RBA leaving cash rates at a measly 2%, dividends not only play a major role for total returns but are an important source of income for many Australians. The dividend yield for these stocks at each year end is shown below.
All three companies offer a similar yield around 2%. However, what is more important than the current yield is the ability to cover the dividend with cash and to increase it in the future. To assess, compute how many times the dividend is covered by free cash flow:
CSL = 1.8x; ResMed = 1.9x; Ramsay = 1.5x
ResMed has the highest dividend coverage ability and no net debt that makes it likely the business that can increase it safely in the future. In contrast, Ramsay has the lowest dividend coverage capability and a large net debt balance. If interest rates increase in the future, its dividend would be the first to come under pressure.
Health: ResMed (3 points), CSL (2 points), Ramsay (1 point).
5. Valuation
Following a 3-year period of exceptional share price performance for all companies, how does their current valuation compare?
Ramsay is currently the most expensive on most basic metrics although its slightly lower EV/EBITDA ratio ( enterprise value / earnings before interest, tax, depreciation and amortisation) can be partly explained by the higher capital requirements of the business.
Overall, CSL offers the most appealing valuation according to these simple metrics.
Health: CSL (3 points), ResMed (2 points), Ramsay (1 point).
Results
After checking the companies across five important metrics, we have a tie between CSL and ResMed with Ramsay coming in last.
Companies within the healthcare sector are arguably some of the best companies you can hold due to their defensive earnings and high margins. However, even the best companies become poor investments when you pay too much to acquire them.
CSL and ResMed appear the most compelling investments and should be the focus of further research.
