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2 healthcare small caps for a healthy long-term portfolio

One of my favourite sectors to invest in is the healthcare sector. In my mind it offers both defensive characteristics and growth potential.

It’s defensive because, generally, we will pay what it takes to remain alive and healthy. Our health is certainly more important than buying a new TV or car. It also helps that health doesn’t really relate to economic cycles – demand for healthcare should be consistent year to year.

In-fact healthcare demand should keep growing due to Australia’s ageing population. Sadly the older we get the more likely medical attention will be needed in some way.

If we can find good small cap ideas then that’s another bonus. Small businesses have much more room to grow until they hit a growth ceiling compared to larger businesses.

With all of the above in mind, here are two ideas:

Japara Healthcare Ltd (ASX: JHC)

Japara is a great example of how Government risk can affect a healthcare business, particularly in the short-term. The share price is down over 15% since the end of last week due to the threat of a Royal Commission into the aged care sector.

More regulations wouldn’t be a good thing in the short-term for Japara, it may permanently reduce profit margins. However, many of the alleged wrongdoings are aimed at smaller operators – many of these players are apparently trading at a loss. They could be tempting acquisition targets.

In the longer-term it may lead to fewer players in the industry with higher barriers of entry. The market has reacted strongly on potential damage.

The ultra-long-term tailwinds of a much larger ageing population still exist and Japara is projected to increase its number of beds by over 1,000 in the next few years when all of its construction projects are completed.

The current share price is almost the lowest it has ever been for Japara. I’m not buying any more shares because of my already-existing position, but I am holding my current shares and re-investing the dividend income.

Paragon Care Ltd (ASX: PGC)

This healthcare product supplier provides beds, devices and equipment to clients like hospitals and aged care providers.

Despite continually growing underlying earnings over the years, the market is still not convinced on the Paragon model of making acquisitions to add additional product lines to its sales platform for clients. There are useful synergies with selling more and more products to a client.

With so many acquisitions and capital raisings going on over the past 12 months it’s quite hard to get a true reading on the business with different pro-forma numbers being produced for every transaction.

What can’t be doubted is that Paragon delivered a statutory earnings per share (EPS) result of 5.4 cents in the last financial year, meaning it’s currently trading at 13x FY18’s earnings with a grossed-up dividend yield of 6.1%.

Management also just raised $45.2 million at $0.91 per share from a new Chinese investor. Not only was this at a significant premium to the share price whilst also giving the company more funds for acquisitions, but it could also lead to cross-selling opportunities for products between the two companies.

There is a lot of work to do to integrate all of new Paragon acquisitions and create synergies, but management only have to do a decent job for this to be a potentially market-beating idea.

It’s trading at under 11x FY19’s estimated earnings.

Foolish takeaway

Whilst the latest Japara setback was disappointing, I continue to believe that over 20 years it could soundly beat the ASX due to the growing number of elderly and the high level of recurring revenue during the resident’s stay.

However, Paragon looks like a very interesting option and I hope to buy more shares if it remains at around this value.

Another share that has a lot of promising growth potential is this exciting ASX winner.

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Motley Fool contributor Tristan Harrison owns shares of JAPARA DEF SET and Paragon Care Limited. The Motley Fool Australia has recommended Paragon Care Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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