Orthopedic and Dental Industry News Complete Archive »

Why Orthopedic Equities Offer Superior Risk/Return Performance BY JOHN MCCORMICK, SEPTEMBER 20, 2004

Using classic portfolio theory to analyze the past performance of orthopedic equity we uncovered data that strongly suggests that Orthopedic equities delivered to investors superior returns with minimal risk and, in fact, provided a better risk/return paradigm than the rest of the US healthcare market.

Data
As a return, risk and valuation proxies we use the US public equity markets. The orthopedic data comes from the HealthpointCapital Research Group's Orthopedic Index, developed in April 2002 and calculated on a weekly basis. For consistency, other indices in this brief use April 2002 as a base period and are likewise calculated on a weekly basis. The Orthopedic Index is a market capitalization weighted index that includes substantially all of the publicly traded "pure play" orthopedic device companies.

Healthcare as a broad category offers lackluster returns
Chart 1 below shows that since April of 2002 the Dow Jones US Healthcare Index has only returned 0.2% on an annualized basis. This compares unfavorably to the S&P500 which returned 2.0% during the same period.

Chart 1 - Healthcare Prior Performance Unattractive

Although the Dow Jones US Healthcare Index represents a broad universe of healthcare companies, it actually has greater volatility than the S&P500. In addition, healthcare as a broad category is highly correlated to the S&P500. Investing in US healthcare has offered less return with greater risk than the overall stock market with almost zero opportunity for diversification. This is clearly not compelling.

Orthopedics offers superior returns
Chart 2 below shows how orthopedics has performed versus healthcare and the overall US stock market. Orthopedics has delivered an annualized 21% return since April of 2002 which substantially exceeds the S&P500 and the broader healthcare market including biotech.

Chart 2 - Orthopedics Prior Performance Attractive

Orthopedics offers superior risk adjusted returns
As shown in Table 2 below orthopedic medical devices have not only delivered superior absolute returns, but superior risk adjusted returns as well.

Although orthopedics does show high volatility relative to other sectors, the outstanding absolute and relative performance of orthopedic equities clearly dominates healthcare and biotech. We divide the annualized returns by the standard deviation to examine the relationship between risk and return. Note the extreme volatility of the broad healthcare category to compare to its returns. Note also how orthopedics has effectively produced double the returns of biotech for the same amount of risk.

From a fundamental perspective, orthopedics remains attractive. Publicly traded orthopedics companies have had a substantial return recently, but the basis for this recent market return on equity is actual return on equity and actual net income growth. We note that almost none of the public companies use meaningful leverage and therefore returns on equity are similar to returns on assets. The average return on equity across public orthopedic device companies has been well above 20% in 2004 and net income growth has averaged as high as 29% in recent quarters.

Recent data shown in Table 3 below suggest orthopedic equities still compare favorably to other medical device sectors. Note the high consensus earnings growth among analysts.

Orthopedics offers diversification
As we noted before, investing in US healthcare broadly has offered almost zero opportunity for diversification. Table 3 below calculates correlation coefficients.

The orthopedic medical device correlation coefficient to S&P500 of 0.84 does not suggest an overwhelming diversification case. When we took a close look at the data for "drawdowns" (negative return events) the arguments favor orthopedics, however. Note how orthopedics has little correlation to the market when the going gets tough. In fact, the correlation coefficient for orthopedics in down markets is 0.29 which suggests powerful diversification benefits.

Concluding remarks
A simple analysis from a portfolio theory perspective will immediately render an affirmative case for orthopedic medical devices as an attractive investment category. Orthopedics has in the past provided superior returns to investors for minimal risk, excellent diversification opportunities especially when compared to broader sectors of the US healthcare markets. Although past performance is no indicator of future performance the return on equity and growth of net income in the orthopedic medical device sector suggest that this market merits consideration.