Healthcare stocks have gained nearly 18.0% in the first nine months of this year, compared to the S&P 500 index’s gain of 3.2% over the same time frame. While the coronavirus pandemic has been disruptive, there are pockets within the healthcare sector that have benefited. Some companies had benefited from increased sales of over-the-counter drugs and personal care items as people stocked up. However, sales were simply brought forward and may level off with a slowdown in sales going forward.
There has been a sharp drop in doctor visits and delays in elective surgeries. In addition, fewer medical visits translate into fewer diagnostic tests and drug prescriptions. However, as the economy slowly reopens, healthcare companies have seen some of this reverse and the earnings outlook has improved. Some companies within the biotech and pharmaceutical industries may benefit if they produce tests and vaccines for the virus, but at high cost and potential delays of other trials.
In terms of risks, healthcare reform and prescription drug prices have become a focus during the run-up to the 2020 election, triggering an increase in volatility.
Some growth stocks deserve their high valuations, while many do not. Partha Mohanram, who holds the John H. Watson chair in value investing and is area coordinator of accounting at Rotman School of Management, University of Toronto, developed a scoring system to help separate the winners from the losers among stocks trading with high price-to-book-value (P/B) ratios. The grading system looks at company profitability and cash flow performance, adjusts for likely mistakes due to naive growth projections and considers the impact of conservative accounting policies to form a growth score, or G-score.
Mohanram’s work identified fundamental factors that are useful when studying growth companies. Investors tend to naively extrapolate current fundamental growth stocks or even ignore the implications of using conservative accounting to project future earnings. Mohanram refers to the signals of his grading system as “growth” fundamental signals since they measure the fundamental strength of these companies in a context appropriate for growth firms. Mohanram feels that stocks with stronger growth fundamentals stand a better chance of expanding earnings and are more likely to beat earnings forecasts.
Profitability, naive extrapolation and accounting conservatism are examined using popular ratios and basic financial statement data to create the G-score. Mohanram found that high price-to-book stocks with higher G-scores outperformed growth stocks with lower G-scores. AAII modified Mohanram’s scoring system to create a seven-point G-score seeking out strong-performing healthcare stocks with attractive G-scores.
Mohanram awarded up to three points for profitability—one for return on assets (ROA) above the industry median (midpoint), one for a ratio of cash flow from operations to assets above the industry median and one point if the cash flow from operations exceeds net income. Mohanram highlights academic research indicating that ratio analysis benefits from industry comparisons.
ROA examines the return generated by the assets of the firm. Operating cash flow is reported on the statement of cash flows and is designed to measure a company’s ability to generate cash from day-to-day operations as it provides goods and services to its customers. Mohanram also measures profitability by dividing the cash flow from operations by total assets. This is like the ROA calculation, but it is based upon cash flow instead of net income.
The final profitability score examines the relationship between the earnings and cash flow. A growth point is awarded if cash from operations exceeds net income. This measure tries to avoid firms making accounting adjustments to earnings in the short run that may weaken long-term profitability.
Too often the market simply examines the past growth pattern of a company and expects it to continue into the future. Two companies with the same historical growth might have the same high valuation, but a company with more stable and predictable earnings and sales is more desirable and more likely to continue its growth. Mohanram feels that stability of earnings may help to distinguish between “firms with solid prospects and firms that are overvalued because of hype or glamour.” Mohanram measures earnings variability as the variance of a firm’s return on assets in the past five years. A company is awarded one growth point if its variance in ROA is below the sector median. A company must have at least three years of data to calculate the variance or it is given a value of zero for this signal.
The second growth signal in this category relates to the stability of year-to-year sales growth. A firm that has stable growth is less likely to disappoint in the terms of future growth. Mohanram examined the stability of sales growth to help overcome the issues of negative earnings that many early-stage growth stocks may have. Sales growth may also be more persistent and predicable than earnings growth because it is less subject to accounting judgments. Here again AAII compares the company variance of year-over-year sales growth to its sector median. Companies with lower variance than their sector median are awarded a growth point.
The final two growth signals deal with company actions that might depress current results but should result in greater growth and profitability in the future. Conservatism in accounting standards forces companies to expense outlays for many research and development (R&D) efforts even if they create valuable intangible assets that do not show up in a firm’s book value calculation.
A firm is awarded a growth point for R&D intensity if its ratio of R&D to assets is higher than its sector median. The same is true for capital expenditures (capex). One point is given for capex intensity if its ratio of capex to assets is higher than its sector median.
Grading Three High-Growth Health Care Stocks With A+ Investor Stock Grades
The G-score system looks at company profitability and cash flow performance, adjusts for likely mistakes due to naive growth projections and considers the impact of conservative accounting policies to form a growth score, in this case, for health care sector stocks. Companies in the health care sector with the highest G-scores (a minimum of six or seven points) were then analyzed using AAII’s A+ Investor Stock Grades grading system to identify three stocks positioned for long-term growth.
A+ Stock Grades is a stock-grading system based on percentile rankings of multiple key metrics within five investment factors: growth, momentum, EPS revisions, quality and value. They represent a summary of a company’s fundamentals.
The three health care companies that are doing the right activities to grow in the future are: Incyte
All three companies saw year-over-year sales increases for the first half of 2020 compared to the same period a year ago. Incyte saw sales increase 22.3% for the six-month period ended June 30, 2020, compared to the same period the year prior. Both Motus GI Holdings and X4 Pharmaceuticals saw sales increase more than 400% compared to the year-ago period.
All three companies saw earnings increase for their latest quarter versus one year ago. Incyte saw earnings increase 171.9% for its latest quarter versus one year ago, while Motus GI Holdings and X4 Pharmaceuticals saw earnings increase 42.3% and 25.6%, respectively.
The A+ Growth Grade looks at quarterly year-over-year growth in sales, diluted earnings per share from continuing operations and operating cash, as well as annualized growth over the last five years for these three elements.
Incyte has the highest growth grade among the three companies with an A, while X4 Pharmaceuticals has a grade of B and Motus GI Holdings a grade of C.
All three companies rate a C or lower when it comes to price momentum based on the weighted four-quarter relative strength, which gives extra weighting to price performance over the last quarter compared to the prior three quarters. Momentum is based on the price change of a stock over a specified period relative to all other stocks.
The A+ Estimate Revisions Grade is based on the magnitude of a company’s last two earnings surprises, using the SUE score and percentage change in the consensus estimate for the current fiscal year over the last month and last three months.
All three companies have a grade of C, with their scores ranging from 44 for Motus GI Holdings to 60 for Incyte.
The A+ Quality Grade is based on how many of the five tests a company passes—management’s use of accruals, asset turnover improvement, buyback yield, dividend growth and earnings estimates. The more tests a company passes, the higher its Quality Grade.
Incyte has a Quality Grade of B, having passed three of the five quality tests, while Motus GI Holdings is a C after passing only two of the five tests.
The last of the five A+ Stock Grades is value. The Value Grade is the percentile rank of the average of the percentile ranks of six common valuation measures:
- Price relative to sales
- Price relative to earnings
- Price relative to book value
- Enterprise value relative to earnings before interest, taxes, depreciation and amortization (Ebitda)
- Price relative to free cash flow
- Shareholder yield
X4 Pharmaceuticals is very expensive and has a Value Grade of F based on its score of 81, but it is doing the right activities to grow in the future. The company does not have positive trailing earnings, positive enterprise value to Ebitda or positive free cash flow, so its Value Grade is based on three of the six metrics. For these other three metrics, its ranking ranges from a low of 38 for the price-to-book ratio to 96 for the price-to-sales ratio.
Incyte has a Value Grade of F derived from its score of 84. It has valid readings for three of the six metrics, with the ranking ranging from a low of 61 for shareholder yield to 87 for the price-to-book ratio.
Finally, Motus GI Holdings has a Value Grade of F and a score of 92 (remember, the lower the score the better for value). This is the worst value score any of the three stocks received.
Motus GI Holdings has valid scores for three of the six metrics, with the ranking ranging from a low of 68 for the price-to-book ratio to a high of 99 for the price-to-sales ratio, with lower values being preferable for value.
Summing It Up
Overall, Mohanram found that high-growth stocks with stronger G-scores outperformed those with lower G-scores, suggesting that the market fails to grasp the future implications of current fundamentals. Even with these financial tests, it is important to perform a careful analysis of any passing stock. However, the individual components of the G-score combined with the grades from AAII’s A+ Stock Grades represent a useful checklist for investors examining growth stocks.
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