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Healthy Ideas: Drugs and Orthopedics

09/10/2018 5:00 am EST

Focus: HEALTHCARE

John Buckingham

Editor, The Prudent Speculator

We concede that we are entering the two worst months of the year and that the "Wall of Worry" shows no sign of dissipating, especially with the mid-term elections on the horizon, asserts value investor John Buckingham, editor of The Prudent Speculator.

But we think that folks who share our long-term investment time horizon can find plenty of reasons to remain optimistic about the equity markets in general and undervalued stocks in particular, including the following two healthcare stocks, one a drug firm and the other a leader in orthopedic implants.

Merck & Co. (MRK) is a global pharmaceutical giant focused on drugs for respiratory and cardiovascular ailments, diabetes, infectious diseases and oncology, in addition to maintaining a significant presence in immuno-oncology (IO).

The flagship IO product, Keytruda, represents a key blockbuster with multi-billion-dollar potential, helped by its first-mover advantage in front-line lung cancer. Also, we expect new cancer drug combinations will further propel Merck’s overall drug sales.

While the stock has performed very well in 2018, we believe there is still attractive long-term opportunity with the potential of Keytruda and a wide lineup of high-margin drugs, as well as a pipeline of new drugs which should ensure strong returns on invested capital over the long term.

MRK trades at less than 16 times next 12-month EPS projections and the company boasts a history of returning cash to shareholders, a diversified revenue stream and solid free-cash-flow generation, while management is on the hunt for acquisitions and drug-licensing deals that could bolster its drug development.

Zimmer Biomet (ZBH) is a global leader in orthopedic implants (hips, knees, spine, trauma and dental) as well as related orthopedic surgical products. ZBH is by far the king in hip and knee implants and we believe favorable demographics, which include aging Baby Boomers and increasing obesity rates, will drive solid demand for large-joint replacement.

We like that Zimmer has a history of strong relationships with its clients, and we don’t see that changing anytime soon. ZBH posted a solid Q2, and we think that these results add credibility to the turnaround story, which could attract more investors. Additionally, we believe that new product launches should bolster both the top- and bottom-lines as the firm heads into 2019.

Zimmer expects to generate free cash flow of $1.2 billion to $1.35 billion this year, while the shares trade at less than 16 times next 12-month adjusted earnings projections, materially lower than the average of its key competitors.

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