Step #5 – Can Raise Prices with Inflation

In Step #5, we are asking, “Can the company raise prices with inflation?”   We are looking to see if a company can maintain its profit margins when inflation raises its input costs. Traditionally, medical supply and device companies like Stryker have been able to raise the prices of their products above rate of inflation. This situation has been benefitial to their gross margins, which have been growing an average of 15%/year for the past 10 years. Stryker’s gross margin growth rate is well above the average annual rate of inflation.

I expect this situation will receive some pressure from the current healthcare legislation that is being debated in Congress. There may be pricing pressure based on possible lower medical remibursements, as a result of the healthcare reform. Even with this possibility, the demographics of an aging population that wants to lead a more active lifestyle and the large percentage of overweight people in the United States will drive demand for Stryker products.

Step #4 – Honest & Transparent Management

In Step #4, we are attempting gain some measure of management’s honesty and transparency.  For Stryker, I think they may fall short on this criteria. There have been recent legal troubles with the Department of Justice with its Biotech subsidiary with the indictment of the Stryker Biotech’s CEO for  marketing off-label usage of its bone growth product. Additional legal troubles found with a little web searching include:

• 2008: One criminal probe into two salesmen who were distributing mis-branded devices and bone drugs and actually giving doctors instructions on how to use them. That’s right  — Stryker salesmen were training bone doctors. The reps pleaded guilty.
• 2008: Three warning letters from the FDA regarding quality at three different manufacturing plants in 2008.
• 2008: Received subpoena into whether company was complying with a previous agreement not to pay kickbacks to bone doctors.
• 2008: DOJ subpoena received into whether Stryker violated the Foreign Corrupt Practices act, which bans companies from paying bribes to do business in foreign countries.
• 2007: Settlement of DOJ probe into kickbacks paid to knee doctors.
• 2007: SEC inquiry into whether Stryker violated the Foreign Corrupt Practices act, which bans companies from paying bribes to do business in foreign countries.
• 2006: Was the subject of grand jury hearings into whether Stryker was violating antitrust laws. No charges brought.

There was a significant change in management at the end of 2008 where a group president, CFO, and a vice president of finance all relinquished their posts.  My review of the annual reports for 2008, 2007, and 2006 do not mention these issues. Some sign of taking responsibility or improving corporate vigilance by Strkyer’s management team would have been nice.

Step #3 – Invests Within Area of Expertise

The idea of strategic focus is at the foundation to this step. If a company sticks to what it knows and does, best then the likelihood of business success increases. For Stryker’s businesses and product lines, this seems  mostly true.

If we view Stryker as having two primary businesses and sources of review. They have stuck very closely to orthopedic joint replacements/implants and medical/surgical equipment. In the instance where they did invest outside of the core competency (i.e. Stryker Biotech), they have gotten in trouble with the Department of Justice.  Stryker Biotech produces a bone growth product and the DOJ is investigating Stryker Biotech for marketing off-label usage of the product. I expect that Stryker will look to settle this lawsuit as quickly as possible, and the current effect on their stock price could present an opportunity. 

Other areas of Stryker’s business include ten discrete operating divisions: Howmedica Osteonics; Stryker Endoscopy; Stryker Instruments; Stryker Medical; Physiotherapy Associates; Stryker Pacific; Stryker Europe; Matsumoto Medical Instruments; Stryker Americas; and Stryker Biotech. For the most part, however, Stryker has stuck pretty close to their core competencies.

Step #2 – Easily Understood Business

This step implies that I should easily understand how the company makes money selling its products and services. For Stryker, it sells products in following broad categories:

1. Joint Replacement/Orthopedic care.
2. Spinal care.
3. Surgical/medical procedural equipment that mostly support product usage in #1 & #2 above.
4. Hospital Equipment, such as hospital beds and accessories.
5. EMS/EMT (Emergency Medical Service/Technician) equipment.

Although any one piece of equipment or product can be highly technical in nature, I can easily understand that Stryker makes money by selling these products to hospitals and encouraging doctors to use their products for medical procedures.

Trends in Stryker’s favor include the aging population with a desire to live more active lifestyles. The demographics are in their favor for joint replacement, spinal care, and orthopedic care. Current  health care reforms may put pricing pressure on their products based on reimbursement policies, but Stryker should be able to respond by lowering costs. They have spent heavily in quality control/improvement systems. Finally, the current economic environment has curtailed hospital capital spending. This current situation will most likely improve, as the general economic recovery happens.

Step #1 – Long-term Competitive Advantage

Stryker has enjoyed brand-name recognition for both joint replacement/implant and medical supply products. Their revenue is split roughly 60% for joint/device implants and 40%  for the medical/surgical supply business

Intangible Assets

• Brand Name – In the area of joint replacement and medical equipment Stryker is well-known and probably only 2nd to Johnson & Johnson in terms of brand name recognition. It is in the top three companies known for joint replacement. Zimmer Holdings would be added to J&J and Stryker to round out the top 3.
• Patents - In the past 10 years Stryker has obtained 278 patents, which shows a significant amount of innovation and product differentiation. The intellectual property protection raises an entry barrier for new entrants and raises R&D costs for competing companies.
• Regulatory Approval Cycle - almost all the medical devices and supplies require government approval to be sold and used here in the United States. This situation also exists most developed countries. The regulatory hurdle places relatively high entry barriers for new entrants. Note:  A Stryker biotech subsidiary is currently attempting to settle a Dept. of Justice lawsuit for using bone growth product in off-label situations. The sales impact of the lawsuit is not expected to be significant, but Styrker is looking to settle the lawsuit as quickly as possible to limit public relations impact.

Low-cost Producer

Stryker is not considered the lowest cost producer in the market segments that it addresses.

Switching Costs

There are some switching costs for doctors and hospitals when moving to different implant and medical equipment products. For doctors, switching to new implant products requires some training and procedural impacts.  For hospitals and clinics, there are some training and procedural impacts associated with both medical and surgical equipment.

Network Effect

As far as I can tell, there is no network effect for Stryker’s products and services.

In summary, Stryker’s combination of intangible assets and some of the switching costs raises a significant economic moat for them. I believe the key to the continued maintenance of their “moat” will be reinforcing their brand with innovative implant products.

A Candidate Company

From my last post, I used the Morningstar premium stock screen to look for a list of companies with a “wide” economic moat. From this list I would like to pick a company to begin analyzing.  Foreshadowing step #2 of the process, I decided to select a company that I could easily understand. The first company I decided to analyze is Stryker Corporation.

They are well-known in the medical profession for supplying joint replacement parts, surgical equipment, and more general hospital equipment. I became very familiar with their products during the past few months, since both my mother and father-in-law underwent hip replacement surgery. It was interesting to see the number of Stryker products in both the hospital and as options joint-replacement parts. On the surface, it definitely looked liked they have an established name brand in their particular markets.  I want to take a closer look at any sustainable competitive advantages that they may have which would warrant a “wide” economic moat rating from Morningstar.

To begin this analysis, I will be pulling information on the company from the following resources:

1. Annual reports from Stryker’s website.
2. Information from Google Finance pages.
3. Information from Yahoo Finance pages.
4. Stock report from Morningstar (fee required for analyst report) – 10 yr data available for free, along with free cash flow history.
5. Stock report from S&P, which is included in a TD Ameritrade account (if you have one).

So from the above list I have some reading to do. In my next post, I am going to attempt to take a closer look at the potential sustainable competitive advantages.

Identifying Candidate Companies

Where do I start? The flowchart on the “Process” page indicates that I am looking for companies that produce brand-name products/services, sell products that are used quickly, provide repetitive consumer/business services, or provide communication services for businesses. As you might guess, there are hundreds of companies that would meet those criteria. Upon further studying of this first step, I figured out that I am looking for companies that have established sustainable competitive advantage.

I know from the development business strategies that there are several sources of competitive advantage. They include:

• Intangible Assets – patents, trade secrets, brand, regulatory approvals, and other actions that raise entry barriers or increase product differentiation.
• Low Cost Position – that can come from economies of scale and  labor arbitrage (i.e. producing in low-cost labor environments).
• Creating High Switching Costs – which makes it hard for customers to move to another vendor.
• Network Effect - this source of competitive advantage comes as the usefulness of your product or service increases, as more customers use it.

So how does this all help. Warren Buffet defines creating a sustainable competitive advantage is creating an “economic moat”.  This idea has made its way in to rating that Morningstar uses as one of its rating metrics for their premium (read you have to pay for it) stock screens. Here is how they define it:

As you can see, it fits nicely with the idea of finding companies that have created sustainable competitive advantage. I do not plan on relying just on their rating for this first step of the process, but it can help find some

Morningstar's Economic Moat Stock Screen

good candidates for our initial evaluation.  I built a stock screen that listed companies with a “wide” economic moat and had the list sorted by their Morningstar rating.  You can see a snapshot of the list to the right. You can enlarge it by clicking on the image. The next thing I will do is to pick one of the companies to see if it makes it past this first test of having an “economic moat” that represents a source of sustainable competitive advantage.  If I am not satisfied that it does have a sustainable competitive advantage, then it is probably not worth my time to continue on with the other steps/tests in the process. I will select one of these companies tomorrow for analysis using our first test.

 

Motivation

It occurred to me today, after my first posting,  I should mention my motivation for learning more about Warren Buffet’s approach to investing. Like most average investors, I am heavily invested in a variety of mutual funds. Some of the funds struggle to outperform the S&P 500, while other ones do so in an inconsistent way. Last year’s financial market melt down obviously did significant damage to large number of investments, including my own mutual funds. I want to do better.

In contrast to this disappointing and mediocre performance of my mutual funds, I have noticed how well Warren Buffet’s investments have fared. In 2008, when the S&P 500 lost 37%, Berkshire Hathaway’s per share book value dropped 9.6%. Now to compare apples-to-apples, Berkshire Hathaway’s (BRK) stock price dropped 29% in the same period.  In both measures, BRK outperformed the S&P 500.  As you might guess, Warren Buffet emphasizes changes in book value, since he does not control market reactions or prices.

From a longer term perspective, since its beginning in 1964 to the last report in 2008, BRK increased it’s per share book value a whopping 362,319%. During this same period, the S&P 500 increased 4,276%. The S&P 500 increase is not bad, but I would rather have the compound annual growth rate of 20.3% that BRK has been able to produce.  I pulled these numbers from Berkshire Hathaway’s 2008 annual report.

The Beginning of a Journey

Welcome to the beginning of my journey to learn more about the investment approach used by Warren Buffet. I have been a fan of his work, his approach to investing, and the results he has been able to produce for his shareholders and partners. As you can see from my “About” page, I am not a professional investor, but I want to learn from one of the very best. This blog will document my educational journey, as I attempt to put together a process based on information that is publicly available about Warren Buffet’s approach to investing.

This site will initially be divided in to two main parts. The primary blog section, which will be on the front page, will document my attempts of applying the investment process steps that I have identified. The second “Process” section of this site will provide the latest overview of the investment steps toward identifying and purchasing equity shares in companies that Warren Buffet might think worthy of investment. Some time in future, I made add a third part that identifies and tracks a portfolio based on the process developed here. If I get that brave, you will be able to learn from my mistakes and hopefully a few successes.