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How to Invest in Medical Device Stocks

Keith Speights, The Motley Fool

As an investor, are you looking for ways to beat the market? If so, you might want to take a look at medical device stocks.

The Dow Jones U.S. Select Medical Equipment Index, which tracks the performance of U.S. medical device stocks, has delivered a total return more than 60% greater than the total returns of the Dow Jones Industrial Average and S&P 500 indexes over the last 10 years.

If you don't know how to get started investing in medical device stocks, we've got you covered. There are seven steps to follow to improve your chances of long-term success:

  1. Develop a general understanding of the medical device industry.
  2. Identify the key trends driving growth for medical device stocks.
  3. Understand the risks associated with medical device stocks.
  4. Know what to look for in medical device stocks.
  5. Evaluate the top medical device stocks and exchange-traded funds (ETFs).
  6. Invest in one or more medical device stocks.
  7. Reevaluate your investment decisions periodically.

Here's what you need to know about each of these seven steps for investing in medical device stocks.

Medical devices in a hospital

Image source: Getty Images.

1. Develop a general understanding of the medical device industry

Let's start with what a medical device is. The U.S. Food and Drug Administration (FDA) defines a medical device as any "instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article, including a component part, or accessory" that is used in diagnosing, curing, preventing, or treating a disease.

There's one key caveat to that definition. A medical device doesn't work through chemical actions within a body. In other words, medical devices aren't drugs. 

These medical devices can range from simple items such as bandages to complex technology including robotic surgical systems. The FDA regulates medical devices in the U.S. and categorizes the devices by three classes:

Class Risk Level Example Products
Class I Low Bandages, surgical gloves

Class II

Moderate Infusion pumps, surgical drapes
Class III High Breast implants, heart valves

Data source: FDA.  

Most Class I medical devices don't require FDA approval. Companies only have to register these devices with the FDA. Most Class II medical devices, however, require companies to file what's called a 510(k) premarket notification. The name, by the way, comes from the section of the U.S. Food, Drug, and Cosmetic Act, which addresses how medical devices can be approved by the FDA.

Class III medical devices involve the most extensive review process. Companies must submit a premarket approval (PMA) application to the FDA. This application has to include clinical data that demonstrate the safety and effectiveness of the medical device.

There are at least 32,000 medical device companies in the U.S. and Europe. Most of these companies are small with fewer than 50 employees. However, some of the medical device companies are large multibillion-dollar corporations. 

2. Identify the key trends driving growth for medical device stocks

Zacks Equity Research projects that global sales for the medical industry will increase by around 5% annually with the total market reaching close to $800 billion by 2030. The global high-tech medical device market is projected to grow at a much faster rate. One analysis estimates a compound annual growth rate (CAGR) of 29.2% through 2026 for the advanced medical technology market. Key trends driving this growth include:

  • Aging demographics
  • Increase in cardiovascular and chronic diseases
  • Innovation

The aging of baby boomers in the U.S. is expected to fuel demand for healthcare products and services, including medical devices. But this aging trend isn't limited to the U.S. Other large countries across the world in Asia and Europe are also experiencing significant increases in the number of senior adults.

An overall increase in the prevalence of cardiovascular and chronic diseases worldwide is also expected. Although aging demographics play a role in this increase, other factors such as diet and physical inactivity contribute to the trend as well.

On a positive note, technology innovations should also generate growth in the medical device industry. There have been multiple major innovations introduced in the 21st century so far, including the use of artificial intelligence (AI), continuous glucose monitoring (CGM) systems, robotic surgical systems, and 3D bioprinting. The pace of innovation isn't likely to slow down in the future. 

3. Understand the risks associated with medical device stocks

There's one potential downside to innovation: It's challenging for medical device makers to stay at the top with competitors launching new products. This competitive threat is perhaps the greatest risk that medical device stocks face because of the rapidly changing dynamics in the industry.

As discussed earlier, many medical devices require regulatory approval. The stocks of companies that make these devices could be negatively impacted if the FDA or regulatory agencies in other countries don't allow a product to be marketed.

Even if a medical device clears the regulatory hurdles, companies face product liability risks. Many medical devices have the potential to harm patients if the devices don't operate properly. There's also a growing threat of cybersecurity attacks on medical devices. Attempts to hack medical devices are increasing.

Many medical device stocks are also sensitive to trade tensions between the U.S. and other countries, particularly China. The imposition of tariffs or other restrictive trade policies is likely to cause the prices of these stocks to decline. 

4. Know what to look for in medical device stocks

While medical devices can be complicated, the key things to look for in buying medical device stocks are straightforward. At the top of the list is the company's competitive advantage

For a company that makes low-tech medical devices such as surgical supplies, it's important that it controls operating expenses effectively to be able to compete on price and still make a profit. Companies that make more advanced medical devices such as artificial heart valves need to have solid patent protection for their devices and demonstrate higher levels of safety and effectiveness than the competition.

Another critical thing to look for in medical device stocks is the opportunity for growth. Ways that companies can grow include geographic expansion, developing new types of devices, and achieving greater penetration in existing markets.

Also, pay attention to the financial position of medical device companies. As mentioned earlier, most medical device makers are small and many of them aren't profitable. This can present challenges for the companies in funding ongoing operations.

There are two primary ways that medical device companies can raise the capital needed: issuing new shares or borrowing. The main problem with issuing new shares is that it causes shareholder dilution -- more shares on the market reduces the value of existing shares. Borrowing has a drawback as well because the higher debt increases interest expenses and reduces the amount of money available to reinvest in the business.

With established medical device stocks, check out their revenue and earnings growth. Many large medical device makers also pay dividends, which can significantly boost total returns over the long run.

5. Evaluate the top medical device stocks and ETFs

Your next step is to evaluate the top medical device stocks that you're thinking about buying. Don't forget about ETFs that focus on the medical device industry. Below are five attractive medical device stocks that you might want to consider. Each of these stocks should have strong long-term growth prospects thanks to their innovative, market-leading medical devices. 

Company

Primary Medical Device Markets

3-Year Annual Revenue Growth 

3-Year Annual Earnings Growth 

Abbott Laboratories (NYSE: ABT) Cardiovascular, neuromodulation, and diabetes care devices 69% 47%
Abiomed (NASDAQ: ABMD) Heart pumps 397% 73%
Align Technology (NASDAQ: ALGN) Clear orthodontic aligners, intraoral scanners 111% 82%
Intuitive Surgical (NASDAQ: ISRG) Robotic surgical systems 53% 38%
ShockWave Medical (NASDAQ: SWAV) Intravascular lithotripsy devices 450% * N/A

Data sources: YCharts, company regulatory filings. N/A = Not Applicable. *ShockWave Medical revenue growth reflects only one year of quarterly revenue growth.

Abbott Laboratories

Abbott Laboratories ranks as one of the 10 biggest healthcare stocks on the market. The company doesn't just focus on medical devices. Abbott also develops and markets pharmaceutical, diagnostic, and nutritional products.

However, Abbott's largest revenue source is its business segment that markets cardiovascular and neuromodulation products. These products include electrophysiology, heart failure, rhythm management, and structural heart devices plus neuromodulation devices for managing chronic pain and movement disorders. In addition, Abbott markets the FreeStyle Libre continuous glucose monitoring (CGM) system. 

Competitive advantages for Abbott include strong, long-term relationships with its customers and the financial resources to invest in research and development that leads to the launch of innovative new products. Several of Abbott's top products also have either technology or price advantages over rivals. For example, the company's FreeStyle Libre is the lowest-cost CGM system on the market. 

Abbott's growth opportunities include launching new products as well as new versions of existing products. The company also should be able to increase sales in international markets in the future.

Abiomed

Abiomed makes medical devices for treating cardiovascular diseases. Over 100,000 of the company's Impella heart pumps have been implanted in patients.

The company has delivered impressive revenue and earnings growth over the last three years in large part because of its launches of new versions of its Impella heart pumps. Abiomed continues to pour more money into further innovations.

Abiomed pioneered the field of protecting and recovering heart muscle. The company's leadership in this arena is definitely a huge competitive advantage. So are the improved medical outcomes and reduction in hospital costs that its heart pumps provide.

The company's products are currently available only in the U.S., Germany, and Japan. Expansion into other geographical markets presents a tremendous growth opportunity for Abiomed. It should also be able to increase sales by greater penetration of the U.S. market. Abiomed estimates that the U.S. total addressable market represents a $6 billion opportunity with its current penetration rate of this market only 11%. 

Align Technology

Align Technology is the leader in the clear orthodontic aligner market. Its Invisalign clear aligners have helped straighten teeth for more than 6.8 million patients. Align's intraoral scanners also help dentists and orthodontists create 3D images of teeth that can be used in developing treatment plans for its clear aligners.

It's achieved its strong growth in several ways. Align ramped up its marketing efforts to reach patients and dental professionals. It introduced new products, and the company expanded internationally.

Align faces more competition now than it has in the past. However, its large network of dental professionals trained on Invisalign and its brand recognition with consumers are key competitive advantages. 

Currently, Align's market share of the total addressable market stands at 16%. Its share of the teen orthodontic market is less than 7%. This represents a significant growth opportunity for further penetrating the existing market. In addition, Align could expand this total addressable market by launching new products that can treat more serious cases of misalignment of teeth.

Intuitive Surgical

Intuitive Surgical dominates the robotic surgical systems market. Close to 5,000 of its da Vinci robotic surgical systems are installed worldwide.

The company also recently introduced a new robotic surgical system, ION. This new system enables minimally invasive lung biopsy even in airways that are difficult to reach with current biopsy methods that involve devices going through bronchial tubes.

There are other companies that market robotic surgical systems and even more on the way. But Intuitive Surgical's huge install base and long track record give it significant competitive advantages. Existing customers have a financial incentive to maximize the use of their da Vinci (or ION) systems. New prospects are likely to find Intuitive's years of experience in pioneering robotic surgical technology attractive.

Intuitive Surgical should be able to grow in multiple ways. The company is likely to continue to expand internationally. Long-term aging demographic trends should fuel increased volumes for the types of procedures for which its robotic surgical systems excel. Intuitive will also continue to seek to introduce new technology that enables the use of robotic surgical systems in additional types of procedures.

ShockWave Medical

ShockWave Medical is the newest and smallest of these medical device stocks. The company was founded in 2009, launched its first product in 2018, and began trading its stock as an IPO in March 2019.

The company focuses on intravascular lithotripsy (IVL) devices. Lithotripsy has been used for over three decades to break up kidney stones using ultrasound shock waves. ShockWave Medical is pioneering the use of this technology to remove plaque in calcified arteries.

ShockWave's IVL devices offer several benefits over traditional methods to treat clogged arteries. They're safer, simpler, and more cost-effective than current treatment options. 

The company plans to grow by capturing a greater share of the peripheral artery disease market and by expanding into additional indications, including coronary artery disease and aortic stenosis (the narrowing of heart valves). ShockWave estimates that its total addressable market is around $6 billion annually.   

However, unlike the other companies on the list, ShockWave isn't yet profitable. It's likely that it will have to raise additional cash down the road to fund its operations.

Exchange-traded funds

Another alternative for investing in medical device stocks is to buy ETFs. An exchange-traded fund is a marketable security that tracks a certain index or group of stocks based on a common characteristic or focus and trades on a major stock exchange. ETFs have some of the properties of mutual funds and some properties of common stock. There are currently two ETFs that focus on medical device stocks: 

  • iShares U.S. Medical Devices ETF (NYSEMKT: IHI)
  • SPDR S&P Health Care Equipment ETF (NYSEMKT: XHE)

The primary advantage of buying a medical device ETF is that it provides diversification across a large number of medical device stocks. For example, the iShares ETF holds positions in nearly 60 individual stocks while the SPDR ETF owns nearly 70 individual stocks.

The main downside of investing in ETFs is that they charge annual management fees. The iShares ETF's annual fees are 0.43% of the amount invested while the SPDR ETF charges 0.35% annually.

6. Invest in one or more medical device stocks

After evaluating the top medical device stocks and/or ETFs, you should be ready to actually invest. Remember that diversification is always important in investing. Don't put too much of your money in one stock. Investors have different views about how much is too much to put in one stock, but a good rule of thumb is to invest no more than 5% of your total portfolio in a single stock.

Even if you buy a medical device ETF that owns lots of individual stocks, it's still smart to limit how much you invest. Again, investors will differ on how much they think is wise to invest in one industry. However, it's a good idea to avoid investing more than 10% to 20% in any one industry. Diversification helps insulate you from risks such as government regulatory changes that can impact an entire industry.

7. Reevaluate your investment decisions periodically

Things change. New competition can arise. Patents on key products can expire. Regulatory processes can be revised. Trade tensions can escalate.

It makes sense to reevaluate your investment decisions periodically. Looking at your investing assumptions on a quarterly basis should be frequent enough. Always keep a long-term perspective in mind, but keep in mind that the long-term prospects for a medical device stock could deteriorate due to significant changes for the company or the industry. 

Start investing in medical device stocks

Now that you know the seven steps for how to invest in medical device stocks, it's time to get started. Note that while five individual stocks were mentioned earlier, there are many more stocks that you might want to consider. Although there certainly are risks associated with investing in medical stocks, there's also the potential to generate tremendous long-term gains. 

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Keith Speights owns shares of Align Technology and Intuitive Surgical. The Motley Fool owns shares of and recommends Abiomed, Align Technology, and Intuitive Surgical. The Motley Fool recommends ShockWave Medical. The Motley Fool has a disclosure policy.