‘Not-Stupid’ investing strategy applied to health care stocks

The previous instalment of Not-Stupid investing discussed three long-term secular trends that could provide the best growth tailwind for investors – health care, agriculture and cloud computing. Now it's time to dig deeper in search of individual long-term stock ideas. We'll start with health care.

The Not-Stupid school of investing is a Berkshire Hathaway-heavy strategy that takes its name from a quote by Charlie Munger, the less publicity-focused half of the Berkshire Hathwaway brain trust.

"It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."

Simply stated, the central tenets of Not-Stupid investing are to value historical consistency of cash-flow growth above everything, buy stocks when trading at a discount to average valuation levels, and to never ever try and predict whether the business environment will get better or worse in the future.

Applying the method to the global health-care sector, all 82 members of the global S&P 1200 Health Care index were first measured for 10-year standard deviation of cash-flow growth. (Standard deviation is a mathematical measure of dispersion; low standard deviation means most data points are closer to the long-run average). Companies without 10-year histories of positive cash flow generation were kicked out.

Why standard deviation? It measures volatility and in the financial world, volatility is synonymous with investment risk. Historically, assets that, for example, grew 30 per cent one year and fell 10 per cent the next are those that do worst when conditions get difficult.

Not-Stupid investing is designed to prepare portfolios for anything. Emphasizing low standard deviation helps uncover stocks that grow cash flow and profits regardless of changes in the economic or business backdrop.

The second part of the screen compared the current trailing 12-month price-earnings ratio with the 10-year average.

The accompanying table shows the results, listed by consistency of cash-flow generation. For example, orthopedics provider Smith & Nephew is ranked first in terms of consistency because it had the lowest standard deviation – it was the sector's most dependable cash-flow machine over the past decade.

The table's final column shows the companies' current P/E ratio relative to its own 10-year average. Smith & Nephew, with a 25-per-cent reading, is trading with a P/E ratio 25 per cent higher than its historical average.

The screen uncovered five stocks of note that demand further study. Britain-based drug maker GlaxoSmithKline has been the second-most consistent cash-flow generator and is currently trading at a valuation discount of 10.5 per cent. Biotech company Celgene Corp. is ninth-ranked in terms of cash flow and is trading at a remarkable 54-per-cent discount to history.

Stryker Corp., another orthopedics firm, finished lower on the list for consistency in cash-flow growth, but is trading at a significant discount to past P/E levels. The same is true of medical equipment providers Baxter International Inc., Varian Medical Systems Inc., and Medtronic Inc.

The screen isn't foolproof and investors will want to closely research the particular fundamentals of any prospective investment. But uncovering stocks with dependable growth and attractive valuations, in sectors with strong secular growth stories, is an excellent start.

Follow Scott Barlow on Twitter @SBarlow_ROB.