When it comes to barriers to entry associated with mid-cap and the smaller of the large-cap stocks, few if any companies enjoy the competitive advantage possessed by Edwards Lifesciences. The company operates in the incredibly regulated field of aortic valve replacements and surgical heart valve therapy.
One of its well-established and fast-growing products is the Transcatheter Aortic Valve Replacement (TAVR), and the companies’ Sapien 3 valves exhibit the lowest rate of death, stroke, or rehospitalization among its users. The Sapien 3 is a valve made out of cow tissue that is attached to a balloon-expandable, cobalt-chromium frame for support.
What I find noteworthy (from an investment point of view) about the Sapien 3 is that it has become the legal “standard of care” for heart valve replacement device in 38 states (and there are no states where it is unsuitable as a standard of care). This is significant because it means that doctors and their insurers know that, by insisting upon the use of these Sapien 3 valves, the physician cannot be held liable for his selection of the device in the case it fails. Generally speaking, the potential liability for the physician and his malpractice insurer is related to the installation of the device, which is an always-present risk.
Warren Buffett has provided advice indicating that the presence of a moat can be identified when a product can maintain its sales even though a cheaper alternative exists. First of all, it’s darn hard to make a heart valve that would compete with the Sapien 3. Even setting that aside, as Edwards Lifesciences’ products become the default option in the industry such that physicians and insurers become familiar with their use and courts determine that the failure of a Sapien 3 cannot be a theory of fault as to the physician for selecting the Sapien 3, the product becomes further solidified.
As I love to point out, wealth gets created according to the Dupont Return On Equity Equation. Its profit margins x the frequency of sales. Crank that number up as high as you can, and wealth gets created. With the heart valves, Edwards Lifesciences enjoys a profit margin of 26.4%. The number of devices sold each year increases by 11%, and the price hikes are usually in the high single-digit range as well.
That is why the company has been able to grow earnings per share at a rate of 21% annualized since 2009. Earnings per share have climbed from $0.40 per share in 2003 to $5.35 in 2019 for a 17.6% compounded growth rate. In the pharmaceutical sector, that type of growth can be found when products with high barriers to entry meet the legal standard of care and then an entrenched insurance/legal bias comes to exist in favor of their sustained use, enabling the firm to hike the price of its devices and generate sustainable shareholder returns.
Even better, the company has a strong balance sheet, with $900 million in cash, $600 million in debt, against a profit engine of over $1 billion. The key is getting the price right for making your initial purchase. It only comes around several times per decade, but any time this firm can be purchased at a P/E ratio of under 20, the odds are heavily in your favor for securing 10% or greater long-term returns.