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These high-flying life sciences stocks make Netflix and Amazon look dull

  • The obscure S&P life sciences subsector is up 41 percent this year compared to the less than 36 percent gain in Facebook, Amazon, Netflix and Alphabet, on an equal-weighted basis.
  • These companies profit from the volume of new-drug investigations and lab tests and favorable demographics without the direct risk of drug-price controls or an Obamacare repeal.
  • It's a dream growth-investor sector but valuations are at the very high end of the stocks' own historical range.

The giants of the internet economy are typically cast as the leading fetish objects for growth investors. But compared to the TAMP stocks, FANG looks a bit dull.

What's TAMP, you ask? That would be Thermo Fisher Scientific, Agilent, Mettler-Toledo and PerkinElmer, just a few of the seldom-discussed names that have powered the obscure S&P 500's life sciences tools & services subsector to a 41 percent year-to-date gain.

By comparison, FANG – Facebook, Amazon, Netflix and Google parent Alphabet – are up less than 36 percent this year on an equal-weighted basis.

The life sciences tools group — which also includes Illumina, Waters and Quintiles IMS — totals more than $170 billion in market value (about equal to the size of Intel). The companies fall within the health-care sector, but they neither discover cures nor deliver care. They provide lab equipment, testing supplies, analytical devices and services to the pharmaceutical and biotech industries, as well as some chemical and industrial customers.

Part of their appeal to investors in an aging and slow-growing world: They profit from the volume of new-drug investigations and lab tests, favorable demographics and the total amount of health care delivered globally but they don't have direct regulatory risk from drug-price controls or an Obamacare repeal.

It helps, too, that the companies generally are steady long-term performers that have done many bolt-on acquisitions in their chosen product areas and tend to convert mid-single-digit sales growth into low-double-digit per-share earnings expansion.

A strong and sustained rally in a cluster of stocks will always have a tidy fundamental story behind it, and here's the case for the lab-products names, according to analyst Paul Knight at Janney Montgomery Scott:

"Even with a sector showing strong performance in 2017, the fundamental backdrop for life science tools is becoming a 'Goldilocks' situation. Asia is the largest tools market and growth is in double digits, industrial demand is increasing with robust PMI indicators at seven-year highs, and currency tailwinds are developing."

S&P 500/Life Sciences Tools & Services versus S&P 500 (YTD)

Source: FactSet

More drug investigations and approved treatments, of increasing complexity, are expected. The booming field of immunotherapy development is a growth engine in itself, requiring complex material-handling and storage processes.

It all nets out to a dream growth-investor arrangement: Long-lived demographic forces, resistance to the economic cycle, stable business-to-business supply relationships, global distribution, and a "razors and blades" recurring-sales model.

The fact that these attributes have propelled such gaudy share-price gains, though, makes it worth asking whether professional investors are crowding into these names to hide from policy or macro threats that might, at some point, fade away.

In the current phase of the bull market, "reliable growth companies" that play a middleman role in de facto oligopolies have hogged a lot of the oxygen, at the expense of more cyclical plays, and especially consumer-facing companies whose moats are seen to be drying up.

Retail, media, branded-clothing and packaged-food stocks are suffering, as investors implicitly shun businesses that require consumers to make an active, conscious decision to spend on a product. Internet platforms, payment processors, aerospace, semiconductors and, yes, health-care tools companies have been enriched at their expense.

The result, for the life-sciences supply names, is valuations at the very high end of the stocks' own historical range. The TAMP stocks and their peers are now fetching between 20 and 40 times projected earnings for the coming year, compared to around 18 for the broader market. And, remember, these are companies generally growing not much faster than nominal world GDP, with admittedly attractive profit margins.

Technical analysts tend to love the group, identifying what look like sturdy long-term uptrends, even if some appear a bit stretched in the short term (note that the sector shed 1 percent on Tuesday in a largely flat market).

The risk to investors at these prices for the likes of Mettler-Toledo, PerkinElmer or Illumina is not that the companies stumble or laboratory volumes roll over. The stocks, instead, could be exposed to a change in investor preferences and outlook on the world.

If the bull market sputters, of course, it would not be kind to once-sleepy growth stocks at premium multiples. And if, instead, confidence grows in the economic-growth outlook and central banks do allow interest rates to rise, fewer investors might feel the need to hide in this corner of the health-care sector.

The question is not whether these are good businesses. They are. The riddle is always what assumptions motivated the last buyer of the stock of a fine business, and what price might be too high to pay for one.

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