On Friday, a reader wrote me an email to ask my thoughts on the Pro Medicus share price. He asked:
“At what point does PME become a meme stock? You, like me, no doubt have tax reasons that make selling pointless, but part of me wonders where growth to justify the price comes from. Is every public hospital in every OECD country likely to use Visage? Seems a stretch. Probably worth an article on value, as many of your followers obviously hold.”
And so I decided to write this article about why I am trimming my Pro Medicus (ASX: PME) position. But to understand my personal psychology you need a little backstory. After all, nobody can be free from their own biases… so it is just as well I try to describe my own!
Pro Medicus has been my largest shareholding for around a decade now.
I first bought the stock under $1, in part because I wanted to specialise in micro-cap healthcare businesses. Once I joined Motley Fool Hidden Gems, it was one of my first recommendations at around $1.50 in March 2015. Unfortunately, I first trimmed the stock under $7 because I was worrying about having too much exposure to one stock. I have trimmed many times over the years while keeping it as my largest single position the whole time. For a while it was over 40% of my portfolio.
At this point, over 99% of the proceeds of any sale is taxable capital gain, so I lose approximately 25% of any sale to the ATO, even after applying the long-term holding discount: that’s the tax situation our questioner described.
And of course, every time I have historically sold Pro Medicus, it has proved to be the wrong decision for my wealth. So you can imagine why I am quite hesitant to sell. Once bitten, twice shy…
The joke between myself and a friend of mine who first purchased Pro Medicus shares around the same time as me is that we ourselves have discovered a unique hack: every time we sell shares the Pro Medicus share price must go higher!
Pro Medicus Share Price Valuation
In FY 2024, Pro Medicus grew basic earnings per share by 36% to 79.3 cents per share. Generally speaking, it would be overly generous to use earnings per share as a proxy for free cash flow per share, but for the sake of this thought experiment we can be overly generous, because I’m demonstrating that even when you are overly generous, Pro Medicus shares are expensive. Let us then also be generous and assume that Pro Medicus can maintain 36% earnings per share growth cagr for the next 5 years. That’s a big ask, but not insane given that earnings per share has grown at over 34% over the last 5 years.
At the end of 5 years, Pro Medicus earnings per share would be just under $3.69. That means, based on the current share price of about $222, Pro Medicus would still have a P/E ratio of 60, implying even after 5 years of an epic 36% cagr in earnings per share, it would still have an above-market growth multiple of over 60.
Now obviously a result similar to this is possible, but it is far from guaranteed. And in this scenario, if the earnings multiple in 5 years is 100, then you would have made decent money. However, to make decent money from here you obviously need a lot to go right and multiples to hold up. It is very hard to argue it is cheap. In fact, the share price is up a whopping 56% since I wrote in my coverage of the FY 2024 Pro Medicus results that “sentiment around the stock is positive… maybe too positive.” And that was less than 5 months ago.
I do not think that Visage will be used everywhere. And as you’ll see below, I do think sentiment around Pro Medicus is unusually positive right now… very likely too positive.
However, I do think that the company could potentially justify its valuation, eventually, by increasing its revenues from Australia, Europe, and North America. I don’t think that the price is totally insane because a combination of new products, new customers, and growing transaction-based revenue from existing contracts could potentially drive super-impressive growth.
However, I certainly don’t think that kind of outcome is guaranteed, and as my reader observed, the market seems to be pricing in a fairly high probability of success.
In fact, Pro Medicus is now trading at a higher multiple of its earnings before interest and tax (EBIT) than it has at any time in the last decade. The simple truth is that, relative to the last decade, the current share price indicates that investors are currently more optimistic about the company’s prospects than ever before. The chart below includes three smaller software companies in which I own shares, just to demonstrate that a few other software companies I follow have enjoyed increasing multiples lately (but not to the extent Pro Medicus has).
Is Pro Medicus A Meme Stock?
According to S&P Capital IQ, there are 14 broker analysts giving price targets for Pro Medicus, and the average price target is around $150, compared to the current price of $222. In a way, this is a good sign because it means that there are at least some people telling others to sell the stock.
Having said that, I did read an interesting bullish note from Wilson’s Advisory called “Special Stock. New Rules.” The report increased the Wilson’s price target by 76% to $255 per share. The note explained that “The brazen lift in valuation is to call the stock as we see it: we value the business as an acquisition target, therefore are only interested in the gross operating cash flows it generates, to be plugged into an acquirer’s (likely global and infinitely more scalable) operating platform.”
In my opinion, it seems unlikely that an acquirer would vastly improve the Pro Medicus business, which already achieves profit-before-tax margins of over 72%. But to me, the idea that a stock is special needs new rules to understand it and that value uplift can be realized through acquisition by an imagined acquirer certainly seems reminiscent of the valuation techniques applied to meme stocks. With such bullish upgrades based around multiple expansion, I can understand why someone would think Pro Medicus is a meme stock.
However, Pro Medicus stock is not a meme stock because it is actually a high-quality business with long-term tailwinds at the forefront of technology. In comparison, meme stocks like AMC or Gamestop are victims of technological progress and face multiyear headwinds and declining demand. Therefore, even if you think Pro Medicus stock is massively overvalued, the Pro Medicus share price is not as stupid as the share prices of the classic meme stocks once became.
That said, it is clear that Pro Medicus is benefitting from the sociological cycle. You see, high-growth software stocks like Pro Medicus have done well as a group over the last 10 years. In comparison, the low-growth or no-growth companies that value investors think are the cheapest have performed relatively poorly.
For example, there is an underperforming fund that I follow because the performance is so bad that I think the holdings might provide a contraindication. For most of its existence, this never disclosed owning Pro Medicus stock, even though the manager supposedly specialised in smaller companies. In the last few months, to my surprise, this very fund recently disclosed a position in Pro Medicus stock! The reason given was that the fund was incorporating a different strategy, implying Pro Medicus would not be purchased under the old (underperforming) strategy.
This is an example of a contraindication that suggests that there are few remaining incremental buyers of Pro Medicus. From a sociological perspective what has happened is that a “value” fund has evolved its strategy, before our very eyes, to incorporate one of the highest growth, highest P/E multiple “quality” stocks. This represents a drift from “value” investing to “quality” investing. We can readily observe that more funds are now favouring high quality stocks, since that is the strategy that has performed best in the last decade. This is a sociological drift in favour of Pro Medicus. It is positive for now, but one day the tide may turn.
Another favourable circumstance for Pro Medicus is that it enjoys the support of Australia’s giant superannuation funds. These funds have relatively few large liquid companies that can absorb the regular superannuation contributions of people who have elected to invest in growth stocks. The continual investment by such funds sure does boost the share price: but the point is that it is already happening.
The more I look, the more I see positive sociological developments that have already happened. Sure, the Pro Medicus share price may benefit from even more hype around artificial intelligence or growing interest from overseas institutions. But a lot of the positive developments that generally occur when a small growth stock succeeds have already occurred.
And of course, the downside of such bullish price action is that even a mere reversal in the Pro Medicus share price could become a sociological negative. After all, the anecdote I shared above proves that even investors who used to eschew the stock based on valuation, are now buying the stock based on share price momentum. When share price momentum changes, the same investors could sell just as fast.
And the consensus estimates tell us that, on average, brokers think it is overvalued, so the stock might not receive support from broker analysts until it has come down significantly. While I have every intention of holding the stock for the long term, it is easy to imagine that the stock price could fall 40% from here. In the 10 years I have owned the stock, it has suffered significant drawdowns before, and that kind of stomach-churning volatility is simply the price we pay for the excess returns generated over the long term.
There is no doubt that Pro Medicus is a high-quality company, and I think it is the best quality stock on the ASX. It has honest, competent and aligned management. But it also has its work cut out to grow into its current valuation over the years to come.
As I write this, Pro Medicus is still my largest ASX portfolio position. Given the optimism implicit in the share price, I think that it is pretty reasonable to trim the position at a share price above $200, and I will likely do so in the future.
My thinking is that other high-quality businesses are earlier in their journey, and currently sport less optimism in their share prices. Therefore, it would probably make sense to tilt my portfolio towards those (arguably) superior options that (in theory) offer better risk versus reward. Of course, this has to be balanced with the fact that every time I have trimmed in the past, the Pro Medicus share price just keeps getting higher!
The silver lining is that, on a psychological level, I think trimming my position helps prepare me for the psychological pain of when I do suffer through an inevitable share price drawdown!
Pro Medicus is holding its annual general meeting (AGM) tomorrow at 10am (here is the registration link). I’m not expecting any major news to be released with the AGM material, and even if there is news, such as a new contract, I doubt it will change my valuation calculus notably. Nonetheless, I will update supporters with my AGM notes and observations after the meeting.
Disclosure: The author of this article owns shares in PME and will not trade PME shares for at least 2 days following the publication of this article. This article is not intended to form the basis of an investment decision and is not a recommendation. Any statements that are advice under the law are general advice only. The author has not considered your investment objectives or personal situation. Any advice is authorised by Claude Walker (AR 1297632), Authorised Representative of Ethical Investment Advisers Pty Ltd (ABN 26108175819) (AFSL 343937).
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