The great challenge for value investors is to buy exceptional, undervalued companies. Respiratory medical stgice manufacturer ResMed Inc fits the first category, but at current prices is trading near fair value. However, on a long-term view, ResMed is a buying opportunity.

The question is not whether to buy ResMed, but when. Portfolio investors such as Self-Managed Superannuation Funds could justify buying ResMed now, provided they can withstand potential share-price volatility over the next two quarters, and hold the stock for several years.

Active investors could wait for better value, as the latest sharemarket correction plays out.

I identified ResMed and the much-smaller SomnoMed, which treats sleep apnea through a dental stgice similar to a mouthguard, for The Bull in July. Resmed has rallied from $5.20 in July to $5.70, and SomnoMed has soared from $1.50 to $2.15 after a better than expected full-year result.

It is a good sign when high-quality stocks can rise in a falling sharemarket. I know some top-rated fund managers have been buying ResMed in recent weeks, to capitalise on its well-received recent product launches and offshore exposure. ResMed and SomnoMed can rally further in the next 12 months, although a share-price pause is likely after strong recent gains.

Chart 1: ResMed

Source: ASX

Chart 2 SomnoMed

Source: ASX

Patient investors will be rewarded with ResMed. Although it does not receive the plaudits of Cochlear or CSL, it is one of the market’s more exceptional companies and a great Australian innovation success. It has a superb position in a superb growth market to treat sleep-disordered breathing problems.

ResMed specialises in making and selling products for the diagnosis and treatment of obstructed sleep apnea, a potentially life-threatening condition that involves repeated episodes of airway obstruction during sleep due to the relaxation of tongue and airway muscles.

Symptoms include snoring, waking unrefreshed and excessive daytime tiredness. Research shows patients with obstructive sleep apnea have a seven-fold higher risk of death and heart disease. Other findings have shown links between this condition and problems such as mood disorders.

The US National Heart, Lung and Blood Institute estimates more than 12 million people in the US alone have sleep apnea. Millions more are potentially undiagnosed, and this trend will surely strengthen as the rate of obesity worldwide increases. More than half of US sufferers are overweight.

ResMed is targeting a growth industry. As awareness of sleep apnea increases, and as more chemists stock continuous pressure airway (CPAP) machines and masks, sales will rise. Its just the type of industry that suits investors with long investment timeframes.

ResMed has several hallmarks of exceptional companies: high gross margins (more than 60 per cent), strong return on equity (19 per cent in FY13, up from 13 per cent in FY11), low debt, excellent cash flow, high cash reserves (more than $1 billion in the current quarter), and a strong position in the large US market. Surplus cash has helped it buy back shares.

ResMed’s mask sales in the US are rising due to solid uptake of its much anticipated AirFit P10 nasal pillow. It had lost market share in the nasal stgices market, off a high base, and the launch of the Swift FX Nano direct nasal mask last year disappointed. Its Quattro Air full face mask is still doing well.   

AirFit’s early success is an important stgelopment. History shows that well-received product launches for ResMed boost earnings as large numbers of current users upgrade to new masks. Nasal masks have good potential because they are more comfortable than full-face masks that connect to the flow generator that pumps air to the patient during the night.

Also, there is a high rate of non-compliance with CPAP machines. Some sufferers find having air blown into the mouth or nose during the night is intolerable. More people are using dental stgices that treat obstructive sleep apnea, and reportedly offer higher comfort, although this is a small part of the market. A more comfortable, quieter nasal mask from ResMed has good potential.

There are also more signs hat ResMed is overcoming pricing disruption from the roll-out of the Medicare competitive bidding (CB2) initiative in the United States. The change means significantly lower reimbursement rates for independent distributors of ResMed products in the US. It led to fears that the company’s margins would be eroded.

However, such sales account for about 10 per cent of ResMed’s sales, and the market fears that led to falls in its share price between October 2013 and April were overdone, judging by its largest quarterly result – which was yet another record. Greater competition from Fisher & Paykel and Respironics in the sleep apenea market is a bigger long-term threat.

ResMed has a strong product pipeline in the next 18 months. Its new Airsense 10 Elite air generator, which broker such UBS say is receiving stronger-than-expected early market acceptance, more market share gains from AirFit, and easing concerns about US health funding reforms should support the share price.

Key to its success is the ability to retain high profit margins, which are currently ahead of its competitors. Stronger volume growth and high margins have the potential to lift ResMed’s earnings growth and its intrinsic valuation, with the share price to follow.

The market, of course, is aware of these strengths. ResMed has a three-year average annualised total shareholder return (including dividends) of almost 30 per cent to October 8, 2014. Over five years, the return is almost 17 per cent and over 10 years, Resmed has delivered an average 14 per cent annual return.

The stock still provides sufficient value for long-term portfolio investors to buy now. And potentially better value for active investors who can watch and wait, and possibly accumulate ResMed at slightly lower prices in the next few months as sharemarket volatility lingers into Christmas.

Tony Featherstone is a former managing editor of BRW and Shares magazines. Readers should do further research of their own or talk to their adviser before acting on themes in this article. This column does not imply recommendations. All prices and analysis at October 8, 2014.