By Robert Barker With even tech titans such as Cisco Systems (CSCO) and Intel (INTC) warning about weak business prospects this year, aggressive investors are looking to the frontiers of medical science for smart plays. And the Feb. 16 publication of the human-genome map has spurred investors to ponder which companies can turn that basic genetic information into profits.
It's a goal that's easier said than achieved, warns Yolanda McGettigan, manager of more than $4.5 billion in health-care stock funds for giant Fidelity Investments, including the Fidelity Select Health Care Portfolio (FSPHX). Through February this year, the fund had lost 10.7%, a hair more than the average health-care sector fund, which was off 10.6%. McGettigan, who took over the fund last June, has also managed Fidelity Select Biotechnology Fund (FBIQX). When it comes to biotech, she says, questions still far outnumber answers.
Just the same, McGettigan has placed her bets on any number of drug and biotech stocks. To find out which ones, and why, I sat down with her recently amid the 23rd Annual Florida Money Show, a convention for individual investors held at Walt Disney World. Here are edited excerpts of our conversation:
Q: What are this year's major themes in health-care stocks?
A: First, the economy. Second, the mapping of the human genome. If you want to add a third, I'd say politics.
Q: How do you see the economy affecting health-care stocks?
A: They tend to be stable, defensive-oriented stocks. These companies, particularly pharmaceuticals, grow their earnings 15% on average, year in and year out. There are always macroeconomic factors or company-specific factors influencing those earnings, but earnings tend to be relatively stable.
Q: So what drives the stocks?
A: Their earnings growth relative to the earnings growth of the rest of the S&P 500. So pharmaceutical stocks tend to outperform when the rate of change of their earnings growth is greater than the rate of change of the S&P earnings growth.
Q: What's the situation now?
A: If you just take a step back, in 1999 the stocks severely underperformed. That was driven by the rapid acceleration we got in technology earnings growth, which drove exceptional S&P earnings. In 2000, that completely reversed itself as the opposite trend occurred. Here we are in 2001...
A: The economy is slowing pretty significantly. The S&P earnings-growth estimates have gone from 16% at the start of the year to 9% a couple of weeks ago. Now, you're seeing estimates for negative earnings growth for the S&P. At the same time, you have pharmaceutical companies expecting to report about 16% earnings growth in 2001.
Q: So that's a nice economic backdrop for a health-care stock-picker, yes?
A: Theoretically, it should be a phenomenal backdrop for health care. As I'm sure you're well aware, the stocks have underperformed in 2001, which, simplistically, doesn't make sense.
Q: Then what's up?
A: Some of it is payback from the strong outperformance in 2000, and some of it is that people question how quickly the S&P will bottom and then reaccelerate. So I think that to the extent the reacceleration in S&P earnings growth is delayed and doesn't occur for several quarters, these stocks are poised for a pretty strong year.
Q: Now, what about the mapping of the genome? At a human level, it's obvious why that's important. Why is it important for your stocks?
A: There are a lot of questions as to how it's going to impact the drug-discovery process from cost and time-to-develop-a-drug standpoints.
Q: What do you mean?
A: As it stands now, it takes about 10 to 15 years and $500 million to $800 million to develop a drug. With the mapping of the human genome, estimates are [that] the number of [drug-development] targets is going to go from 400 to 500 to about 10,000. Presumably that generates a lot more drugs, but in the interim, what you're dealing with from a cost standpoint is (a) the investment to build the [research and development] capability in genomics, [and] (b), some people believe that, because there's less knowledge about these targets, that there are going to be a lot more failures up front.
A: Now, on the other side of the equation, you're going to have more drugs. What happens with those drugs? Does everyone have their own individualized medicine that treats just them? Do you start curing diseases rather than just treating diseases? If you're able to have individualized medicine, how much can you charge for those drugs? So a lot of questions, basically, and no one knows the answers. Right now, for every expert out there, you can find another expert with the complete opposite opinion.
Q: So how do you manage that as a portfolio manager?
A: How do you play it? Within the pharmaceutical companies, I try to pay attention and invest more money in those companies that have developed a genomics capability because I think that if you haven't already integrated genomics into your research and development process you're already behind the eight ball. It's too late.
Q: What are some of those companies that you have particularly focused on because they've developed genomics?
A: Pfizer (PFE). Pfizer is actually the only big pharmaceutical company that currently has full access to Celera's (CRA) database, for example. That's one of the fund's bigger holdings. Eli Lilly (LLY) is the largest biotech-within-a-pharma company, for lack of a better word.... They've been at this for a long time. They understand how to develop proteins, how to work with the genes, they have a fully integrated effort within their company.
Q: What about some biotech companies?
A: One of the fund's holdings is Exelixis (EXEL), which is a smaller company that has some of the software to analyze genes. For the most part, given the complexity of all this, I tend to keep a more conservative bias and have positions in Human Genome Sciences (HGSI), Abgengix (ABGX), Medarex (MEDX), and Protein Design Labs (PDLI).
Q: You also mentioned politics as a key this year.
A: The biggest thing is the Medicare drug benefit. It's highly likely that one gets enacted if not this year, then the following year.
Q: How do you know that? Is that something you're really paying attention to, or are you relying on someone else at Fidelity?
A: I actually go down to Washington periodically and have meetings set up with staff members of all the people involved in health care from both the House and the Senate.
Q: What's the implication for stocks?
A: The big thing that I keep track of with the pharmaceutical stocks is 3% to 4% of their earnings growth every year comes from price increases. To the extent that the government becomes too large of a purchaser of pharmaceuticals, whether implicit or explicit, there could be price controls. Basically, the government already accounts for 40-something percent of pharmaceutical purchases through Medicare and Medicaid, but if that goes significantly over 50%, it's just inevitable that at some point they're going to put the clamp on price increases.
Q: So, what would you do with the portfolio?
A: I would try to focus more on pharmaceutical companies that have a lot of drugs in the pipeline because there's unlikely to be regulation around introducing new drugs, and new drugs always come out at higher prices. It's the existing drugs that would be subject to price-increase controls.
Q: Which are some of those [companies planning to launch many new drugs]?
A: Eli Lilly has the strongest pipeline among the pharmaceutical companies by far.... It has...10 products expected to be launched over the next three years. Bristol-Myers Squibb (BMY) would be next, introducing a potential blockbuster in the next year or two for hypertension. And then, secondly, as far as price increases on existing products go, Pfizer is [more attractive] because positive benefit from price [increases] tends to be only around 1%. Bristol-Myers on the other end tends to often get 5% or so from price increases.
Q: What should an individual investor thinking about making an investment in your fund worry about?
A: Biotech is 20% of the portfolio, and it's the most volatile.... So to invest in this portfolio, you have to be willing to accept the implicit volatility created by the investment in biotech. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online.
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