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Flying High with Biotechs

Biotech stocks have soared over the past 18 months, buoyed by a flurry of drug approvals and improving fundamentals. The $659.4 million Franklin Biotechnology Discovery Fund/A (FBDIX), managed by Evan McCulloch, surged 58.3% for the one-year period through February, while health-care funds gained an average of 43.1%.

McCulloch primarily invests in biotechnology and discovery-research companies, including small-cap outfits. Within biotech, the manager prefers therapeutic companies over platform-technology companies.

Relative to its peers, Franklin Biotechnology Discovery features greater volatility as measured by its three-year

standard deviation and

beta. On the flip-side, it boasts significantly lower

turnover and an

expense ratio slightly below the average equity sector fund.

CHART POSITIONS. Despite the current euphoria surrounding biotech, the sector is very volatile -- any scent of bad news from the Food & Drug Administration can send stock prices reeling. Moreover, the process of bringing a drug to market is long and cumbersome. Valuations often ride purely on capricious investor sentiment.

For the three-year period through February, McCulloch's fund dropped 6.1% annualized, vs. an average 1.5% loss by health-care funds. However, over the five years through last month, the fund beat its peers, 16% vs. 9.6%. Illustrating biotech's volatility, this fund declined 20.5% and 42.5%, respectively, in 2001 and 2002, before roaring back with a 43.6% gain in 2003.

Palash R. Ghosh of S&P's Fund Advisor spoke recently with McCulloch about the fund's strategy. Edited excerpts from their conversation follow:

Q: Describe your investment process.

A: We use a bottom-up investment methodology focusing on fundamental analysis and research. We invest in companies with favorable competitive profiles, large market opportunities, and strong intellectual property. Generally speaking, we like companies with excellent management, strong financial characteristics, and attractive valuations.

Within the biotech universe, we tend to favor therapeutic companies over platform-technology firms. Among the therapeutics, we are focused on the later-stage companies, those with products on the market and/or in the later stages of clinical trials. We occasionally invest in companies where the lead compound is in Phase II trials, but valuations must be very attractive.

Q: What factors drove biotech's strong performance in 2003?

A: It was essentially accelerated FDA drug approvals and the sector's rebound from depressed levels. Biotech bottomed in July, 2002, as a string of unfortunate events weighed on valuations. Then, news turned very positive in 2003, with many drug approvals and successful clinical trials -- the most important being positive Phase III results for Avastin, Genentech's (DNA) drug for colorectal cancer. This rejuvenated hopes for oncology drugs in development and lifted the entire sector.

Q: What are your top holdings?

A: As of Feb. 29: Amgen (AMGN), 7.5%; Gilead Sciences (GILD), 7.5%; Genentech (DNA), 5.7%; Biogen Idec (BIIB), 5.6%; Genzyme (GENZ), 4.6%; MGI Pharma (MOGN), 2.9%; MedImmune (MEDI), 2.9%; Chiron (CHIR), 2.8%; Alkermes (ALKS), 2.7%; and NPS Pharmaceuticals (NPSP), 2.6%. These top 10 stocks represented 44.8% of the fund's total assets, with a total of 62 holdings.

Q: What are some newly approved drugs that you think will become blockbusters with at least $1 billion in annual sales?

A: We think Avastin will likely reach the $1 billion figure. It benefits large patient populations and is very expensive.

Other drugs that could reach blockbuster status include Cialis, a treatment for erectile dysfunction jointly developed by ICOS (ICOS) and Eli Lilly (LLY), and Risperdal Consta, a treatment for schizophrenia created by Alkermes and Johnson & Johnson (JNJ). However, these two drugs resulted from partnerships with large pharmas, so the innovator companies will only receive a portion of the profits.

Lastly, two drugs, FluMist, an influenza vaccine developed by MedImmune and Wyeth (WYE), and Velcade, a multiple myeloma drug made by Millennium Pharmaceuticals (MLNM), could reach $1 billion in sales if additional trials come out positive.

Q: What's your view of ImClone Systems' (IMCL) cancer drug, Erbitux?

A: Erbitux is an important development for colorectal cancer patients because it's approved for third-line treatment, a setting where the prognosis for patients is very poor. While we don't expect Erbitux to become a blockbuster, it will still be a significant drug and will probably treat other tumor types.

Q: What's your view of the planned merger of Genzyme and ILEX Oncology (ILXO)?

A: We had mixed emotions on this deal. While it's important to Genzyme, because it expands the company's offerings in oncology -- one of the most promising therapeutic areas for drug development -- we also believe ILEX Oncology is worth more than the $1 billion Genzyme is paying. We own both stocks. Overall, M&A activity is robust in the biotech sector, and we expect more takeovers in 2004.

Q: Do you expect more M&A activity between big drug companies and smaller biotechs in 2004?

A: Yes, because big pharma pipelines remain weak, and biotechs have higher R&D productivity. There were several such deals in 2003, the largest being Johnson & Johnson's (JNJ) acquisition of Scios.

Q: Tell me about the biggest biotech company, Amgen.

A: 2003 was a fantastic year for Amgen, as its sales grew rapidly and benefited from several new drug launches. Its stock rose about 25.7% during the year. We expect 2004 to be another solid year for the company. Although it's more difficult to grow a larger company than a smaller one, large-cap firms like Amgen benefit from diversified revenues, which decrease the overall risk. There's a trade-off between slower growth and the risks to that growth.

Amgen will need to bolster its new product pipeline to maintain current growth trends. We hope their initiatives meet those demands, but with over $5 billion of cash, Amgen can also acquire smaller companies to fill their pipeline.

Q: Do you believe the biotech sector is overpriced now?

A: We believe there are as many overvalued biotech stocks as undervalued ones. However, a stock like Genentech, which rose 175% in 2003 and now trades at 60 times forward p-e, is selling at a premium.

Q: What's your outlook for the biotech sector in 2004?

A: We're very optimistic about the sector for 2004 and beyond. Valuations are fair, and the macro perspective is benign. There's little on the slate in terms of legislation, and the FDA has been cooperative. Individual companies are making tremendous progress, and the recent flurry of IPOs offers fresh investment options.

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