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The Smart Money In Healthcare

By Amey Stone Brandi Allen, co-portfolio manager of the top-performing Live Oak Health Sciences Fund (LOGSX), has a background as a technology analyst and it shows. She looks for healthcare stocks that boast many of the same characteristics tech investors crave -- demonstrating a talent for innovation, involved in making the tools used in new-product discovery, and young enough to still bubble with promise.

But Allen, who has managed the Live Oak Health Sciences fund since its 2001 inception, says she currently prefers the healthcare sector to tech. Powerful demographic trends give the healthcare sector a long-term growth "tailwind" that should prevent it from experiencing the boom-and-bust cycles of tech's recent past.

STRONG PERFORMANCE. That doesn't mean Allen likes every healthcare subsector. Hospitals, managed care, and big pharmaceutical companies -- the stuff of traditional healthcare funds -- are all deemphasized in her fund.

"It's just as important what we don't own as what we do own," she says. And as with all Oak Associates funds, she concentrates her fund in just 25 holdings at any one time.

The result of her somewhat unorthodox approach is a portfolio that doesn't look much like other health funds, but has been more successful than its peers in 2005. This year it is up 19% and ranks in the top 4% of all healthcare funds, according to Morningstar. For the past three years its average annual return is 15% -- better than the 13% achieved by Standard & Poor's 500 Index funds and placing it in the top third of health funds.

LONGER HORIZON. Success in 2005 follows some rocky years. "You don't have to look that far back to see that it wasn't always a stellar performer," says Christopher Davis, a fund analyst at Morningstar. Live Oak Health Sciences underperformed its peers in 2002, 2003, and 2004. "This year is the first it has outperformed its category," he says.

Allen is unapologetic, noting that her fund is meant for long-term investors. She keeps turnover to a minimum (last year it was just 4%) and picks growth stocks she expects to outperform over a three-to-five year horizon. These are the key stock-picking themes that are working for her this year:

#1. Invest in the tools of new-drug discovery.

About 40% of the fund is devoted to this idea. Rather than try to pick biotech companies that will discover the next blockbuster drug or treatment, she identifies those that make the tools upstart outfits consume in their search.

Many of these "life-sciences tool" companies debuted after the human genome was mapped, since that work allowed scientists to take a much more methodical approach to testing new drugs, says Allen. "Now they can use a more targeted approach to test how different diseases and compounds react," she says.

The fund's top holding is Affymetrix (AFFX), which makes silicon chips that are embedded with genetic data and sold to labs for use in research. In the future, its chips will likely be used to help diagnose disease in individual patients or determine how an individual will respond to certain drugs. That is the stock's long-term promise, says Allen. As of September -- the last data available -- the stock made up 10% of the fund's assets.

Now at $50 a share, Affymetrix rocketed from $35 to $59 in the first half of 2005 -- until it announced a delay in a new product and plummeted to $45. It's coming back now, and Allen is hanging on to it.

Live Oak Health Science's second-largest holding, at 6% of assets, is Invitrogen (IVGN). It makes test kits used to clone genes. Another holding that fits the "tools" theme is Waters (WAT), which was spun off from Millipore (MIL), and has technology to help researchers analyze the chemical structure of different compounds. Like other tool-makers, its products are sold to large pharmaceutical firms.

2. Look for the great innovators.

Medtronic (MDT), the fund's third-largest holding at 6.1% of assets, is the "poster child for innovation," Allen says. The company makes implantable medical devices, such as defibrillators and pacemakers. Its newest device stimulates brain activity in patients with Parkinson's disease, and on the horizon are new treatments that combine devices with drugs, says Allen.

There was some concern earlier this year about just how Medtronic would meet its target for 15% earnings growth in 2005, but strong growth in its products has reassured investors. The stock is now at $56, up from $48 at the start of the year.

Stryker (SYK), which makes orthopedic hips and knees and has started offering artificial spinal disks, is a recent addition to the fund. Its innovation is making artificial joints that last longer than older versions -- and advance that is encouraging more people to have the surgery at younger ages, Allen says.

The worry on Wall Street that it wouldn't be able to keep raising prices on its products at the same rate hurt the stock. For Allen, however, that was an opportunity. "The price came down and we thought it was a good time to step in," she says. Stryker is now at $44, down from $56 in early September.

3. Make strategic bets on early-stage stars.

This is a higher-risk strategy and Allen devotes only 10% of the portfolio, or five of her smallest holdings, to this concept. One such company is Cell Genesys (CEGE), which is working on a vaccine for prostate and pancreatic cancer. Proof of success won't be available for about a year, she cautions, adding: "We were able to buy it at attractive valuations when all of biotech was down."

Corsept Therapeutics (CORT), another small company with a make-or-break product, is working on a treatment for psychotic major depression. It is the first advance in treatment for that disease since shock therapy, says Allen. Trials are in the later stage of clinical testing, known as Phase III.

MANAGED-CARE NO-NO. Another early-stage stock, Rigel Pharmaceuticals (RIGL), is working on a treatment for allergic asthma. "Data [are] due any day," Allen says. If positive, [they] could provide a big boost for the stock.

Live Oak Health Sciences is far from a standard healthcare fund. Allen's only large pharmaceutical holdings are Pfizer (PFE), Eli Lilly (LLY), and Teva Pharmaceuticals (TEVA), a generic drug maker. She continues to avoid managed-care stocks, which she admits might be a mistake, but she still thinks the subsectors' ability to raise premium rates is peaking.

Davis of Morningstar warns that the fund's high recent returns come with plenty of risk. But with such standout 2005 results, Allen has little need to make excuses. Investors who like the idea of a tech-like approach to healthcare investing may appreciate her style.

Stone is a senior writer for Business Week Online in New York

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