Pockets of Profit in Health-Care Stocks

Health care has historically been a defensive sector of the stock market. It continues to underperform in an environment in which many would have predicted it would do better. This is because there's a lack of leadership in the household names: Merck (MRK), Pfizer (PFE), Johnson & Johnson (JNJ), Medtronic (MDT). In the next 6 to 12 months, none of these companies will be in the early phases of—or about to engage in—important new product cycles.

Also, many of these companies have European exposure, and health-care budgets around the world are growing at an unsustainable pace. In Europe, austerity measures were implemented and companies absorbed overnight price cuts. The market worries that could happen in the U.S. down the road.

Yet the perception of risk is greater than the reality. The sector's returns will improve with time. For the last decade we've been overweight in biotech, and that continues. Large-cap stocks Amgen (AMGN), Celgene (CELG), Gilead Sciences (GILD), and Biogen (BIIB) look as attractively valued as they've been since I began covering them in 1997. The general view is that growth coming from these companies will likely be modest, but the market is overly discounting their growth prospects.

That said, my strategy for some time has been to invest in small and midsize companies. We have a reasonable sampling of larger companies, including Pfizer and Amgen, but the medium market cap of [stocks in] our fund is significantly smaller than the average health-care fund. We're looking to invest in innovation and important new medical products.

One good example is Human Genome Sciences (HGSI). I think they are on the verge of introducing an important new medicine for treatment of lupus. The company has been in existence for some 15 years and it's never made money. With the introduction of this product, it's on the verge of becoming profitable.

Another smaller company is Incyte (INCY), which is bringing an important cancer product to the market in 2011. Incyte has been in existence as long as Human Genome Sciences and has never been profitable. I think that's about to change. Alexion Pharmaceuticals (ALXN) is increasingly profitable and has an innovative new product for people who suffer from rare genetic diseases. It is the fund's largest holding.

There are two medical-device companies we're excited about. One, Edwards Lifesciences (EW), will soon reveal late-stage clinical trials for a new heart valve technology. For people who have a diseased aortic valve, this technology wouldn't require open heart surgery. The second, HeartWare International (HTWR), has the best technology for what's called a ventricular assist device and is basically a heart pump. In a world where a substantial number of people have heart failure—and there aren't enough heart transplants to go around—there's going to be a big market for this over the next five to seven years. While the device isn't available in the U.S. yet, its technology looks best in class.

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