Between bioterrorism, cloning, stem-cell research, the aging of America and new developments on the medical front, health care is a hot topic, both in the news and among investors. But will health care dominate the market over the next decade the way technology stocks did in the 1990s? Ask health-care fund managers, and you'll get a resounding "yes," of course. Arguments that support this optimism include:
Favorable demographics. Today, the 34 million Americans over age 65 represent some 13% of the population, yet account for one-third of health-care spending. Members of that age group are expected to double in the next 30 years. With the aging of America, health-care expenditures will double from $1.3 trillion today to $2.6 trillion in 2010.
Strides in medicine and technology. New medical devices promise to make detection and treatment of diseases less invasive and more effective, while new computer systems and relational database software will help HMOs and hospitals operate more efficiently.
Built-in demand. Patients can't put off treating serious illnesses like AIDS, heart disease or cancer, and that traditionally has made the sector more resistant to a recession than, say, hotels or automobiles.
Short-term, however, even the sector's strongest proponents admit the industry faces serious challenges. Government controls, whether in the form of pricing ceilings or slow approval by the Food and Drug Administration, cloud the profit picture for the large, dominant pharmaceuticals. Expiring patents that open the door to competition from generic, low-cost drug producers pose an even greater near-term threat.
Following the patent expiration of Eli Lilly's blockbuster drug Prozac in August, several large U.S. drug makers revised their earnings forecasts downward. In December, Merck & Co. announced that 2002 earnings per share would be lower than Wall Street estimates because of lost revenue from patent expirations and increased research and development costs. Two days after the Merck surprise, Bristol-Myers Squibb announced earnings for 2002 would be lower than 2001.
The red flag these high-profile bombshells raised may have been overdue. In 2000, health-care funds were up an astounding 55%, compared with a drop of 9 % for the Standard & Poor's 500 Index. Thanks largely to the run-up, which also brought in some $14 billion in investor inflows that year, health-care funds hold $48 billion in assets, compared with $26 billion in 1999, according to Morningstar.
But health-care funds can be volatile, and on average, they underperformed the S&P 500 Index for most of the late 1990s. At the beginning of December, the average health-care fund was down 13% year-to-date, a showing that was no better than the overall market.
The recent pharmaceutical company earnings disappointments underscore the need for fund managers specializing in the sector to pick their spots carefully this year. Despite coming under the broad umbrella of health care, biotechnology, pharmaceutical, medical-device and services companies-the four groups that traditionally are included in the health-care sector-all have different earnings-growth outlooks and risk profiles. Small, unprofitable biotechnology companies with drugs under development stand at the higher end of the risk spectrum, for example, while profitable medical services and drug companies provide tamer fare.
To get a handle on prospects for this diverse sector, Financial Advisor spoke with three leading health-care fund managers to find out where they are placing their bets right now, and what they're avoiding.
Merrill Lynch Healthcare Fund
Assets: $850 million
Top five holdings: Wellpoint Health Networks, Cerner Corp., Amerisource Bergen Corp., Baxter International, Tenet Health Care.
The big pharmaceutical companies that represent the 900-pound gorillas of the health-care industry don't carry much weight in the Merrill Lynch Healthcare Fund. Although these companies make up two-thirds of the total market capitalization of the health-care sector, Jordan Schreiber, manager since 1983, says they make up only about one-fifth of the assets in his fund.
By some measures, these stocks are selling at historically low valuation levels compared with the rest of the market. Right now, says Schreiber, stocks of big pharmaceutical companies sell at price-earnings multiples only slightly higher than the market average, compared with historic premiums of 20% or more.
"Premiums are relatively narrow now because investors are concerned about several industry issues, including thin product pipelines, a shortage of products coming into the market because of slow FDA approvals and an unfriendly political and regulatory climate," he observes. "Expiring patents could also put a serious squeeze on profits. Once generics become available, prices can drop 20 to 30% initially to as much as 90% over the long term."
Lately, Schreiber has been investing in biotechnology companies, as well as safer picks such as health maintenance organizations (HMOs), hospital-management companies and drug distributors. The approach "covers both ends of the risk spectrum in this sector. Biotechnology companies can be very volatile because their future depends on the success of one or two products, but they can also be very rewarding investments. It's important to keep a balance."
Biotech holdings include Genta, which is in late-stage development of a drug to treat lung cancer, and Idec Pharmaceuticals, which is working in a joint venture with Genentech on a drug for non-Hodgkin's lymphoma. Schreiber mixes these lesser-known names with larger, more established biotechnology companies like Amgen that have products on the market and established sales and earnings.
Health maintenance organizations, eschewed by some health-care fund managers because of cost controls, are a part of Schreiber's portfolio because well-run HMOs such as United Healthcare and Wellpoint Health Networks (the fund's largest holding) are adept at overcoming the obstacles posed by cost cutting and red tape. "These HMOs have been able to raise premiums and keep costs under control. And they have very reasonable valuations, given their sturdy growth."
The shift out of big pharmaceuticals and into lesser-known, smaller companies in the biotechnology and health-care management areas has changed the complexion of the fund. "We have a lot more small- and mid-cap names now than we did a couple of years ago," says Schreiber. "We also have less foreign exposure."
"Less" is a relative term in a fund that, in the past, has been known to have more money invested overseas than its peers. Currently, Merrill Lynch Healthcare has about one-fourth of its assets in foreign stocks, but there have been times when more than half its assets had a foreign flavor. Schreiber attributes the shift to less emphasis on international pharmaceutical giants, and more toward smaller American HMOs, biotechnology and hospital-_management companies.
Eaton Vance Worldwide Health Sciences Fund
Assets: $1.9 billion
Top five holdings: Sanofi-Synthelabo, Altana, Pfizer, Genentech, Pharmacia
In contrast to Jordan Schreiber of Merrill Lynch, Sam Isaly, manager of Eaton Vance Worldwide Health Sciences Fund since 1989 and president of OrbiMed Advisors, an investment-management firm in New York, takes a dim view of medical device or service companies. "Except for the occasional stock or two, we usually avoid those areas," he says. "The services group is too labor-intensive, medical device products have short life spans, and we think we can get better rates of return elsewhere."
Isaly turns to a mix of about 40 to 50 pharmaceutical and biotechnology companies in the fund's portfolio to get the 15% to 20% annual earnings growth he's looking for. His universe consists of the 600 public pharmaceutical and biotechnology companies worldwide that have a total stock market capitalization of $2.5 trillion. With market capitalizations of $5 billion to $250 billion, the 50 largest of these companies represent 80% of the value of the sector's universe. Most of them are profitable, while the remaining 550 generally are not.
Isaly is emphasizing the smaller companies in this universe-many of them biotechnology companies with drugs under development-to add some octane to the portfolio. These companies represent about half his fund's assets, compared with 20% of the sector's equity value.
"Stocks rise the fastest just before a company moves toward profitability, and that's the point where we like to step in with this group," says Isaly. He believes Gilead Sciences, which recently introduced the HIV drug tenofovir to the market "will move from losses to exponential profits in 2002." Tenofovir is among the new medicines developed to combat strains of HIV that have grown resistant to antiviral drugs that patients have used for years.
To help balance the volatility of these smaller biotech stocks, Isaly invests about half the fund's assets in larger, profitable biotech and pharmaceutical companies. Among his favorites is Swiss drug company Novartis, which he believes is undervalued right now. Based on 2002 earnings, its price-earnings ratio is 22, compared with 27 for the average large pharmaceutical.
Even though Novartis sells at a 20% discount to its peers, he says, its product pipeline is stronger than that of most drug companies, which should help it achieve stronger earnings growth than they do. He also controls volatility through international diversification, with about 30% of assets invested in foreign companies.
Even after the strong run-up for the sector in 2000, Isaly says its valuations still are reasonable because the stocks pulled back last year, while earnings continued to grow at a healthy clip. "Earnings are still coming through in the intermediate-term, and the long-term prospects for the sector remain undiminished," he says. "How many other sectors can make that claim?"
AIM Global Health Care Fund
Assets: $950 million
Top five holdings: Tenet Health Care, Pfizer, Universal Health Services, Community Health Services, Sanofi-Synthelabo
"Lower than expected earnings for some of the large U.S. pharmaceutical companies hasn't changed our strategy that much," says Michael Yellen, manager of AIM Global Health Care Fund. "We didn't really have that much invested in the group to begin with."
While the fund has about 35% of its assets in pharmaceutical companies, large U.S. drug makers account for just 8% of assets. Foreign drug companies, including France's Sanofi-Synthelabo and Germany's Altana comprise another 17%, while mid-cap specialty pharmaceuticals make up the balance for the category.
The latter group, which includes names like King Pharmaceuticals, Teva Pharmaceutical Industries and Forest Laboratories, sport higher valuations than their larger counterparts but also have better growth prospects, he says. On the foreign side, Yellen has been buying stocks of Japanese drug makers, such as Fujisawa Pharmaceuticals, since early November. These companies have good growth prospects and "are much cheaper on a valuation basis than European and U.S. drug stocks."
Despite his low weighting in U.S. drug stocks, Yellen says the beating the group took last year has added to its appeal, at least from a pricing standpoint. "Merck and Bristol-Myers are priced at a discount to the market, while Pfizer and Eli Lilly are at a slight premium," he says. "It's very rare that you'll see any of these companies selling at those kinds of valuations."
Pfizer, his largest pharmaceutical position, is "undoubtedly the best-positioned drug company in this country because of its strong product pipeline and negligible patent exposure." Yellen also has begun "nibbling" at Bristol-Myers Squibb, which he believes will recover from its problems in 2002 to see "healthy growth" in 2003.
At 40% of assets, hospital-management companies such as Tenet Health Care and HCA represent the fund's biggest bet. "There are only seven publicly traded hospital-management companies," says Yellen. "All of them had stellar earnings growth in 2001, and I expect earnings growth in the 20% range for 2002. Yet the stocks are trading at a discount to the market." Biotechnology stocks account for about one-fifth of the fund's assets, with larger, profitable companies such as Amgen and Genzyme dominating the group.