Feeling Good about Health Care


Health care is the place to be in the current market -- especially if you're a value investor. So says Timothy P. Beyer, co-manager of the USAA Balanced Strategy Fund (USBSX). Beyer specializes in the equity side of the fund, which mingles stocks and bonds.

Although he's wary about telecom stocks, Beyer notes that R.H. Donnelley is among his fund's top holdings because of its Yellow Pages business, which generates rich cash flow without requiring a lot of capital.

Beyer made these and many other comments in a chat presented May 23 by BusinessWeek Online on America Online, in replying to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. What follows are edited excerpts from this chat. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: What criteria do you look for before you buy a stock?

A: There are several primary things I look for as a value investor. One is companies selling at a significant discount to our calculated intrinsic value. The second thing is value that's actually growing, vs. value that's stagnant. We use the example of Merck (MRK) vs. Ford (F). We see Merck growing at a low double-digit rate over the next decade, while Ford will probably grow at a low single-digit rate.... The third factor we weigh is strong financials. We primarily look for strong free cash flow and high returns on invested capital. And to throw one more factor in, we look for shareholder-oriented management teams. Do the company insiders -- the managers -- own stock at the personal level, and are they buying it?

Q: What is favorite holding right now?

A: Let me say broadly that, in my opinion, health care is the most attractive sector. Four of my top five are health care: Merck, Bristol-Myers Squibb (BMY), Invitrogen (IVGN), and IMS Health (RX). We also recently bought Schering-Plough (SGP). Invitrogen is one of my favorites. This company sells consumable products into the drug-development market. They don't make drugs, but they make the materials companies and labs need to make them. (For another perspective, see BW Online, 5/29/02, "A More Jaundiced View of Health Care")

Q: Are you seeing any value in tech? Do you have an opinion on Flextronics (FLEX)?

A: Our tech managers like that stock, but I don't own any in this fund. The tech stocks we do feel good about include eFunds (EFDS), MIPS Technologies (MIPS), and Electronic Data Systems (EDS), which we recently bought. We're always looking for new tech ideas because we do like the long-term growth potential in the industry, but at this time we don't see much value there.

Q: What's the current balance between stocks and bonds in the USAA Balanced Strategy Fund?

A: Right now we're about 53% stocks with the rest in bonds -- 47%. That's the low end of where it has historically been. We increased the weighting to 70% stocks after September 11. We reduced it to 60% in December after the market had run back up. And we reduced it earlier this year, given the current relative valuation of stocks vs. bonds.

Q: What type of bonds are in the current mix?

A: In the current mix, we generally won't own Treasuries because we get higher yields in corporates. We do own some of the Treasury inflation-protected bonds (TIPs). Overall, though, I'd say we like short-term corporates more than long-term.

Q: What about Pfizer (PFE) and Genentech (DNA)? And how about biotech generally?

A: Pfizer is a fantastic company with a good pipeline and little patent exposure over the next several years. Those are two very important points in weighing any drug stock. But relative to its peers, Pfizer trades at the high end in valuation -- and for good reason. We like the company. You'd do O.K. holding it in the long run. But at current prices, we'd prefer Merck, SGP, or Bristol. Genentech is also a fine company. But it's simply too expensive for this fund.

Q: Telecom stocks have been beaten down for some time. Do you think they are a reasonable buy-and-hold opportunity?

A: While some telecoms may make for a good trade at these prices, I don't think many would make for good long-term buy-and-hold investments.... The best part of the telecoms' business is the Yellow Pages business, which Qwest (Q) and Sprint (FON) are both trying to sell. They generate huge amounts of cash flow with very little need for capital. So an alternative to telecom stocks that you may want to look at is R.H. Donnelley (RHD), which in essence owns the Yellow Pages. This is one of our top 10 holdings that we feel you'd be well-served to hold over a long period of time.

Q: What are your thoughts on the retail sector?

A: I used to be the retail analyst at Bank of America many years ago, so from firsthand experience, I know that it's a very tough business because it's an open lab. Anyone can copy what you're doing. There are a few with sustainable competitive advantages, such as Victoria's Secret, owned by The Limited (LTD). Victoria's Secret doesn't really have a competitor.

Probably our favorite retailer would be BJ's Wholesale Club (BJ), a membership-based warehouse club retailer in the Northeast, spreading to the Southeast. BJ's, Costco (COST), and Sam's Club are all rational competitors and capital-allocators, and it's unlikely that they would ever open a store in a market that's already saturated with competitors. So we see them sustaining mid-teens growth with high-teens return on equity over the next several years.

Q: How has the balanced strategy performed in the recent difficult times vs. other approaches? And historically?

A: Very well -- for our fund, I should say. The balanced style will underperform an equity fund over the long run typically, because over the long run equities outperform bonds. I'm talking about over decades. Therefore, if you have a very long-term horizon and don't have a need for current income, general equity funds may be better. But if you either need current income or can't withstand the volatility of a pure equity fund, then a balanced fund might be for you. Also, it's good for people who want both stocks and bonds but don't want to make the asset-allocation decisions between them.

So to get back to the question, the balanced-fund style has performed well over the last five years -- about in line with the S&P 500 but with less risk. Over the last three years, the average balanced fund is flat, vs. a 6% drop for the S&P. Our fund is up 4.9% over three years and 9.2% the last five years -- substantially outperforming our peer group.


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