A Heavy Dose of Drug Stocks


Drug and biotech stocks suffered last year from poor earnings, a dearth of new products, and an alarming number of patent expirations, which allowed smaller generics companies to make the same drug at a fraction of the price. This year, though, the health-care sector, particularly biotech, has rebounded strongly thanks mostly to a flurry of new drug approvals and greater optimism about the industry.

After shedding 23.4% in 2002, the $150 million Evergreen Health Care Fund (EHABX) soared 32.2% year-to-date through July 31. For the three years ended in July, the fund gained an average annualized 7.4%, vs. 5% for the average health-care fund.

Though Evergreen Health Care has assumed slightly more risk than the average health-care fund, it has also gained the edge. The portfolio, which has been managed by Liu-Er Chen since its inception in December, 1999, is ranked 4 Stars by Standard & Poor's. Palash R. Ghosh of S&P's Fund Advisor recently spoke with Chen about the fund's strategy. Edited excerpts from their conversation follow:

Q: Could you describe your investment process?

A: We invest in health-care companies around the world -- without regard to market-cap size -- that are trading at significant discounts to their intrinsic value and have the potential to deliver above-average long-term returns. We focus on business fundamentals, valuation, and earnings growth. We are not momentum investors.

Q: What are the portfolio's characteristics?

A: The fund currently has a median market cap of about $1.68 billion, which might imply a mid- or large-cap bias, but it actually reflects our heavier weightings in the bigger companies. We have about 125 stocks in the fund, but the top 80 names represent 90% of total assets.

Q: What are your top holdings?

A: As of June 30: Pfizer (PFE), 6%; Genentech (DNA), 4.4%; Johnson & Johnson (JNJ), 4.3%; Amgen (AMGN), 3.8%; Merck (MRK), 3%; CIGNA (CI), 2.3%; Bristol-Myers Squibb (BMY), 2.1%; Schering-Plough (SGP), 2.1%; Abbott Laboratories (ABT), 2.0%; and Eli Lilly (LLY), 1.9%.

Q: What is your industry allocation?

A: As of June 30: pharmaceuticals, 48.1%; biotechnology, 24.8%; health-care providers and services, 17.3%; and health-care equipment and supplies, 8.3%.

Q: Can you illustrate your investment style through a particular stock?

A: In early 2002, I bought shares of Biosite (BSTE), a provider of medical diagnostics, when its stock crashed to the low teens as a result of a patent-infringement lawsuit filed against the company by XOMA (XOMA).

However, on a fundamental basis, Biosite was in the midst of enjoying accelerated revenue growth, with significant amounts of cash on the balance sheet and margin expansion. So the stock was significantly undervalued. Based on our analysis and due diligence, we concluded the stock was worth $25 a share. After three months, the stock rose to the mid-$20s, and I sold it off.

Q: What's the fund's turnover rate?

A: It was 198% for the year ended June 30, however, that doesn't accurately reflect my buy-and-trade decisions. This is a relatively small fund, and investors move cash in and out of it frequently. We maintain a full investment policy.

Q: AstraZeneca (AZN) just received Food & Drug Administration approval for its new cholesterol-lowering drug, Crestor. Will this pose a competitive threat for Pfizer's cholesterol drug Lipitor?

A: I think Crestor will definitely be a blockbuster drug, but it will not really hurt sales of Lipitor, which is the world's top-selling prescription drug and generated $7.9 billion in sales last year. I believe the market for the whole class of cholesterol drugs will increase globally, even though Lipitor might give up some market share. I expect Crestor to eventually become a $3 billion-plus drug.

Incidentally, we added to our position in AstraZeneca on this news. The stock is now among our top 10 holdings.

Q: Teva Pharmaceuticals Industries (TEVA) got tentative approval from the FDA to make a generic form of Neurontin, an epilepsy treatment that Pfizer makes. What does this bode for Pfizer?

A: Once a generic version of Neurontin comes to market, Pfizer will lose most of its sales from this drug. The stock market has already discounted the risks posed by both AstraZeneca and Teva to Pfizer's share price.

Neurontin currently generates about $1.6 billion in annual sales for Pfizer, but keep in mind this company generated about $33 billion in sales in 2002.

Q: What's the outlook for Pfizer's most well-known drug, Viagra?

A: Viagra is a blockbuster drug, with sales of $419 million in the recent quarter alone. However, Viagra will soon face competition from rival sexual-impotency drugs manufactured by Eli Lilly and ICOS (ICOS), and by Bayer (BAY) and GlaxoSmithKline (GSK).

However, like the situation with Lipitor, Pfizer should continue to see double-digit annual growth in sales for Viagra, despite competition, because of aggressive marketing and enduring high demand.

For a company of its large size, Pfizer has a relatively impressive number of drugs in its pipeline -- it expects to file about 20 new drug applications by 2006.

Q: What did you make of the excitement over Avastin, the anti-cancer drug that has driven Genentech's stock through the roof?

A: Genentech's stock price has more than doubled since the beginning of the year -- driven primarily by Avastin, which I think will become a $3 billion product after its release next year. For the medium term, Avastin will face no direct competition. I'm extremely bullish on it.

I think the company's stock price can double again over the next three years. At such time, Genentech will likely replace Amgen (AMGN) as the world's biggest biotech company. Aside from Avastin, Genentech already has two other promising new drugs in Raptiva {for psoriasis] and Tarceva [for cancer].

Q: Are you bullish on the pharmaceutical sector for the long term?

A: The pharmaceutical industry is cyclical, and it's largely a function of the product cycle. For example, the big drugmakers launched a lot of blockbuster products in the early 1990s, which was the result of scientific research that began in the late 1970s. Thus, it can take at least 10 years for a product pipeline to come to market.

Now we're again witnessing a renaissance of exciting scientific research. So for the long-term, the big drug stocks should prosper, since there will likely be a new wave of products in the next 5 to 10 years due to the genomic revolution.

In 2002, the big-drug sector was hurt by poor earnings growth and by the patent expiries of some prominent products, including Merck's hypertension drug, Prinivil, and Bristol-Myers' diabetes drug, Glucophage.

Q: Biotech stocks have rebounded this year, after a disastrous 2002.

A: This also reflects the product cycle. In 2002, the biotech drug approval process dried up. But in 2003, we've seen a flurry of new product approvals. This has pushed the entire biotech sector upwards.

Biotech stocks are extremely volatile, with an endless "boom-and-bust" cycle. I think we're presently on the cusp of a new biotech boom. This fund's exposure to biotech typically varies between 20% and 30%.

Q: Do pharma and biotech represent overweight positions in the fund?

A: Yes, but for the vastly different reasons: Biotechs look good on fundamentals. Pharma looks good because they're cheap now.


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