10 Questions With Franklin Global Health Care Fund's Evan McCulloch

Health care funds were last year's port in a storm. But now that they're all wet too, let's talk it over.

Today, we're huddling with Evan McCulloch, who co-manages the broker-sold (FKGHX)Franklin Global Health Care fund and runs the (FBDIX)Franklin Biotechnology Discovery fund. It's always more interesting to talk to sector-fund managers when their sectors are under pressure, and that's the case with the average health care fund -- down 11.4% already this year.

McCulloch admits that this year will be much tougher than last, but says he is finding opportunities as well as traps. Which companies are in which pile? What course is he charting? Read on.

Evan McCulloch

Fund: (FKGHX)Franklin Global Health Care

Managed Since: November 1, 1994

Assets: $190 million

1-Year Return/Ranking: 11%/Beats 67% of peers

3-Year Annualizer Return/Ranking: 11%/Beats 23% of peers

Top-Three Holdings:Pfizer(PFE)Bristol-Myers Squibb(BMY)Genentech(DNA)

Sources: McCulloch and Morningstar. Returns and rankings through March 2.

1. Last year, health care just trounced the market. So far this year, we've seen the first-to-worst syndrome. Do you see this year as sort of a long valuation crunch after last year's heady returns?

McCulloch: I hope not. It's going to be a tougher year, simply because the stock did so well last year and a lot of the individual subsectors are trading at the high end of their historical valuation ranges.

That said, I still think there is a lot of opportunity for stock picking within the sector. It's just not going to be as easy as last year. We're very evaluation-focused, and so we've been looking for pockets of the market that still have decent valuations. One has been the generic drug stocks. We have a couple companies in there that are trading at under 20 times earnings. And also, our largest sector is the biotechnology sector. Yes, it has done well, and it is expensive, but that said, some of the individual companies seem to do very well, simply from their own fundamentals.

2. Given the sector's high valuations after last year's big gains, there is a lot more downside risk than there was at this time last year. How are you navigating? Health care is a very broad term; what industries and companies are looking most attractive to you today?

McCulloch: Again, the biotechnology sector looks very good. We like the valuation in the generic drug sector. And another little pocket -- we don't have a large investment in this area -- is the clinical lab companies. They certainly had 180-degree reversal in fundamentals over the past 12 months. And that's been a great area for us.

In terms of specific companies: In biotech, our largest two positions are in the leaders, Genentech(DNA) and Amgen(AMGN). Amgen is not only the largest biotechnology company but is on the front end of a very exciting new product cycle. On the one hand, their two products, Nupogen and Ipogen, have been experiencing decelerating growth. But they have four new products coming out over the next 18 to 24 months, which we think will drive the next growth cycle.

Genentech has far and away the strongest new product pipeline. There are a number of new technologies in psoriasis and cancer. Whether or not they discover the drugs or someone else did, they somehow seem to get their fingers in it. And so I really think that's a testament to its excellent management team.

First to Worst Health care funds led the pack last year, but 2001 has been a painful odyssey so far
	YTD	2000
Avg. Health Care Fund	-11.4%	55.4
S&P 500	-6.5	-9.1
Sources: Morningstar and Baseline/Thomson Financial. Returns through March 2.

If they don't create a drug, how do they manage to become a part of it?

McCulloch: They license it. So, when you think about some of the smaller companies we invest in, and the smaller biotechnology companies that are out there, [with] their first compound in the market, they don't have the resources to build up a sales force, to sell the drugs to physicians.

So what they'll do is they'll license it to another company. And it's often times a very competitive process. Inasmuch as Genentech will pay the discoverer company for that drug, they will compete with other large biotech and [pharmaceutical] companies for that drug. And I think Genentech has not only a strong management team, they also have an excellent distribution system, particularly in the cancer area. They really are the partner of choice.

That's interesting -- sort of outsourcing as a wholesaler.

McCulloch: Actually, you'd be surprised. If you took a big pharma company and went down product by product, you would find over half of those drugs were discovered elsewhere.

Let's say we use at least a three-year time frame. You think biotech is an attractive area if we look at that far out?

McCulloch: Well, that's the time horizon that we use when we look to invest in a sector. These companies are very early in their lifecycles. Looking out three-four years, projecting sales and earnings out over that time horizon and seeing what sort of upside is presented to the investor at current levels, we're seeing some very extraordinary opportunities right now. Now, given the volatility in the market right now, you may not get that money right away. But I think in a three-four year time horizon, investors can do very well.

3. Now of course the flip side is: What parts of the sector look less intriguing to you given that time frame today?

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McCulloch: I think the fact that we've been lightening on our health care services stocks would be a reflection that we don't think fundamentals will be as strong as they are right now, 12 months from today.

Let's talk about the HMOs first, because it's probably the most obvious. They've been experiencing very dramatic price increases over the past two years, and they can't go on forever. These companies are subject to an insurance cycle where typically they'll have three years up and three years down in terms of pricing. We're in the third year up.

So I think next year will be a good year in terms of pricing, but the increases will be less than they were for 2001. And then in 2003, they'll be less than they were in 2002. So you're certainly facing the downside of that cycle. Beyond that, the stocks were getting up toward the higher end of their historical valuation range. Typically, these stocks have traded between 12 and 20 times earnings, and some of them were getting around 20 times.

So, we still have holdings there, but they're about half of what they were two months ago.

Well, I guess when an area gets to the top end of its historical valuations, you just have to start thinking long and hard about it.

McCulloch: You definitely have to re-evaluate. And you have to look to see if there is there a potential for earnings surprises, meaning that your investments are too low and the fees are overstated. But, at that point, all the good news is in the stock, any surprise is probably going to be biased toward the negative. That's why we've been lightening on those names.

Health Care Is a Many-Splendored Thing
	YTD	2000
Amex HMO Index	-1.9%	116%
Amex Biotechnology Index	-8.1	62
Amex Pharmaceutical Index	-8.1	77.6
S&P Health Care Index	-8.8	34.4
Sources: Morningstar and Baseline/Thomson Financial. Returns through March 2.

4. One thing that I've heard from a lot of folks that invest in this sector is that last year the gains were due in part to a lot of growth-fund managers fleeing the tech sector. When it become obvious that demand was slacking there, growth skippers headed into health care because there was more secular reliable growth. It ended up being a really profitable port in a storm.

Some folks say that this year, a lot of those managers are leaving and going back to tech, anticipating what might be an economic recovery down the road. Did you see that last year, are you seeing the reverse of it this year and is that having an effect on the sector's performance?

McCulloch: Yes. When you talk about health care in general, yes. We certainly saw a rotation out of technology stocks -- and really out of the rest of the market -- into health care as a defensive investment. The reasons for that are obvious. For example, large pharma companies will grow 15% -- recession, expansion, everything in between, they will grow 15%.

Last June, we saw S&P 500 earnings growth peak at close to 20%, so it was growing faster. All of a sudden, growth is flat: Health care is looking a lot better. Health care doesn't really strengthen and weaken with the economy; it's a lot more of what's happening around it that governs these money flows.

So, yes, we saw this huge rotation into health care last year, as the economy turns, and it's likely to happen sometime in 2001. You're probably likely to see that sector rotation unwind.

But now the interesting thing is there's a bifurcation even within health care. Biotech has tended to trade with technology stocks. It's decoupled itself from the rest of health care. Not all the time, but about 80% of the time. So, within that, when we see the economy strengthen and tech stocks start to do a little better, we will increase our biotechnology weighting in response. It's about 30% right now, but over the past 18 months, it's been anywhere from 20% to 40% based on a number of factors, our outlook for the sector, valuations. But lastly, it's kind of this broader perspective on what's happening in the market.

5. With a sector fund, there's a narrower band of the market that you're investing in. When that sector's going to have a tough time, people wonder if a manager takes evasive action -- meaning, maybe let cash rise a bit higher than usual, or short some stock. Do you folks do any of that at all?

McCulloch: Well, we do. But I would not say the effect of that is very extreme. Just as an internal policy, we don't go much beyond 20% cash. We do have the ability to go short, although we have not historically and do not plan to in the future, at least in the Global Health Care fund. We've shorted periodically in the Biotechnology fund simply because it's even narrower. I mean it's a subsector of a sector. [Laughs]. There will be times when it's tougher to invest in this area and we see that, and certainly looking out in 2001, it will probably be one of those years.

But, I'm currently working on a study right now. I'll replicate a study that I've seen, where if you combine just the Lipper Group average return for health and biotech funds, and combined it with an indexing strategy with the S&P 500 -- because of the fact that health care's defensive moves [are] opposite a lot of aggressive growth investments -- you can actually enhance your returns by lowering the risk. It's a very interesting study.

Yes, we actually just did the same thing. I was working on a piece about health care funds a couple of weeks ago.

McCulloch: Oh, that's right. You're the one that did it. Well, we're going to try and replicate that and tweak it a bit. We'll try to tweak it to 20% or 30%. It'll help our sales out, I guess.

Boosting Returns with Less Risk Yes, health care funds are sagging, but adding the average health care fund to a diversified portfolio would've raised returns, while reducing beta or volatility
Volatlity
	100%: Vanguard 500 Index	90%: Vanguard 500 Index 10%: Avg. Health Care Fund
Best Year	52%	50.2%
Worst Year	-9.1	-3.3
10-Year Beta	1	0.98
Source: Morningstar. Annualized returns through Jan. 31.

Just to swing back and give folks a range, I know that you mentioned you keep your cash always below at most 20% as a ceiling. What cash level would you say you're carrying these days?

McCulloch: Oh, right now it's pretty low, it's about 4%.

Right. But obviously, when you can see it's going to be rough on the sector, it's natural not to rush in and be putting money into the market.

McCulloch: Yes, I would say it ebbs and flows, certainly. ... Since Jan. 1, I can say we've had cash levels as high as 10%. We did a bunch of investing, we saw some opportunities to pick up some good biotech stocks on the dips, and so we've been adding there.

We added Pharmacia(PHA) to the portfolio and haven't yet taken out another pharma stock. So it's just, today, it's 4%, but I would say where I want to be right now is between 5% and 10%. And I think that's a good place to be right now, considering there's still a lot of uncertainty with respect to the economy. I don't think a lot of people saw the preannouncements coming from Nortel and JDS and some of these others. I think health care's still a pretty good place to be until you see the economy going straight up.

6. Would you mind playing a little word association? I'm going to throw out some stocks -- mostly pharma bellwethers -- and if you have some others you would like to talk about briefly, feel free to throw them in. I'll just say their names and if you can give me just a quick hit on what your take is on the company. If you would, please give a three-year time frame and say whether or not you own the stock.

McCulloch: Oh, sure. This is the part our PR department really doesn't like. [Laughs.]

First, Pfizer(PFE).

McCulloch: Largest and fastest growing pharma company in the world. It's our No. 1 position, and we think they're going to do great, at least in the near term. We're certainly keeping our eye on the long term, given that their new product pipeline isn't great, but at least two or three years, they'll put up industry-leading [earnings per share] growth based on cost-cutting.

Merck(MRK).

McCulloch: That's one I've been negative on. Let me make sure we don't own it. While it is an exceptional company and has very good science and drug-discovery effort, we think the stock is slightly overvalued in the short term, for a number of reasons. First, their new product pipeline is nothing to rave about right now, and also, they're facing a number of large patent expirations of their existing drugs.

Their EPS growth is expected to slow to well below the average pharma company, and [because of that] I don't think it's deserving of an industry group average price-to-earnings multiple .

Johnson & Johnson(JNJ).

McCulloch: J&J. We are also not there. While they have a number of interesting things going on, on the cardiology side, I'm just not very impressed with their drug business.

Bristol-Myers Squibb(BMY).

McCulloch: Bristol-Myers is a large position in the fund, mostly because it's a cheap stock. It's obviously a very good company, but they've just come out of a period where everything that could go wrong did. We're just waiting for some positive things to occur and think the stock will rebound.

7. Let's talk about generic drugmakers. Drug patents run out, and when that happens these folks have an opportunity. Mylan(MYL) is a stock name that gets thrown around a lot. What companies stand out to you as being the most solid and why?

McCulloch: We have holdings in a few. Our largest one is Watson Pharmaceuticals(WPI), simply because of the management there. We think that they are probably the second-best managed generic drug company. The best-managed company is Andrx(ADRX), and we have a smaller position there. It's just a little smaller simply because of valuation.

But Andrx is trying to break into the largest generic drug opportunity ever, and that's on Prilosec, which is the largest selling drug in the world. Then we also have a position in Alpharma(ALO), and it's a bit more under the radar screens. It's a very cheap stock at about 16 times earnings, and they've come down on some concerns on their animal health business, but we think if the problem's worked through then the stock will be fine.

8. As a sector-fund manager, you look at things maybe a bit more closely than other folks. What are the rest of us missing? If you're investing in tech or biotech or health care, there's always that sort of painful hindsight where you say: How did I not understand this trend? What are investors not making enough out of, and what are we maybe making too much out of?

McCulloch: I think a lot of investors get focused too much on the short term. I think if you adopt at least a one-year time horizon, it'll change the way you invest.

Beyond that, I think people are missing the earnings consistency and the defensive nature of health care. You see a lot of people whipping in and out of the sector, just because they want a place to hide from tech, but they're missing the fact that health care is an exceptional area for investment. It combines defensive characteristics with moderate growth. I think it deserves a higher premium in the market than it [has].

An area where people are, let's say, overenthusiastic, is in the genomics phase. It's going to be a long time before some of those companies produce even products, let alone sales or revenues. In a couple of companies, there's very large valuations attached to that promise, and it could be a long time before they grow into that valuation.

9. What kind of return are you talking about this year? Do you think the sector can finish in the black, or do you think it's going to be one of those years where you just have to kind of labor along and build positions with your eye on next year?

McCulloch: I absolutely think they can finish up in the black. We have this opportunity to invest within two very different sectors within health care. One is the biotech sector, which is an aggressive growth instrument and will probably do well if and when the market rebounds. On the other hand, we have health care, which is essentially defensive but still has strong earnings growth.

The negative returns so far this year have been from sector rotation, in the first days [from] profit-taking and some overall market jitters. But the earnings growth is still there, and we think the sector will do well, if not this year then certainly in the longer term.

10. If you have to pick three health care stocks to buy and hold for five years, what would they be and why?

McCulloch: I'd go with Pfizer, No.1. Despite my concerns about their product pipeline, five years from now I think they'll have that figured out, and it's an exceptional management team and a very, very good marketing organization, as well. I would definitely want to have a lot of exposure to the pharmaceuticals phase.

Also, we talked about Genentech. This really is the partner of choice for all the smaller biotechnology companies; they also have a very good drug-discovery engine as well. Great management team -- I have a very high confidence level in their ability to execute.

And lastly, I'll go with a little bit of a contrarian pick simply because I think five years from now, people will perceive this company much differently, and that's Abbott Labs(ABT). It's also a large holding in the fund, another company that's had a lot go wrong the past couple years. They have a new management team that's young and aggressive. They want to accelerate the growth profile for Abbott, and they will do so through acquisition. And I think five years from now, you're going to see a much different company.

What caused their stumble?

McCulloch: [Laughs.] There are so many things! The big one, actually, was, they had the [Food and Drug Administration] shut down their diagnostics business because of concerns over manufacturing practices. And that happened, say, November 1999.

Not only that, but they had a drug get pulled -- it was one of their AIDS drugs -- they had some manufacturing problems: They tried to merge with Alza (AZA) and called it off simply because there was some product crossover between the two companies. They couldn't figure out how to divest the products, and there were just a lot of things that went wrong. One of their products went off patent as well.

So, from here, it's nothing but good news. They had a new drug launched late last year that's going very well, and sometime in 2001 the diagnostics business will come back online. And we think they'll continue to be aggressive on the acquisitions side and accelerate the growth rate from low teens to midteens.

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