Meet the Street: Continuing to Bet on Biotech

This year, the biotech sector has been on something of a roller-coaster ride, reflecting the many ups and downs felt by the market overall. Although biotech stocks were hit hard just after Sept. 11, they have since rebounded and are now above their pre-Sept. 11 levels.

James Fenger Fund Manager, Scudder Health Care

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TSC turns to James Fenger, lead portfolio manager for the Scudder Health Care fund, to see what accounts for the renewed interest in biotech and which names are working for him now. His fund invests in companies of varying sizes with drugs at different stages of development in order to increase overall returns and reduce volatility.

While Fenger sees only limited potential for the interest in vaccines and antibiotics arising from bioterrorism concerns to translate into profits for drug companies, he is enthusiastic about recent medical breakthroughs that have led to promising drugs coming to market. The stocks he likes include those in the medical supply and special pharmaceutical categories, but he is staying away from the HMOs and many large-cap pharmaceutical companies. To find out why, read on.

TSC: How has your fund been faring year to date?

Fenger: Initially, we started out with a rather difficult first quarter. The reason was that the Nasdaq was weak and had a negative effect on the biotech sector, which is closely tied to the index. Also, early in the year, there was optimism about a quick economic recovery, which benefited the cyclicals. In 2000, health care overall was very strong. Our fund was up 63%. And we saw that rich valuation contract somewhat in the beginning of 2001.

Since then, we have seen a rebound. Our fund is down about 13% year to date vs. the S&P 500, which is down 20%. Here's why I think this [recent] turnaround has occurred: Investors have gravitated back toward the companies that are not economically sensitive, as we saw many earnings disappointments throughout the year. People are looking for companies that can deliver earnings even in economically challenging situations.

TSC: How do you think the biotech sector will perform for the near term and next year? How has the sector been doing amid fresh concerns about terrorism?

Fenger: We will continue to see strength in the biotech area for the foreseeable future due to several catalysts.

First, we are anticipating several high-profile medical meetings this year, which are forums for clinical data and new products. Second, we are awaiting several approvals from the FDA. After Sept. 11, there was a freeze in these activities involving product review and approval. But now things are picking up again.

Idec's(IDPH) non-Hodgkin's lymphoma drug Zevalin is likely to be approved soon; Gilead's(GILD) drug for HIV just got a very positive review and may soon be approved as well; and Amgen's(AMGN) Aranesp -- a new drug to increase red blood cells in kidney dialysis and oncology patients, also got a go-ahead.

New product approvals also seem to be coming through. What also gives me confidence is that we're seeing successful joint ventures among biotech and pharmaceutical companies to maximize profits. Biotech firms are very good at product discovery, while pharma companies are good at marketing and product development.

For instance, ImClone(IMCL) has a very promising cancer drug. Bristol-Myers Squibb(BMY) has just done a deal with ImClone with very attractive terms: ImClone will receive about $1 billion upfront and will get 50% of the profits from the product. Bristol-Myers will build the marketing infrastructure for the drug.

TSC: Could you describe your fund's overall approach?

Fenger: By diversifying into several areas in health care, we can increase overall returns and reduce volatility. This approach allows you to shift among different sectors depending on valuation and opportunity. Our fund stands in contrast with other funds that have more narrow focuses.

In terms of risk management, a couple of things: First, we not only diversify into subsectors within the industry, we also have holdings in a range of market caps . While we own large-, mid- and small-cap names, our average market cap is mid-cap. To manage risk, we limit position sizes of some of our biotech holdings to 1% to 2% [of the entire portfolio] if they are deemed higher-risk where they do not have current profitability or near-term milestones. But we usually prefer companies with more solid prospects of profit and product to market within a year.

We also diversify by investing in different stages of drug development and therapeutic categories. We have about 60 to 80 companies within our universe.

TSC: What are some of the companies and sectors that are working for you right now, and which are you staying away from?

Fenger: In biotech, as mentioned, you can see near-term catalysts and milestones that will drive the sector. This is the area with the highest growth rate and one which will be helped by the recent scientific advancements. We have about 35% of our fund in the biotech, life sciences and equipment companies. We also like specialty pharmaceutical companies, which are in the niche and higher-growth sector. Some of these companies have exposure to the generic market, which will substantially increase given the expirations of major drug patents. Some specialty pharmas are successfully transitioning from the generic to the specialized brand strategy to increase profit margins.

Medical device and supply companies will have new opportunities in new drug developments. My favorites are Baxter(BAX), Johnson & Johnson(JNJ) and Abbott Labs(ABT). J&J will soon bring to market its drug-coated coronary stent, which has shown great efficacy in reducing the reclosure of arteries. J&J has a big lead over its competitors in this area.

In addition, we have seen improving fundamentals in the hospital segment in terms of increasing admissions and price flexibility.

On the other hand, we do not have any exposure to the HMO sector, where, despite strong price increases, we see steepening cost trends and limited room for margin expansion. We are relatively negative on large-cap pharmaceutical companies due to the following reasons: You see a number of patent expirations here, pulling the growth rate down, while there seems to be a dry spell of new drugs being launched. Some new drugs introduced were pulled off the shelves due to safety concerns. These setbacks not only retard growth and revenue, but also make the FDA more careful in examining medical data and approving the drugs.

In the third quarter, large-cap pharmas grew at only about 8% vs. double-digit growth only a year ago. Baxter and American Home Products(AHP) here are in better positions than the rest of the group. Eli Lilly's(LLY) new product pipeline looks more solid, also.

TSC: Are there any biotech names you like in particular?

Fenger: Genentech(DNA) has many great products on the market and a strong pipeline. The company has a great franchise in the cancer area, one for non-Hodgkin's lymphoma and one for breast cancer, both of which use a new technology. It is a targeting method, which allows the antibody to selectively tag the cancer cells and thereby allow the patient's immune system to attack the cancer cells.

In fact, there was news just last week that the National Institutes of Health halted its clinical trial on one of Genentech's drugs for kidney cancer, called [Avastin], early because the trial has sufficiently shown that the drug is highly efficacious.

TSC: Could you comment on how beneficial, if at all, the demand for vaccines and antibiotics against potential bioterrorism may be on some of the companies you watch?

Fenger: Benefits to any of the companies may be fairly limited. Bayer(BAYZY) had a large move up because of the anthrax antibiotic Cipro, but you should know that there are a number of cheap generic drugs that could be used for anthrax.

I must also point out that if you're a drug company dealing with the government, there are huge pricing concessions involved. The government is forcing Cipro to be sold for under $1, while the regular retail price is $4 per tablet. There are also some companies bidding for vaccines, but they have relatively low margins. And from the PR standpoint, some of them might do it for free.

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