10 Questions With Merrill Lynch Healthcare's Jordan Schreiber

Health care funds have quietly topped all other types of stock funds over the past decade, but what now? To figure that out, we huddled with Jordan Schreiber, the category's graybeard.

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Schreiber has run the (MAHCX Quote)Merrill Lynch Healthcare fund since ye olde 1983, giving him the longest tenure in the health-fund bin, and he has made his experience pay. The fund beats more than 80% of health care funds and the S&P 500 over the past 10 years, according to Chicago research house Morningstar.

He sees bright days ahead, but he's no cheerleader. A paucity of new drugs has Schreiber down on pharmaceutical companies, and he thinks the situation will lead to mergers very soon. And he admits that ImClone's(IMCL Quote) tailspin after the Food and Drug Administration rejected its new cancer drug caught him by surprise. Where does he see risks and opportunities? Read on.

1. What's the case for investing in health care today?

Well, there are three main reasons that aren't new. First, I'd point to demographics as the world's population ages. Then there are technological advances, including genomics. The third is the broadening of the market for health care as political demands and health care needs exert themselves. There I'm speaking of places like India and China with billions of people due to come into the market for health care.

Talking With: Jordan Schreiber

Fund: (MAHCX Quote)Merrill Lynch Healthcare

Managed Since: April 4, 1983

Assets: $793.1 million

1-Year Return: -0.5%/Trails 79% of Peers

10-Year Return: 15.7%/Beats 82% of Peers

Expense Ratio: 1.24% vs. 1.73% category avg.

Top Holdings: AmerisourceBergen WellPoint Health Networks Tenet Healthcare

Source: Morningstar. Returns through Jan. 8

2. Given the sector's solid gains over the past decade, some might say it's due to cool. What's your response, and what's a worst-case scenario for the sector this year?

Well, you can't get much better than it's done. But I think the sector can continue to have superior performance as long as the reasons I just mentioned are still in place. I think they are and will be.

The worst case would be a situation where some very radical governing body came to be, which I don't see happening. I think that the present administration is levelheaded and rational, and I don't think any threat exists from a runaway FDA. If something happened in the next election, where some political upset in either the extreme left or extreme right led to arbitrary oversight of the FDA, that would be bad. But I don't see it happening.

3. Let's drill into the sector's major industries, starting with pharmaceuticals. What's your take on the group's prospects?

We're lukewarm on them and we've underweighted this area. No. 1, there's a dearth of new products, which are these companies' lifeblood. No. 2, expiring patents are exacerbating this shortfall. No. 3, in the near term I think investors will be rotating out of this sector and into more depressed cyclical areas if we have a robust economic recovery, as I think we probably will.

Among the big players, who's on the upswing and who's losing ground?

Generally, most of the companies are on the downslide. Eli Lilly(LLY Quote) has a nice pipeline, but Merck(MRK Quote) doesn't have much. Pfizer(PFE Quote) has an excellent pipeline but anticipates greater competition for their key cholesterol-lowering drug Lipitor, so they'll need it. AstraZeneca(AZN Quote) is developing a competing drug. As for Bristol-Myers Squibb(BMY Quote), everything rests on [the approval and marketability of the blood pressure drug] Vanlev.

4. Given the lack of new products, do you expect consolidation?

I see continued consolidation everywhere -- globally, across subsectors and within subsectors. What's driving it is what we've discussed -- the shortfall of new products and the inability of companies to sustain the midteens earnings growth rate that their [stock's price-to-earnings] multiple depends on. They need to combine with somebody who can give them short-term synergies and maybe some products that can sustain them long term.

What are some marriages that make sense?

I would expect Pharmacia(PHA Quote) to make an acquisition or be acquired themselves to increase their scale. I'm also not sure how viable Schering-Plough(SGP Quote) is at this point.

How soon do you see deals happening?

Now.

Healthy Indeed Schreiber has kept his fund ahead of its peers and the S&P 500

Sources: Morningstar. Returns through Jan. 8.

5. When we spoke last year, you said a sluggish FDA might hold pharmaceuticals back. Are you still worried about that?

Yes, but the situation might improve. There has been a shortfall in the number of new products approved. At that time the FDA denied this, but they've now admitted it and appealed for more money. Unfortunately, they don't have a commissioner who can help to push the legislative effort. The presumption is that if they get more money, they'll speed up their efforts a little bit. At least they're not blaming somebody [else] for what they're not doing, which was the case before.

6. Let's move on to the biotech area -- what's your take there?

I'm excited and I think this area will do well. But be aware that you're catching me at an up moment because I'm at the JPMorgan H&Q health care conference [in San Francisco]. Some companies now have vaccines for lung cancer and prostate cancer advancing in the approval process. That's pretty damned impressive. This looks promising, and it's going to attract investor attention.

What biotech firms stand out to you?

Let's talk about some of our holdings. Among the big ones with solid pipelines, I like Amgen(AMGN Quote) and Genentech(DNA Quote). Amgen's biggest problem is that the shares might be hurt by conjecture on any governmental questions regarding its acquisition of Immunex(IMNX Quote). Genentech has an excellent pipeline and great management. The stocks are not cheap by any means, though.

In general, I'm less enchanted by the big ones than I am with the mid-caps. For example, there's nothing on the market to treat insomnia other than Ambien, which has been out there for some time and is not a great medication. I think Neurocrine Biosciences(NBIX Quote) [which is developing a new insomnia drug] has an opportunity there. Clinical studies show fast onset of sleep, and uninterrupted sleep, and that represents a pretty good market opportunity. They're doing it all by themselves, and they have full rights to the products. That kind of thing absolutely fascinates me, and we do own some shares.

Emisphere Technologies(EMIS Quote) is a drug-delivery company we like. They're developing an oral means of delivering drugs. So if you're a diabetic, you don't have to stick a needle in your arm every morning. They're moving ahead both an oral insulin and heparin. With insulin, they have yet to negotiate a deal, but I'm sure it's coming.

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7. How about health care service companies -- the HMOs and hospitals? They had a great run in 2000; what do you see now?

We think this area is an excellent way to lower [a health care portfolio's] risk, and we do have a fairly decent position in HMOs, hospitals and drug distributors.

What holdings here are you most excited about?

We like drug distributor AmerisourceBergen(ABC Quote), because they still have the synergies in front of them from the deal they made -- the combination of AmeriSource Health and Bergen Brunswig. The numbers are very impressive. We think they've got 20% earnings growth locked in for the next several years. Also, Caremark Rx(CMX Quote) is attractive as a pharmacy benefits manager with a solid mail-order business.

8. As you say, pharmaceutical and biotech companies' prospects are based on their product pipelines, but the average investor often doesn't have much visibility there. What obscure development has you most excited now?

There are companies that have made great progress in developing therapeutic leads for drug discovery if they work. Lexicon Genetics(LEXG Quote) comes to mind. They've discovered a lead for controlling cholesterol, obesity and maybe diabetes. It's early, so it's not worth going too far, but that's how you start to find ideas.

9. Things can go very wrong with biotech companies, too -- ImClone has been in a tailspin since it was learned that the FDA rejected its cancer drug Erbitux on Dec. 28. Did the fund own shares?

Can we have a drink first?

Yes. But what's your take on that situation from here?

It's a legal mess. We don't own it now. Let me say that we did own it, but we sold it [last Tuesday].

I didn't see it coming. I wasn't aware of the leaked FDA letter [rejecting the drug's approval application]. It wasn't leaked to me. I can't say anything beyond that. It's nothing that I could have foreseen. It was a bombshell. I relied on due diligence, to some extent the due diligence of [ImClone's partner] Bristol-Myers Squibb, and the eminent reputation of Dr. John Mendelsohn, who's president of the M.D. Anderson Cancer Research Hospital in Houston and the discoverer of the drug. These are reputable sources, but it was poorly managed.

10. What are three companies you'd be willing to buy and hold for five years, in light of their products, management and valuations?

I'd pick [hospital operator] HCA(HCA Quote), which is one of our more solid holdings. I think that's a very stable, long-term holding. Medtronic's(MDT Quote) studies have indicated that implanted mechanical devices are superior to drugs in many important heart conditions, and I think they have a long way to go. And Forest Laboratories(FRX Quote) has been extremely successful in marketing Celexa, their depression drug. They've also got a generic drug business and a good selection of licensed product rights from other companies.