10 Questions With Christy Turner at American Century Life Sciences - TheStreet

There is little doubt among investors that drug stocks have disappointed as of late.

Typically, pharmaceuticals and health care stocks are safe havens in a weak economy because consumers tend to continue spending on their health even when they are short on cash. To a certain extent, that has been the case. The average earnings in the health care sector for the latest 12 months increased 12%, compared with the

S&P 500's

20% decrease, according to Thomson Financial/Baseline. But the average share price for the health care sector has dropped 9.5% since the beginning of the year, vs. the 3.6% decline for the S&P 500.

Much of this downward pressure on stock prices is due to regulators tightening requirements for patent approval and cracking down on quality control. In addition, state governments are taking coordinated legal action to reduce drug prices, and patents for big blockbuster drugs are expiring. As a result, steady, reliable earnings are harder to find in the sector these days.

Nevertheless, Christy Turner, who co-manages the

(ALSIX) - Get Report

American Century Life Sciences health care fund with Arnold Douville, has done a good job of weathering these pressures. Launched in June of 2000, the fund is beating 83% of its peers on the basis of its one-year annualized return, according to Morningstar. And on a year-to-date basis, the fund is beating 96% of its peers. To find out why American Century Life Sciences is doing well despite the tough market, we spoke with Turner about her strategy.

1. With patents on many brand drugs expiring, increasingly tough FDA Food and Drug Administration standards, and growing pressures to reduce drug costs, the big pharmaceutical companies have become a much riskier group. Is it fair to call drug stocks "defensive" anymore?

Talking With:

Christy Turner
Co-Manager,
American Century Life Sciences Fund

Sales charge: none

Expense ratio: 1.50%

Managed Since:
June 2000

One-Year Return:
beats 83% of its peers

Five-Year return:
not available

Top Holdings: Baxter International, Abbott Laboratories, Johnson & Johnson, WellPoint Health

Assets: $220 million

Since we launched the fund in June of 2000, earnings revisions are down and the head winds are bad, so it no longer looks like the safe haven that it was in the early '90s. Despite the fact that the market is down overall, you're not finding a lot of bargains.

As you can tell, this should have been the perfect market. Late 2001 and early 2002 should have been the market where the drug group screamed. And they've been real laggards. That's because earnings revisions continue to move down, as blockbuster drugs that are in the pipeline continue to fall out or get delayed.

We launched our fund June of 2000, and at that time we had a very negative bias on the large pharmaceutical group. We felt that due to not only the FDA slowdown but also the lack of large-scale phase III drugs, the head winds from the generics that were coming, and the valuations at the time.

We do have a very concentrated period of time, starting last year with Prozac and then moving forward three or four years, where an unprecedented number of blockbuster drugs are coming off patents. That creates opportunities for other people. But, obviously, it's bad for the major pharmaceutical companies. Because their top revenue lines are so big now, it's tough to keep those engines growing. That is a head wind that probably will persist for some time.

2. What areas of health care do you find attractive in this environment, and what strategy do you use to make your picks?

Our style of investing is to look for companies that are showing improvement in their growth rates. So they can have negative growth rates, as long as they're improving. Maybe they've gone from negative 2%-3% growth to positive 1%-2%. That's a positive trend, and you get multiple expansion with that trend.

So we focus on acceleration, and we saw major deceleration in the big-pharma group. So we stayed away from the group largely, with the exception of

Pfizer

(PFE) - Get Report

and

American Home Products

, which is now

Wyeth

(WYE)

. These two names really showed us the potential to at least meet estimates that were year-over-year improving or flattish.

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We also made some selective investments in international names and stayed away from the broad names, like

Eli Lilly

(LLY) - Get Report

and

Merck

(MRK) - Get Report

.

Instead, our investment strategy took us into the services sector, or hospitals, HMOs, distributors, home health care providers, rehab providers.

3. How do your top three holdings -- Johnson & Johnson (JNJ) - Get Report, Baxter International (BAX) - Get Report and Abbott Laboratories (ABT) - Get Report -- fit into this strategy?

Baxter, Johnson & Johnson and Abbott are really hybrids. They're a combination of drug exposure -- or in Baxter's case, recombinant Factor A and bioscience exposure -- and devices, and also mainline hospital supply. We separate them from the pharma group because they have hybrid sources of operating income.

Volume is picking up at hospitals, which feeds the demand for Baxter's med-device hospital supply business. We also saw a supply demand imbalance for Baxter's recombinant Factor A after one of the big suppliers in the market was taken out due to FDA issues. So Wyeth and Baxter filled that void, and that's been a nice steady earnings driver for Baxter.

Abbott is flat year to date, as is Baxter. Abbott had a couple of specific issues. They had a consent decree that they've been working on with the FDA for their diagnostics business. We had expected clearance of that consent decree. It has been going on for 18 months now. And the FDA came out and said, "You still have some manufacturing issues." So they've been precluded from launching new product in diagnostics, which is less than 10% of their business. We are really focused on Abbott's D2E7, which is a novel arthritis product. So we're focused on the rest of the business and didn't take the consent decree as very bad news. The stock lost $1 billion in

market cap on the consent decree news.

4. A consumer group called Public Citizen said Tuesday it's urging the U.S. government to bring criminal charges against Abbott for allegedly withholding information about its diet drug Meridia. They're claiming eight deaths were caused by Meridia. Do you think this is a serious threat?

Meridia is on the market in Europe and in something like 40 countries without any problems or safety issues.

For most every diet drug that has ever hit the market domestically, it has had issues with side effects. Abbott's counter to that is that you have to go in and look at the specific circumstances surrounding each death, particularly when you're dealing with morbidly obese people, who have valvular problems and diabetes issues. It's hard to say it's the drug as opposed to the individual to begin with.

5.Schering-Plough (SGP) just agreed to pay the FDA a $500 million settlement to resolve manufacturing problems -- the largest FDA settlement ever. What repercussions does this have for other drugmakers?

We've been very negative on Schering, but I found that very interesting. You say, "They're going to allow them to continue to put product on the market if they pay the FDA $500 million. If they don't pay the $500 million, then they have to stop shipping." Well, that doesn't resolve the problem of whether or not the drugs are contaminated. The FDA does seem to be taking a very heightened approach to inspection. Practically every drug company in the last 12 months has had some issue at some plant.

6. How much could this cost the drugmakers, in terms of increased investment in quality control improvements?

Most of our companies are saying they have solid quality control at this plant or that plant, or this drug or that drug. It's very hard for an investor on the outside to know. And even sometimes the CEO doesn't know. So I can't give you an estimate. But I can tell you that Schering took their guidance down because of the quality control spending they're going to have to do. So has Eli Lilly for the same reason.

7. Are there any low-risk stocks in the health care sector right now? Any that might be immune from regulatory problems?

It's really a stock-picker's sector at this point. I can give you good news and bad news on every subsector. You dig into any of them and you've got specific late-stage trial designs that might be flawed, and you've got manufacturing capacity, which isn't sufficient. So we truly just approach things stock by stock. We own stocks in almost every sector, but you'll see lower weightings in some sectors, like HMOs. We're out of HMOs now because we think that valuations got rather lofty. At one time we did have quite a holding there.

8. Do you like any of the generic drugmakers, considering their potential to benefit from expiring patents?

We try to value-fish there, too. You have true generics like

Watson Pharmaceuticals

(WPI)

,

Mylan Laboratories

(MYL) - Get Report

,

Teva Pharmaceutical Industries

(TEVA) - Get Report

. And then you have the hybrids, which might have some legacy business that they really want to be specialty pharma -- the

Biovail

(BVF)

,

Allergan

(AGN) - Get Report

and the

Forest Laboratories

(FRX)

of the world, and the

King Pharmaceuticals

(KG)

. And we separate the two.

We thought valuations in the specialty sector had gotten crazy, and we didn't think some of the growth rates were sustainable. And a lot of those are one-drug bets. So you really have to pay attention to weekly prescription trends.

Back on the actual generics side, we really only own one, and it's

Israel's top drug firm Teva. It got hit because of the unrest in the Middle East -- which was a great time to enter. I think they do 20%-25% of their manufacturing product in the Middle East, and they can do backup manufacturing in the rest of the world. It's a very well-run company.

But Andrx Pharmaceuticals is in a big battle

along with some of the other big generic drug companies over Prilosec, and we're not going to find out about that until midyear. That would add $4 to earnings possibly for the six-months of exclusivity there. But it's too binary for me. If it doesn't work, it's already fairly expensive.

(Editor's note: Andrx Pharmaceuticals is controlled by Andrx Group (ADRX) , and Prilosec is the generic version of AstraZeneca's (AZN) - Get Report blockbuster ulcer product.)

As far as

generic drugmaker

Ivax

(IVX)

is concerned, you'd have to believe in an extended relief version of Taxol, which is already generic. And we've seen

Bristol-Myers Squibb

(BMY) - Get Report

lose $800 million in revenues on Taxol in a hurry. So I don't know what that franchise is going to be worth, even if they

can

make Taxol work. It's hard to pick out any in there that are really clean stories.

9. What about diagnostics and biotech?

I'd stay away from the diagnostics. You've seen some of the press articles lately: Can we pay for them, why aren't we paying for them? People want to find out if they have the Alzheimer's gene. But we don't have any treatment if they have the disease. And with the scrutiny on cost-escalation in the payment system, it's hard to imagine a lot of free reimbursement. So I'd stay away from diagnostics, other than blood-based or treatment-based diagnostics, which is where Abbott and Baxter are.

In biotech, we're sticking to names that have late-stage clinical trials, that look like they're working on a novel mechanism for action,

and have a pretty big market. And the data that we've seen so far looks pretty compelling. And then we're staying away from concept stocks, with phase I and phase II drugs.

10. What are the biggest issues facing health care providers right now?

We're actually positive on the hospitals because we think a lot of the problems in the sector are manageable. But we're conscious of valuations.

Right now, we're focusing on what the reimbursement system will be like for fiscal 2003 and beyond. There's a lot of speculation in Congress. Typically, they get paid market-basket inflation. But you're getting rhetoric out of the House and Senate, and then there's the president's budget. They can't all see eye to eye, so we're going to hear a lot of noise going into the election about what the reimbursement rates are going to be. So the hospital group will come in and out of sentiment with that.

For example, devices are a supply cost to the hospitals, but reimbursement for the purchase of these devices lags by a year. If a new device gets approved and it's more expensive than the old product, then payment for the new product will eat into margins while the hospital waits for reimbursement. So things coming out of devices can be bad for hospitals' margins.

On HMOs and hospitals, you need to look at how many of them can really stomach rising employment costs year after year. And both of those sectors have been pretty strong in this market.