Hey Doc, what's up with those health care funds?
Despite all those reports about aging baby boomers and their increasing health care needs, health care funds have been acting downright sickly for more than three years now, and a recent pulse-check failed to indicate much improvement.
According to fund tracker Morningstar, health care funds, which are dominated by pharmaceutical stocks, are the worst-performing long-only category over the past three months (down 9.06%), year to date, (down 5.3%), one year (up 2.14%) and three years (up 6.89%).
The ailing group's problem, say a number of health care fund managers, has nothing to do with a lack of patients, but instead a lack of patience.
"The market is capricious," says Bruce Abel, portfolio manager for the $14 million
Kinetics Medical fund. "Several years ago, these stocks were trading like they were going to create a new cancer-curing drug every day, and now they are being treated like they will never introduce another drug again."
Near the top of the list of problems dogging the sector is the constant refrain about pipelines and patents. But those issues, in Abel's view, should already be known to discerning investors.
"Nobody should be surprised when a drug goes off patent," says Abel, whose fund is up 4.45% this year, more than a percentage point better than the
. "And R&D spending is something analysts track, so it also should not sneak up on anybody."
Abel looks specifically for companies willing to spend the dollars to fill their pipelines. His current favorite pharma pick is
because of its 28% return on equity, 4.4% dividend yield, low trailing P/E multiple of 16 and strong research-and-development spending of $2.75 billion in 2005.
His prognosis for whether the range-bound stock will ever break out: "It's a matter of when."
Surprisingly, one stock Abel does not own is
, notwithstanding the company's ability to boast the industry's largest pharmaceutical R&D organization, with actual spending of $7.4 billion in 2005.
"It's a great company, but they are too big," says Abel. "It's just hard to grow off that massive asset base. They need to pump a blockbuster drug out of their pipeline every year, and that's an almost impossible feat in this business."
As for patent problems, Matthew Willey, portfolio manager for the $140 million
Franklin Global Health Care fund, estimates that brand-name drug companies are at risk of losing $50 billion out of a $250 billion drug market to generics between 2006 and 2009. Typically, generics cost 30% to 50% less than the equivalent brand-name drugs.
Willey believes Big Pharma's loss means big gains for the pharmacy benefit managers, or PBMs, such as
Medco Health Solutions
"The PBMs make three times as much profit from a generic than a branded drug," says Willey, whose fund is down 1.5% year to date. "And Medco's historical relationship with former parent
will serve them well when Zocor goes off patent." Zocor, Merck's blockbuster cholesterol-lowering statin, raked in $4.4 billion in sales last year.
Another key to investing in the down-and-out health care sector, says Willey, is "to avoid areas which rely on the government to pay for medical services at all costs." As a result, he often finds himself investing in companies that serve the more cosmetic side of medicine, many of which are not fully reimbursed by insurance.
"The boomers want to look and feel better, and they have the ability to pay for the upgrades," he says.
On this note, one of Willey's top choices is breast implant maker
. According to Willey's figures, 90% of women in Europe choose silicone rather than saline for their breast implants. Meanwhile, he sees silicone approval by U.S. regulators imminent. When these implants finally get cleared for takeoff, he forecasts, they will sell at a 100% premium to saline, which would in turn boost Mentor earnings by 50%.
"And that's not in the stock," says Willey, who also likes Botox maker
for similar cosmetic-focused reasons.
Jeff Herrmann, one of the portfolio managers of the $195 million
Exeter Life Sciences fund, also is betting on boomers with means. But he says the group's first move will be to take care of the essentials before the extracurriculars. That means preserving one's vision, hearing and teeth before splurging on toys.
"You can't buy that flat-screen TV if you can't see it," says Herrmann, who likes names such as
Bausch & Lomb
Herrmann also prefers foreign drug companies such as
, because they tend to "avoid the blockbuster mentality of U.S. drug companies."
"U.S. drug companies tend to be leveraged to a handful of drugs, while European companies are more diversified. And obviously you can see from what happened with Merck what happens if one of those drugs runs into trouble," says Herrmann, referring to the lawsuits over the withdrawn painkiller Vioxx.
Hermann contends that the domination and overvaluation of mammoth drug companies such as
Johnson & Johnson
, Pfizer and Merck during the late 1990s set the stage for the category's five-year slump.
But that slump could end if things get unpleasant elsewhere.
"The group will turn around if and when the economy rolls over into recession," says Herrmann.
Unfortunately, that's a bug most people would rather not catch.