Sam Isaly remains bullish on biotech -- just don't call it biotech.

The 58-year-old skipper of the

(ETHSX) - Get Report

Eaton Vance Worldwide Health Sciences fund prefers the term "discovery" companies, because hot chemistry shops such as

Gilead Sciences

(GILD) - Get Report

and

Ligand Pharmaceuticals

(LGND) - Get Report

don't fit the strict definition of the term. "Discovery companies" make up the lion's share of Isaly's fund, which is rounded out with more mature pharmaceutical companies such as

Pfizer

(PFE) - Get Report

and new addition

Schering-Plough

(SGP)

.

Isaly's bullish stance should hearten biotech-stock lovers, because he knows the arena better than just about anybody. He's covered health care for 35 years and has helmed the fund since 1989. Backing him up are a dozen highly skilled researchers who help him pick the best of the breed -- and the proof of their expertise is in the pudding. The fund, up 28% this year, has posted a five-year average annual return of 21.5% and a 10-year average annual return of 17.6%, placing it in the top 5% and 7%, respectively, of all health care funds, according to Morningstar. That performance should intrigue investors looking to get more health and biotech exposure in their portfolio, but consider: The fund sports a 5.75% upfront load, and the expense ratio -- pegged in part to Isaly's performance -- runs pretty high at 1.67%.

In this week's

10 Questions

, Isaly offers his expert opinion on why health care looks poised to outperform the broader market, why he stuck to his guns on

Genentech

(DNA)

against the urgings of his colleagues but still doesn't like

Biogen

, why European biotech

Serono

(SRA)

is his favorite pick right now, and why he's betting on beleaguered Schering.

1. How should the average long-term investor use a health care fund such as yours?

Typically, I would imagine mutual fund investors buy generalist funds. They buy a Fidelity Magellan, a Vanguard index fund, because there aren't too many specialized funds. Now, in the U.S, about 10% of stock market is in health and biotech. If you by a Magellan or some other big fund, you're getting maybe 10% exposure to health care and biotech, maybe a little more or less, depending on what the manager thinks of the sector.

Investors then can make a judgment on what sectors they believe are most attractive. That may be different than what the Magellan manager has in mind.

We think a double weight in health care is a sensible allocation in the sector. An investor in generalized mutual funds can add our specialized fund. They know we aren't going to own

Citigroup

(C) - Get Report

,

McDonald's

(MCD) - Get Report

or

Microsoft

(MSFT) - Get Report

. Some health care funds do have very strange holdings, but we remain solely focused on health care and biotech.

2. What's turning up in your fund these days?

We let the winners ride and often pare away losers. We're pretty long-term investors; turnover in the fund is only about 30%, which means we turn the fund over every four years.

Right now, we think the fund is in real good shape. The Worldwide Sciences fund is broadly balanced between new and traditional. We have about 30% in Big Pharma -- that excludes

Amgen

(AMGN) - Get Report

, which we own. Cash makes up about 4%, and the balance, about two-thirds, is what most people call biotech but what we call "discovery." We are not active in health care services nor medical-equipment makers. We keep a tight portfolio; right now we have about 35 names.

Among the discovery companies we like are

Gen-Probe

(GPRO) - Get Report

,

Human Genome Sciences

(HGSI)

,

Icos

(ICOS)

and Ligand Pharmaceuticals. We've added some new companies that have moved to profitability.

3. What do you like in Big Pharma?

Among Big Pharma companies, we like

Lilly

(LLY) - Get Report

, Pfizer, Schering,

Wyeth

(WYE)

TST Recommends

and

Novartis

(NVS) - Get Report

.

4. A lot of individual investors are interested in the volatile biotech arena. Many of these companies are afforded rich valuations -- some don't have any earnings at all yet. How do you assess valuations in this area?

It's not magic. It's fairly steely-eyed analysis. Because there are a lot of uncertainties with evaluating these companies, some people call it an art. I believe it's more science than art.

We'd rather characterize biotech as discovery companies -- sometimes companies called "biotech" don't fit the strict definition. The development of a replacement protein or an antibody involves biotechnology. Amgen's replacement proteins -- these fit the strict definition of biotech.

The industry has evolved to define as biotech all products that involve new technology in health care. We don't care if it's a new product or hot chemistry. Most of these products are new chemicals. Gilead Sciences, which we own, is straight-out chemistry, but some people call them a biotech company.

Genzyme

(GENZ)

works on replacement proteins. Ligand Pharmaceuticals, all chemistry. But they are all discovering new things.

The exciting thing is that they are discovering new products. They will have a life cycle that is going to be longer than Big Pharma. They are not old companies. They are "discovery companies." You have the opportunities for very rapid growth.

We go to the opportunities. We follow all companies worldwide -- there are about 600. We compare them one to another. We choose the several that meet our criteria and can contribute to a portfolio that is balanced and attractive. We can own Human Genome because we own Novartis.

We couldn't own all Human Genomes. There are funds that own all Human Genomes. You can choose to invest in those funds. It's a decision that the investor makes. We put out a product -- a collection of stocks -- that has a fairly expected risk/return characteristics.

We try to compose a portfolio with growth of earnings per share in the range of 20%-plus annually. If the underlying earnings of a company are growing 20% a year, we expect stock prices to post similar increases over time. Now, we will not be stupid enough to pay top price -- we do not ignore valuation. But we seek to increase the fund's net asset value by 20%.

5. You and (VGHCX) - Get Report Vanguard Health Care skipper Ed Owens are probably the two deans of the health care fund arena. How does your approach differ from his?

Ed's a good manager. We have some different approaches. We believe we are more oriented toward high growth. This year, he's in

Merck

(MRK) - Get Report

and Pfizer. He's having a bad year

the Vanguard fund is up 10.9% this year; we're having a good one

his fund is up 22.4% this year. It's sure to be the case that he'll have great years and I'll have bad ones.

Ed's been investing in health care for a long time, and so have I. Unlike some other health care funds, where the managers are in their 20s and it's their first time managing money. (Laughs.)

6. You've recently cited Serono, the biggest biotech company in Europe, as your favorite pick. What does Serono do, and why does it look so attractive to you right now?

Serono is a Swiss biotech company -- a real biotech company. I think it's a neat company, and a good valuation. As a company, it may not be best company on our list. But as a stock valuation play, it is.

They make replacement proteins. The biggest is a follicle-stimulating hormone called Gonal-F. Women inject it in order to stimulate ovulation. It's used by couples -- maybe younger couples -- or by older women whose fertility has diminished over time. Serono is the world leader in assisted reproductive technology, or ART. They have 60% of the market, Organon has about 40% -- which is really a duopoly.

It's a good business, grows at a moderate rate. It is fairly sensitive to the economy. Fertility enhancement business can be a bit expensive. They also have growth hormone and interferon franchise. Serono's multiple sclerosis treatment is in competition with Avonex, made by Biogen, and it has been doing very well.

7. Is your fondness for Serono part of the reason why you don't like Biogen?

Yes. One theme evident in our fund is that we like to buy companies increasing in market share. Biogen is decreasing its market share. We'd have to find another reason to own Biogen, and we haven't.

Do you have a set price target for Serono?

We don't establish target prices.

8. Genentech is the fund's second-largest holding. Why do you like it?

Well, the stock has more than doubled this year, so we like that. (Laughs.)

Actually, we fought about it in our house. One of our Ph.D.s thought

colon cancer treatment Avastin would fail. So did

Mike King, the Banc of America Securities analyst. I didn't really know if it would fail, but I liked it for other reasons. I hung in there, against the slings and arrows of our colleagues.

Then it came right. Our other colleagues were not in our that day

on May 19, Genentech rose 45% after posting stunning results in its late-phase study of Avastin's effectiveness in tandem with chemotherapy. My colleague wasn't in that day, but I went right into his office and yelled at his empty chair anyway. (Laughs.)

But I didn't bet on them because of Avastin. Genentech has broad discovery capabilities. They are the best in strict biotech. They don't do chemistry.

What is the potential impact of Tarceva, Genentech's latest cancer drug?

Genentech's market value went from $20 billion to $40 billion, thanks to Avastin. If Tarceva works, it adds another $10 billion to Genentech's market cap. It's a bigger base, so you don't get quite the same proportional burst.

If you want to be in a situation where it can double,

OSI Pharmaceuticals

(OSIP)

which is co-developing the drug with Genentech is the place to be. But we're not in that stock because we see too many question marks.

How long have you held Genentech?

Five or eight years. Actually, we first bought in 1990. There was a period of time when we didn't own it. We owned until Roche bought us out. Then when Roche brought it public again, we took a look and got back in.

We think it's important to hold these companies for a long time. We've owned Serono, and it's gone up 20 times.

9. Let's talk about nonbiotech "biotech." Which other discovery companies do you like?

We like Human Genome and Ligand Pharmaceuticals, those are the two favorites. We purchased more Ligand

Wednesday in a PIPE transaction

private investment in public entity, a negotiation of a private sale of stock to select investors at a set recent price. We occasionally do that in this fund. We paid $13.50 in the PIPE

the stock closed Wednesday at $14.47.

There's short-term news on Ligand that may not be entirely favorable, but I'm not overly concerned.

Ligand is active in transmission vectors. Some of the applications they have are in diabetes, another in osteoporosis. Nothing is out of Phase III yet, but they are a commercially driven company. They want products.

They have had some success with Ontak, an early product used for certain cancers. It has another approved pain-killer product, Avinza. It's a once-a-day product with about 2% market share. We expect that 2% to increase by several times.

We think it can be a very big product. What does that mean? Maybe $500 million a year in sales. Next year, calendar 2004, we should see in excess in $100 million. Now, Avinza's a fairly well-known investment factor. We think investors fail to realize the prescription factor research at Ligand.

When we buy these companies, we want products, finances and people. Products assured rapid growth for extended period of time.

We expect Ligand will have it's first sustainable profit this current third quarter; if not, it will be the next quarter. It depends on transaction.

Ligand's product line is right; they are moving toward profitability. We find that when stocks are at their inflection point of moving to profit, this is when they do best

Lastly, we think the people are good. We go with humans. With small companies like these, the people are all there is. Gilead, we go with John Martin. We think they have skilled executives, so we will look past short-term hiccups if we think people will deliver.

10. Why did you recently purchase Schering-Plough? Do you think Fred Hassan will be able to turn the company around?

With Schering, it's all a value call. The price-to-earnings multiple is meaningless here, because their earnings aren't normalized.

We simply think the underlying assets are worth more than the stock. The cholesterol treatment Zetia, in combination, with Merck -- that thing is worth billions of dollars. Let's say it's worth $14 billion -- half of which goes to Schering. I could actually get cash for it if there's a takeover, so that's pseudo-cash of $7 billion.

Now, it costs me about $15 billion to buy Schering, given that its market capitalization is about $22 billion. What do I have left after Claritin goes to hell? I've got $7 billion in sales, so I'm getting the company at about two times sales.

Schering has had some hard times, but they also have some good assets, and Hassan is man who knows how to get the most out of those assets.