Drug Stocks Finally Make Their Move

Story corrected to show Auxier Asset Management has $476 million in assets under management.

BOSTON ( TheStreet) -- Drug stocks such as Johnson & Johnson ( JNJ) and Gilead Sciences ( GILD) have been beaten up in the year since the health-care reform bill was passed. That may soon change, as fund managers are pouncing on shares of undervalued companies.

Over the past year, the S&P 500 Index has climbed 13%, while the Health Care Select Sector SPDR ( XLV), which counts Johnson & Johnson and Pfizer ( PFE) among its top holdings, has risen only 2.5%.

The health-care reform bill, signed into law on March 23, 2010, is mostly to blame for the decline in health-care stocks. With uncertainty looming over provisions in the Patient Protection and Affordable Care Act slated to become effective each year through 2015, related stocks have been brutalized by investors put off by the increased risk. WellCare Health Plans ( WCG), for instance, tumbled more than 20% last year while the broader market was up about 15%.

Many of the stocks, though, are beginning to be bid up by investors, thanks to attractive valuations. Pfizer shares have rallied more than 15% this year, easily outpacing the 4% gain in the S&P 500. Even so, fund managers with a focus on value over growth expect bigger returns from many of such companies.

"Health care is very out of favor. It's a pretty contrarian investment these days," says Connor Browne, co-manager of the $4.9 billion Thornburg Value Fund ( TVAFX). "The market is skeptical and is assuming that long-term growth for the space is much lower than it had thought before. While some of this is warranted, the conclusions that the market is drawing are much too extreme."

Jeff Auxier, president of Auxier Asset Management and manager of the Auxier Focus Fund ( AUXFX), says he prefers to buy stocks when the news headlines are horrible.

"With a lot of the fears of the unknown, health-care stocks dropped to bargain-price levels given that they're strong global franchises," Auxier says. "A lot of the industry leaders have sold off but historically they've traded at multiples that are at least 30% to 40% higher. There is still relatively good value."

The health-care reform overhang has been problematic for the sector because of implementation times. The so-called "bad" pieces of the legislation, which include increased taxes on medical devices, have been enacted earlier than some of the positive benefits of the reform package, such as increased-coverage benefits that aren't scheduled to become effective until 2013.

In addition to suffering from the uncertainty over reform, many companies have struggled due to high employment, as fewer doctors' visits have meant lower revenue. Companies have reported a change in mix from private payers to state payers, like Medicaid and Medicare. Browne argues that health-care stocks become a strong play on employment gains.

"As the economy recovers, unemployment continues to slide and more patients are covered by managed-care plans, so we'll start to see revenue growth kick in and it will fall to the bottom line," Browne says. "I don't think the market is expecting that from most health-care companies."

Not all health-care stocks offer the same value to investors, though. Browne and Auxier, as well as Thornburg Investment equity analyst Matthew Burdett, offer their health-care equity picks, detailed on the following pages.

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Matthew Burdett, Thornburg Investment Management

The pharmaceutical industry historically has been driven by research-and-development productivity, though true innovation has been missing in the past decade, says Thornburg's Burdett. He is keenly aware of this issue, having himself conducted pharmaceutical research for Sunesis Pharmaceuticals ( SNSSD) in the past.

For that reason, Pfizer ( PFE) has become a favorite pick of the $8.4 billion, Santa Fe-based Thornburg Investment Income Builder Fund ( TIBAX). Burdett says the dividend yield of nearly 4% is attractive for an income-building strategy, but he's a fan of the stock because of what the company is doing to combat innovation stagnation.

For years, Pfizer has been known as a master of selling drugs rather than an innovator of life-changing treatments. Burdett notes that Pfizer's Lipitor wasn't the first cholesterol drug to market, but it has grown to become the largest selling medicine in history. But the company's style of acquiring businesses to grow, like its $68 billion acquisition of Wyeth in 2009, may be coming to an end with the installation of new Chief Executive Officer Ian Read.

"Read is doing what a lot of pharmas should be doing, and that's tackling the R&D innovation stagnation," Burdett says. "He laid out a plan to spin out the non-pharma part of the business, such as nutritional, animal health and consumer health. Read is really trying to get Pfizer to its pharma, innovative core."

Strategy aside, Burdett says Pfizer is trading at a low multiple to earnings, making it a compelling investment when considering the yield. "It trades at 9 times this year's earnings, which is still significantly below the S&P," he says. "They raised the dividend recently and have said they will continue to raise that dividend to be around a 40% payout ratio. There will be more cash coming back to shareholders."

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Connor Browne, Thornburg Investment Management

The Thornburg Value Fund ( TVAFX), with $4.9 billion in total assets, is overweight health care with 14% allocated to the industry, above the 11% weighting on the S&P 500.

As of Feb. 28, the Thornburg Value Fund had lagged the benchmark S&P 500 Index over the past year. The fund has a one-year average annualized return of 21.1% to the S&P 500's 22.6%. However, the fund has easily outpaced the benchmark over three, five and 10 years. Since its inception in October 1995, the fund has an average annualized return of 10.4%, better than a return of 7.4% on the S&P 500.

Gilead Sciences ( GILD), a holding in the fund since 2001, has been one reason for the fund's long-term success, as the stock has surged more than 1,000% over the past decade. "The early experience was quite good, but the recent experience has been much less good," Browne says with a laugh.

Like most health-care companies, Gilead has suffered under the weight of reform uncertainty and unemployment. Browne notes that in the recent quarter, 34% of Gilead patients were reimbursed by private or managed-health care in the U.S. That's down from 45% a year earlier, with Medicaid mostly picking up the difference.

Browne argues that the fundamentals of Gilead's business continue to develop as he expected, as the company has the leading treatment for HIV in developed markets. "Of the 1.2 million individuals in the U.S. infected with HIV, only about 600,000 are on treatment," he says. "There is a tremendous opportunity to increase the penetration of the HIV population."

From a value perspective, Browne also notes that Gilead trades at 9 times forward earnings, a discount to the S&P 500. He also notes that the company bought back over 10% of the shares outstanding, "so they're returning cash to shareholders aggressively."

Browne also picks out Varian Medical Systems ( VAR) as part of the fund's comprehensive approach to value investing, saying the stock falls into the fund's emerging-franchise category.

Varian is the leader, by far, in the radiation-oncology space, Browne says, and he expects the technology to improve in its ability to successfully treat many different cancer states. Playing on the same idea Burdett brings up with innovation, Browne notes that Varian spends more on R&D than the rest of the industry combined.

"Even given all of the promise, there's a case to be made that the stock is trading cheaper than our calculation of intrinsic value," Browne says. "In the U.S., there is an opportunity for an upgrade cycle. We think orders can grown above 15% for the next few years. Then there's really a tremendous opportunity outside the U.S."

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Jeff Auxier, Auxier Asset Management

Auxier knows how to spot good businesses with huge free cash flow yields, which becomes important to investors looking to defend against a downturn in the market. Based in Lake Oswego, Ore., Auxier invests his entire personal retirement into his own fund, so he's certainly putting his money where his mouth is.

The one-year average annual return on the Auxier Focus Fund ( AUXFX) trails the S&P 500, 15% to 22.6% as of Feb. 28. The fund has outpaced the S&P 500's average annual returns over three, five and 10 years. Since its inception in July 1999, the fund has an average annual return of 6.7%, compared to 1.3% on the S&P 500. The fund has $141 million in assets, while his firm has about $476 million total including the fund.

Auxier's fund has performed so well because he loves to pick up beaten-down companies that rebound. Recently, those have been mostly health-care stocks. "They're priced with a pretty poor outlook right now," Auxier asserts.

He sees benefits to the health-care sector in two areas. First, Auxier cites the aging population argument, which hypothesizes that baby boomers will be spending more on health care as they hit retirement. On the job front, meanwhile, Auxier argues that the U.S. is looking at really strong numbers over the next three to five months in terms of hiring.

"From my homework, you're looking at 200,000 in terms of monthly job gains. Then people will start to get treatments they've been delaying," he says. For that reason, he has been hunting in the pharmacy benefit area, picking up stocks like Medco Health Solutions ( MHS) and even CVS Caremark ( CVS).

One of his best value picks, though, is Johnson & Johnson ( JNJ). Auxier says J&J is a great business that has temporary, fixable problems. Most notably, J&J announced a recall of its flagship Tylenol pain reliever in 2010 due to contamination.

"They've had problems with execution and we're in a market that really rewards execution," Auxier says. "They've had a lot of product recalls and the overhang with taxes on medical devices. The market does not like poor execution." Auxier argues that Johnson & Johnson could spin off some of its business units in order to create shareholder value.

Auxier is also a fan of Medtronic ( MDT), which he says the fund bought around $33 a share. "Here's an industry leader at 10 times earnings. And it really isn't broken," he says.

Again, Auxier points out that the company is an industry leader but suffers from fixable problems. "In a weak economy, people delay these major surgeries," Auxier says. "If you're unemployed, you'll delay a lot of these things with uncertainty over reimbursement."

-- Written by Robert Holmes in Boston.

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