Here's an earlier Fortune article that also mentions Rezulin and is very bullish on Biotechs:
September 29, 1997
Finding New Life in Health Stocks
How can investors profit from this fast-changing but
potentially lucrative sector? Three top pros offer their
strategies.
Lawrence A. Armour;
Jerome R. Brimeyer; Larry N. Feinberg; Samuel D. Isaly
Plus: What's Next for Columbia/HCA?
Major demographic shifts, a bulging pipeline of new drugs, expiring
patents on existing drugs, fresh questions about the future of managed
care--the health-care sector is one of the toughest to predict. Sure,
there are lots of great buys out there, but there are also plenty of
popular stocks that look suspiciously overvalued. The potential
rewards are too tempting to ignore, so how should investors play
health stocks in the years ahead?
To sort out the answers, we turned to three of the sharpest minds in
the business: Jerome R. Brimeyer, an all-star analyst who recently left
Lehman to head up global health-care research at UBS Securities;
Larry N. Feinberg, whose Oracle Partners--a hedge fund that
specializes in health-care stocks--has racked up net gains of better
than 35% a year for the past nine years; and Samuel D. Isaly, whose
Mehta & Isaly counseling firm runs Eaton Vance Traditional
Worldwide Health Sciences, which is the top-performing health-care
fund over the past five years. Given the uncertainty over what happens
next, we asked our experts, What should an investor do?
Pharmaceuticals
Brimeyer: The big drug stocks are a
good place to start. I think they're in
good shape. Very little of the growth
in pharmaceuticals sales has come
from prices, which have actually been
moving down. Unit volume, on the
other hand, should show a good gain
this year, and U.S. drug companies
are developing new markets in China,
the Pacific Rim, Latin America, and
Russia. This is creating big
opportunities, which means the sustainability of industry growth is
probably higher than ever. I'm not suggesting the pharmaceuticals
deserve a Coke-like P/E multiple....
Feinberg: I'm not sure Coke deserves a Coke-like multiple.
Brimeyer: Agreed, but I'd argue that pharmaceuticals deserve a high
multiple given the growth in worldwide demand, new technologies, and
demographics. Between 1995 and the year 2000, there will be a 22%
increase in the number of people in their 50s. Those are the years you
begin to need therapy for cholesterol, osteoporosis, enlarged prostate,
and adult-onset diabetes, and the list goes on and on.
Sure, but lots of big drugs are coming off patent, and
generic-drug makers are springing up like weeds. Won't that
hurt industry profit margins?
Brimeyer: No. Competition from generics will become important in
the early part of the next decade, but right now the pharmaceuticals
companies are developing new delivery systems and finding new ways
to extend the lives of existing drugs.
Does that mean old favorites like Merck and Pfizer are still a
buy?
Isaly: Not at today's
prices. I have no idea
whether the overall
market is appropriately or
inappropriately priced,
but I don't think the
big-cap U.S. drug stocks
offer good value
compared with what's
available in other parts of
the world.
Feinberg: We've been short the large pharmaceuticals because I don't
like companies selling at 30 and 35 times earnings that are growing
only 15% a year. If you look back in history, drug stocks sold at a
market multiple in the mid-'50s. Over the next 20 years, new product
cycles--primarily in antibiotics and cardiovascular drugs--carried the
group as high as 2.75 times the market. We're now at the start of
another major new-product cycle, but this time the big winners will be
the late-stage biotechnology companies that are coming out with new
cancer treatments and new drugs for diseases like osteoporosis.
Brimeyer: Merck and Pfizer were expensive a month ago, but the
recent pullback has created a decent buying opportunity for investors
who are looking for a 10%-to-15% return over the next year or so. If
you're looking for more than that, you'd have to go with companies
that could have significant upside earnings surprises. I'm thinking here
of companies like Eli Lily and Warner-Lambert.
Isaly: There are about 50 big multinational drug companies, and the
least expensive are in Japan. The overall Japanese market is down,
and these companies may not be growing as fast as their U.S.
counterparts, but on a relative basis I could make a strong case for
Banyu Pharmaceutical, which is 51% owned by Merck. My European
pick would be Novartis, which was formed last year through the
merger of Sandoz and Ciba-Geigy. The company should experience
significant cost savings from the merger, and it's doing leading-edge
research in immunology and gene therapy. It also sells at a discount to
its universe. Its ADRs trade on Nasdaq.
Brimeyer: For what it's worth, Novartis is the top pick of UBS'
European analyst.
Feinberg: Novartis is my major European pharmaceuticals holding as
well.
Isaly: With all this agreement, it's probably time to sell. But here's how
I look at things. The world stock market has a total value of $16 trillion
to $17 trillion. The straight-up pharmaceuticals, including biotechs, add
up to maybe $l.2 trillion, and if you throw in the HMOs, Johnson &
Johnson, and a few odds and ends, you start closing in on a $1.5
trillion worldwide health-care stock market. That's an enormous fishing
pond, and there should be something there for everyone. You just have
to make sure you've got your line in the water.
Managed Care
Feinberg: Many investors and
analysts seem to think
Columbia/HCA Healthcare will be
able to settle with the government for
a large sum of money and go its
merry way. I don't believe that's
possible. There's a strong contingent
in Washington that's determined to
put the fear of God in the industry,
and I'm afraid we're in for a long,
drawn-out investigation, with huge
amounts of publicity that will cast a pall over the entire health-care
service sector and signal a slowdown in the growth rates of U.S.
hospital companies.
In other words, the recent 15%-a-year rate is no longer in the
ballpark?
Feinberg: Right. A lot of that came from overhead reductions when
not-for-profit hospitals were consolidated into the for-profit sector, but
there's just so much you can squeeze out of the industry. To make
things worse, the hospital companies will be one of the major losers in
the $116 billion Medicare cut.
Is the Columbia investigation likely to spread?
Feinberg: Absolutely. I'm told 500 federal agents are investigating the
health-care industry right now. I'm also told that knowledgeable
health-care economists say that 20% to 25% of all health-care costs
reflect overbilling.
What does it all mean for HMOs?
Brimeyer: We're cautious on the industry, but there could be
opportunities among companies that deal with smaller employer
groups, where there's more pricing flexibility. Firms like Oxford Health
Plans, whose earnings have been growing 40% a year, and Wellpoint
Health Networks, which is beginning to expand out of its home state of
California.
Feinberg: I think it's a good area for investors. I was in California
recently, and the people at Foundation Health Systems were telling me
they're getting significantly better prices than last year. Is this a
long-term phenomenon? I doubt it, but the HMOs are in a position to
prey on the hospitals a bit and extract better prices from their
corporate clients. Some of the HMOs sell at high P/Es, but I'm very
comfortable with Foundation, which is selling at around ten times
earnings.
What about home care?
Feinberg: It's one of the most rapidly
growing sectors in health care, largely
because it's a lot more cost-effective to
treat people in their homes than to put
them in the hospital. I own Apria
Healthcare Group, which gets a big chunk
of its income by providing oxygen
respiratory therapy for home use, but it
had problems integrating a takeover, and it
recently announced that it wants to be
acquired. The stock's at about $17. The company should be worth at
least seven or eight times cash flow, or something in the $20 to $25
area, so there's some upside and not much downside.
Brimeyer: Home care is benefiting from the consolidation of a very
fragmented business. Our two favorites are American HomePatient,
which focuses on respiratory, infusion, and medical equipment, and
Home Health Corp., a regional provider of in-home nursing care.
Where does J&J fit into the overall health care picture?
Brimeyer: Johnson & Johnson has their mitts into every area of health
care except worldwide services. They're in pharmaceuticals, medical
technology, hospital- supply products, and consumer products. This is
a company that has the flexibility to penetrate new markets, great
financial strength, and the ability to meet earnings expectations, but
from time to time the stock reacts to concerns over a relatively small
piece of the pie. There's concern today that new competitors will be
moving into stints, which are the small wire pipes that prop open
arteries so blood can flow through. It's a competitive business
overseas, but J&J owns the U.S. market. The likelihood of U.S.
competition has hurt J&J's stock price, but that could be a buying
opportunity. The stock is around $58, down from a 1997 high of
$66.50.
Biotech
Feinberg: Last I looked, there were 299 public U.S. biotech
companies. In round numbers, the entire industry has a market
capitalization of $85 billion, revenues of $9.5 billion, annual R&D
spending of $5 billion, and slightly more than 200 new products in very
late-stage development. Merck, by contrast, has a market cap of
about $l40 billion, and it does $20 billion a year in revenue, but its
annual R&D is $1.5 billion and it has ten products in late-stage
development. What's my point? It's a lot more attractive to have
money in biotechnology than in big drug stocks.
Isaly: I reach the same conclusion using different math. A study
presented a few years ago found there were about 3,000 new drugs in
development--l,000 in the hands of the big companies, 2,000 with the
biotechs. Let's assume the numbers haven't changed much. The large
drug companies today have a combined stock market value of about
$750 billion, which works out to $750 million per new drug. Larry
says the biotechs have a market cap of $85 billion. If we make the
math easier by rounding up to $100 billion, that means the stock
market value of a new drug candidate is $50 million if you take the
biotech route, $750 million if you buy a big drug company. That's
misleading, of course, because you get current profits and worldwide
distribution with the big guys, but if you want to emphasize technology,
biotech is the way to go.
Brimeyer: Our top pick in this area is Biochem Pharma, which is
likely to have a drug for hepatitis B on the market in 1998 and is
currently making money, but biotechs in general are out of favor
because a lot of their new products have failed. Some of the drugs
now going through clinical trial are bound to make it, but at this point
investors want to be convinced. Once biotechs become profitable,
they'll get decent valuations. Until then, they'll probably remain "show
me" stocks.
Feinberg: I think the vast majority of risk is out of these stocks. The
biggest move in biotechs took place between 1989 and 1991 following
Amgen's launch of Epogen and Neupogen. The industry currently has
205 products in late-stage development, and some are going to be
successful. Chances are also good that the major drug companies will
attempt to acquire biotech companies that come up with big new
products. And because the group is currently out of favor, investors
can buy stock in companies that have good products on the market but
are selling at substantial discounts to earnings or revenues. Companies
like Chiron, which sells at less than three times revenues, or half the
typical big drug company multiple. Or Idec Pharmaceuticals, which just
got a panel recommendation approval for a cancer therapeutic that has
potential for annual sales of $500 million to $1 billion.
Isaly: The industry has developed new ways to find drugs that involve
combinatorial chemistry, which creates chemical compounds in a rapid
fashion, and genomics. It's difficult to come up with a single stock that's
strong in both areas, so we've paired companies from each discipline.
The two we like best are Pharmacopeia and Millennium, which have
promising new techniques for modern drug discovery. We also like
Agouron Pharmaceuticals, Vertex Pharmaceuticals, and Gilead
Sciences, which are working on antiviral enzyme inhibitors for AIDS
and other viral diseases.
Brimeyer: Another way to play biotechs is through one of the major
pharmaceuticals that have formed collaborations with biotech
companies. A good example would be SmithKline Beecham, which
just announced a joint venture with Incyte Pharmaceuticals that will
develop and produce diagnostic tests for infectious diseases and
cancer using Incyte genetic databases. Pfizer, Eli Lily, American Home
Products, and Bristol-Myers have also formed numerous
collaborations with biotech companies. The upside potential of these
stocks vs. the leveraged potential of the drug discovery technologies is
obviously more limited, but it's a safer way to go.
Three for the Road
What's the big picture that investors in the sector need to hold
on to?
Brimeyer: The changes taking place in health care are creating great
investment opportunities. Cost pressures in health services will produce
more consolidation among HMOs and hospitals, and they'll wind up
with greater purchasing power as they get bigger. At the same time, the
new genomics and combinatorial-chemistry research technologies are
going to lead to major new drug discoveries and the development of
huge new markets.
Feinberg: The key to the industry's future lies in the demographics.
The population is aging, and the elderly consume a disproportionate
amount of health care. The other key is Washington. The Medicare
reform measures and the recent budget cuts are the most aggressive
I've seen in my 19 years on Wall Street.
Isaly: I wouldn't be parochial and get hung up on things like
Medicare. The reality is that health care worldwide will continue to
grow as a proportion of national incomes. If you're an investor, you
have to be there.
Any other stocks you want to mention?
Brimeyer: Warner-Lambert is a great play on the baby-boomers who
are now moving into their 50s, putting on weight, and seeing increases
in their blood-sugar levels. The company is well positioned in these
areas with Lipitor, a drug for lowering cholesterol, and Rezulin, which
deals with adult-onset diabetes. Warner-Lambert's profit margins are
not very high, and you get pleasant surprises in pharmaceuticals when
big sales of new drugs enable margins to expand. The company could
have a dramatic profit-margin expansion throughout the rest of the
decade.
Feinberg: I'm one of the largest owners of Barr Laboratories, which is
a unique generic company--their expertise is more legal than scientific.
They've been extremely successful at challenging patents. They'll have
$200 million of Tamoxifen sales this year, and they're launching a
generic version of Coumadin, which is currently a $500-million-a-year
product. Barr has earnings potential over the next 12 months of $3 a
share, and the stock is around $38.
Isaly: My parting stock would be Swiss Serum Institute, a tiny
company that is the world leader in vaccines for travelers. If you're
going to visit a country where typhoid is endemic, you can take one of
their orally active vaccines. They have an orally active cholera vaccine
pending at the FDA, and they market a hepatitis A vaccine that
competes with SmithKline and Merck. Swiss Serum Institute is a little
baby of a company with annual sales of around $150 million, but at
$15,000 a share, it is one of the world's highest-priced stocks. My
advice: Save your pennies, and buy a share.
What's Next for Columbia/HCA?
Amy Kover
Few health stocks have gone from darling to pariah as quickly--and
spectacularly--as Columbia/HCA. Two years ago some 17 analysts
gave it a strong buy recommendation. Doubts surfaced in the spring
with reports of the FBI's investigation into the company's billing
practices. On July 16, just before CEO Richard Scott was fired, 12.9
million shares changed hands--eight times the amount traded the day
before. (It fell 4w, to $34.)
What's the prognosis now? "A lot of the company's positives are
gone," argues Phoenix Growth manager Van Harissis, who had
dumped all one million of his shares in June. American Century,
Dreyfus, and others have also bailed.
Others (like AIM Value and Vanguard Special Health Care) continued
to hang on as of July 31. And on Aug. 12, Goldman Sachs actually
added Columbia/HCA to its buy list. Its reasoning: New management
will cooperate to bring investigations to a quick close and rebuild the
company's reputation. Goldman figures that even factoring in asset
sales, a halt to acquisitions, and a hypothetical $1 billion fine,
Columbia's earnings can still grow at a rate that makes its current stock
price, $33, a bargain.
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