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Special Report

Biotech Managers' Roundtable: Part 3

On July 1, 1999, Morningstar conducted a roundtable discussion with three mutual-fund managers who focus considerable attention on the biotechnology sector. Kurt Von Emster runs Franklin Biotechnology Discovery FBDIX--a dedicated biotechnology offering. Ken Kam is manager of Firsthand Medical Specialists and a comanager of Firsthand Technology Value TVFQX (although he will be leaving his post as comanager of Firsthand Technology Value in October 1999 to start his own firm). David Carlson, a comanager with Putnam Health Sciences PHSTX, focuses his attention on the small-cap end of the health-care market, where most biotech firms currently reside.

What follows is part three of this discussion, regarding the biotech sector and how a biotech fund might fit into a diversified portfolio. Part one deals with stock-picking strategies and what the managers look for in a company; part two is about some of those very companies.


Let's talk a little now about biotechnology funds. Kurt Von Emster, why would investors want to own a dedicated biotechnology fund? What role does it serve in an investor's portfolio?
Von Emster: There are a couple of reasons people own biotechnology funds. (I'm speaking specifically about a retail audience here.) One reason is the Las Vegas theory. There's a certain excitement in investing in high-risk stocks that have a potential to deliver super-high rewards. It's much like investing in Internet stocks. You have unlimited upside. Second, we find a lot of the investors in our mutual fund are drawn to it by the fact that a member of their family may have cancer or another serious medical condition that has caused them to learn a lot about particular health issues and particular therapies. They realize that biotech is the next generation in treatments and therefore financially it would probably be rewarding to invest in the industry. And on a personal level, they feel they are helping to finance these companies. When we look at our average shareholder, they're a little bit older. They understand the wide severity of health conditions out there. They also keep the fund as a relatively small part of their asset base, but one that they feel is an important component in their overall portfolio.

 Franklin Biotechnology Discovery FBDIX: Performance and Risk Analysis
Star Rating
NA
  Category
Spec-Health
Return
NA
  Risk
NA
Net Assets
$83 million
 

Expense Ratio
1.52%

Sales Fee
5.75%
  Initial Invest
$1000
Trailing Total
Ret %
+/- S&P
500
% Rank
Cat
YTD 26.47 17.24 13
12 mo 82.25 46.01 10

Ken, your Medical Specialists fund isn't a dedicated biotech offering, but it has a lot in biotech compared to the typical health-care fund out there these days. Why would people want to invest in biotechnology?
Ken: The reason why people should be interested in investing in health care is primarily a demographic argument. Over the next 10 years, we're going to have 80 million baby boomers enter their fifties. When you combine that with the observation that over 50% of the average health-care dollars are spent after we're 50 years old, that adds up to huge growth in spending on health-care-related products. So I think that anyone investing for the next decade or so needs to have a good chunk of his or her money in health care.

The reason I like biotechnology in particular is because it's changing the pharmaceutical industry. It used to be that pharmaceutical companies were basically outgrowths of the old-line chemical companies. They were in the business of producing petrochemicals. Occasionally, these people would find some compound that had some therapeutic value by accident and that's how many of today's pharmaceutical companies got started. So I would argue that in the next 20 years, that hit-and-miss method of finding new drugs is going to be largely ineffective. As a pharmaceutical company, if you're not able to master these techniques to develop and market new drugs, you're going to be out of business.

Then you combine that with the tremendous growth in knowledge that the human genome project is going to add to our ability to target drugs for specific diseases. Anyone that can master these techniques to develop new therapies is going to be in a position to create significant shareholder wealth. It's going to happen during our lifetime. You just have to invest with an appropriate time horizon to take advantage of it. Occasionally the market is very inefficient toward biotech stocks because, for so much of these companies' lives, they have not been able to show earnings and revenues. Instead, for much of their life their value is purely in their clinical trial data, which very few people on Wall Street analyze. That doesn't mean these are poor investments. It just means you have to have a longer investment horizon to hold them, and you have to be looking for the value in other places besides the balance sheet and income statement.

David Carlson, you help manage a very different kind of fund. What place do you think biotechnology has in an investor's portfolio?
Carlson: I think the better question here is, what's the role of biotech investments in our fund? And what opportunities are there for biotechnology as an investment group? I think beyond the overall demographic trend, I'll just point out a couple of things about health care overall. You're seeing pharmaceuticals as a class becoming a greater portion of health-care spending. But when you look at the pharmaceutical firms, there's a clear need for these companies to look outside of their walls for a greater and greater amount of their pipeline over the next three to five years. Second, many biotech companies--at least the upper quartile of the biotech companies--are able to get better deals from the pharmaceutical companies now. You're seeing more 50/50 relationships. Maybe they'll move on from there. Maybe you'll see more biotechnology companies going to market themselves, in which case the drug companies increasingly have to pay up for pharmaceutical products coming out of the biotech pipeline or alternatively pay big premiums for the biotech firms themselves.

 Putnam Health Sciences PHSTX: Performance and Risk Analysis
Star Rating
4
  Category
Spec-Health
Return
Average
  Risk
Below Average
Net Assets
$2,870 million
 

Expense Ratio
1.00%

Sales Fee
5.75%
  Initial Invest
$500
Trailing Total
Ret %
+/- S&P
500
% Rank
Cat
YTD -5.70 -14.93 82
12 mo 17.11 -19.13 74


As Ken was talking about before, the biotech industry has grown out of the drug-discovery aspect of the business, which is very different from the pharmaceutical companies. I would maybe give the big pharmaceutical companies a little more credit than Ken does in terms of their having developed internal drug-development capabilities over the years. Nonetheless, I think that from our perspective, the biotech industry is very well positioned to become increasingly valuable. We really like the biotech area. We've actually increased our weight in it and are clearly looking for a number of names in that area.

Let's talk about the biotech sector now. I know that resources in the capital markets have really dwindled, particularly for a lot of smaller biotech companies. Why do you think this has happened? Do you see a turnaround now or at any time in the near future?
Von Emster: There's been a bifurcation of this market over the last three years in which the large caps have done extremely well and the small caps have done exceptionally poorly. There have only been a few companies that have really made the break out from the small-cap to the larger-cap group in the last year--companies like QLT PhotoTherapeutics QLTI and even Sepracor SEPR a few years ago.

It's very difficult to step out of one group and into the next group unless you have a significant product and or service or pipeline to move you up. So the small companies have stayed small, investors have passed them over and capital is dwindling. We think that over the next year or two, you could see sort of a Darwinian effect take place in the small-cap group. If that happens, either the large caps will come down and pick off the small ones for their technology issues, or a lot of the small ones will just go bankrupt. In fact, in our work--assuming the cash-burn rates are all pretty much the same--we see dozens of companies going bankrupt or near bankrupt over the next 12 to 18 months. Considering there's only 350-something publicly traded biotech companies, that's a relatively significant event. The financing window for little companies is not all that open right now.

But more of the small caps are now talking with the pharma group and their large-cap brethren for alternative means of financing their vehicles either through mergers, being acquired, or selling off assets. I think virtually anything is open for discussion. Look at companies like Sugen--which was on the cash-strapped list coming into the end of the year. It was sold to Pharmacia & Upjohn PNU at a 50% premium, a move that was definitely in the best interest of shareholders. Hopefully we'll see more consolidation in the industry. I think that will be driven by the lack of capital in the small-cap group.

Carlson: There's been clear underperformance of smaller names in the general market, not just in biotech. I would say people have had, until very recently, shortening time horizons in terms of what they were willing to discount for more speculative names, although clearly the Internet is the big exception to that.

The other issue is liquidity. As our fund has grown, I've seen firsthand that inability to invest in small names and the difficulty of trying to get out of a small name on bad news. The illiquidity of some of these names keeps people from getting interested. You just have larger investors moving on because they just can't play in these names. That's our perspective from a relatively big shop.

Kam: When biotech went through its boom, much like the Internet is now, very few investors who put money into biotech companies expected that it would take 10 or 15 years to get those products to the market. I think the average time for a new biotech product to come to market today is like eight years at a cost of over a quarter-billion dollars. An eight-year time horizon is a fairly long time horizon for most investors. The people who can make eight-year investments are not a significant part of the market. That is not the sweet spot of the market right now. I think the parts of the biotech market that have done well are those parts that can produce results in a two-year time horizon. That's where I'm looking at because I know that my investors don't have an eight-year time horizon.

To follow on that discussion, there's been speculation that some of the venture capital that used to go to biotech has been going to the Internet instead. Is that anecdotal or do you think that's really happening?
Von Emster: That's definitely happening. There have been two fairly high-profile venture capitalists that have moved completely out of health-care investing, Excel Partners being one. And a significant number of the existing health-care investors have pulled back their venture financing in the group, particularly in the biotech sector. There's a lot less in the way of new venture financing. Maybe there should be a lot less, given that of these 350 publicly traded biotechs, at least 250 are probably at venture stage. There's essentially a public market for venture companies right now because of the tremendous amount of expectations that were built in 1993 for the companies that came public then.

The talk of Medicare reforms including prescription drug coverage has cast a pall over the pharmaceutical side of the health-care sector. Do you see that as a threat to the biotech area as well?
Carlson: I think it's kind of an oblique threat. First of all, the potential negative is more significant for the big drug companies. More of their products have generic substitutes and more of their products would be directed to the senior population, and in some of the big categories such as the antihypertensives. The risk is that the government will provide a benefit at maybe 50% of what the seniors are currently paying for drugs. There may be price controls--that is, the government may institute what they consider to be the proper price in some way for these products. That is the part of the program hasn't been made clear yet but certainly it's a risk. The biotech companies, though, are more likely to be sole-sourced. They are also less sensitive to the bigger, overall drug-demand trends. The reforms also, in our opinion, are not likely to pass in their current form. So there is some risk, but I think there's a lot of mitigating factors for the biotech industry.

Kam: I'd just like to add that when you're talking about biotech-type drugs, when they get to the end of phase-three clinical trials and you can see the improvement in quality of life for the patients that the drugs help, it's going to be very tough for a politician to tell a patient that they're not going to reimburse. It basically comes down to: How effective are the drugs in improving the quality of life? If they are effective, someone will pay for them. It might be the government. It might be the existing health-care system. From an investor's perspective, as long as the drug provides a big improvement in the quality of life and it's sufficiently patent-protected so that you have some market exclusivity period, it's a good investment. All the other issues about how you set up the mechanism to pay for it, they're concerns, but they are smaller-order concerns.

 Firsthand Technology Value TVFQX: Performance and Risk Analysis
Star Rating
5
  Category
Spec-Technology
Return
Above Average
  Risk
Above Average
Net Assets
$384 million
 

Expense Ratio
1.95%

Sales Fee
none
  Initial Invest
$10000
Trailing Total
Ret %
+/- S&P
500
% Rank
Cat
YTD 92.49 83.26 5
12 mo 192.46 156.22 7

Von Emster: Some of these biotech products are budget-buster drugs. Enbrel costs over $13,000 per year and it replaces a two-dollar-a-day therapy. Medicare, if it's really going to pay for these sorts of items, is going to have to realign its budgets and find new monies.

But there's another challenge facing the biotech industry in Washington. Dr. Jane Henney, the new FDA commissioner, is very concerned about the number of new drugs that are going to hit her agency for approval and her lack of budget funding for enough people to review all of them. The lack of funding for FDA reviewers is a bigger concern than any sort of Medicare price issues.

Thank you very much.

If you missed them, be sure to check out part one and part two of this discussion.