Prescription for Success?

Have you back-tested, or been using this method, for long periods, say, through the mid-’80s so it’s actually survived a bout of hyperinflation? Yes. That’s part of the modification I put in from Graham’s day–the ability to handle higher growth. So with it we are “industry indifferent.” We can value biotech or automotive. We’re “cap indifferent.” In the case of the last couple of years, we have favored industries made up of smaller and mid-cap companies, and within industries we have tended to find better value in the smaller and mid-cap companies. As you get into the holdings of our health care fund, you won’t find the usual large-cap suspects–Merck, Pfizer, Lilly. We’re off into smaller and mid-cap companies. That may change next year, but it just happens to be where we are now.

Why do you think the two-year time period, in terms of rotating market themes, is so consistent? I attribute it to the following: In tough times or uncertain times, investors cling to the large-cap household names, and I think that’s what they’ve been doing the last two years. So from a valuation standpoint, we see the large-cap household names as carrying a premium. People still hold them, thinking they’re finding comfort there, and to us, we just see them as overpriced. So, that’s our explanation of why the last two years, those large-cap issues just haven’t been on sale where most other things have been.

What’s your fund’s current industry allocation? Our largest industry is managed health care, and it’s almost 40% of the fund. Examples of managed care would be U.S. Oncology or Oxford Health Plans. Our second-largest industry is the health care distributors and services. Cardinal Healthcare is in there. It’s not our largest holding, but it’s in there. There’s two more sub-industries: health care equipment, health care supplies. Healthcare equipment is 10% of the fund, and an example there would be Mentor. Under health care supplies, which is about 11% of the fund: Cooper Companies. The pharmaceuticals industry is represented. It’s only 4%. And it’s a mid-size company: Mylan.

According to your discipline, and in terms of the portfolio’s current construction, how long into the two-year non-large-cap pharmaceuticals theme are we? There was one theme that went from February of 2000 through the end of 2000, and the leaders in that period, which had to do with recession-resistant, recession-proof companies, made major pharmaceuticals part of that good leadership in 2000. In 2001 and continuing into this year, it’s more of a consumer cyclical/industrial scene, anticipating an economic recovery. We believe without the terrorist attack, the bottom would have been a year ago, right now late March or early April, and that we were on our way to a recovery rally. The terrorist attacks sent the markets to new lows, but since then the market’s up around 20%. Generally big-cap pharmaceuticals are not part of that leadership, because the market’s off chasing more economically sensitive issues.

Do you do your own research, or purchase secondary research? Yeah, we don’t take any brokerage research. We don’t take any newsletters. We just buy data and compute value. We need the ability to behave different than the crowd at times. So we don’t want to be part of the crowd.

Who is your fund best suited for? Not a growth-and-income-oriented investor. We discourage timers. We don’t want hot money in there. It’s for tactical investors who want to ride a one- to two-year move, or for those that think that with the aging population, health care will be special over the next 10 to 15 years, and want more of a strategic holding within it. In terms of income, we don’t care what dividends are in a company, we never look at those. We just buy value, so sometimes we have companies that pay dividends, sometimes we have ones that don’t. Right now we do not have biotechnology in there. Sometimes we do. We had lots of it in there in ’99. Somebody coming to us really needs to believe in our ability to capture themes and tilt towards favorite industries in health care.

In your opinion, is there a relative weakness of say, an ETF, which holds the whole pharmaceutical index and doesn’t trade or weight positions? I’ll back up a little bit to answer that. A strength of our system is to handle change. When the market is behaving one way, and certain things are in favor, and then that ends and something new comes out, we have built our system to have its strength in the ability to handle that change. I believe that’s normal in the market: to go through theme changes every one to two years. The late ’90s was a very unusual period when we had a momentum-type market that had the same theme that went on for two years, three years, four years, and even more. I think that’s very unusual. So exchange-traded funds could do well in that system where it’s just a momentum market, but they can’t handle change, and our system is designed to handle changing market conditions: Riding a theme, selling it, rotating, and capturing the next theme. And that’s still low turnover because when we buy a basket of stocks in an industry, say, four to seven companies in an industry, we tend to just hold that basket during the whole time of that theme. We do not try to move toward Merck this week because they’re bringing out earnings, and Pfizer will next week, or speculate on some announcement. And we don’t estimate quarterly earnings and react to whether they hit estimates or don’t hit estimates. We don’t care about that game at all.

Have you ever computed the tax efficiency of the fund? No. We don’t come in here thinking taxes first, but I would expect us to show favorably in a statistic like that.

What are the cash levels in the fund? You’re catching us on a day when it’s unusually high. It’s 8.9% today. That stands out, I think. If you go back through last year, we probably averaged 2%. We’re just looking for some bargains with that 8%. Once we decide on the industry that we’re going to buy, we then have to decide which stocks to own. We favor ones that are high in cash, low in debt, and well managed. And to analyze management quality, we look at income statements, balance sheets, and ratios. We do not visit with companies or go to PR lunches. And we can assess in a few minutes of looking at statements if we think a company is well managed. We look for evidence of efficiency. Evidence that they plan and set targets. If we’re going to buy an industry, and if we’re right on the industry, we just want the stock that we picked to participate. We don’t want them to deteriorate on their own or experience some unique problems. The net effect; you’re getting heavy industry tilting, high-quality companies that are on sale, and the ability to handle changing themes.

ETF/Mutual Fund Holdings

No Miracle Cures, but…

Mylan Laboratories has built its business slowly and steadily

Pharmaceutical firms are generally among the world’s most profitable companies. So how do you grow a pharmaceutical firm? There are multiple routes into the industry.

One is the biotech route. Find a Ph.D. with an exciting idea, and raise a lot of money to test it. Then, if it works, and you don’t sell out to an existing pharmaceutical firm, raise more money to build manufacturing facilities and get final FDA approval. If all goes well, and you have several successes, you may end up with a valuable pharmaceutical firm, like Amgen or Genzyme. And if your first idea or two doesn’t work out to the satisfaction of the FDA, you’ll disappear when you run out of cash. Guaranteed high risk, at least in the early years, and typically an elusive reward.

But there’s another, stodgier way to build a pharmaceutical firm. You concentrate on building efficient laboratories, and you make other firms’ drugs under contract, and/or sell generic versions of drugs whose patents have run out. With your knowledge of existing technologies and drugs, you may then start working on improved formulations, or “me-too” drugs which are chemically similar to existing products. Your products aren’t as sexy as breakthrough drugs, and established competitors may look askance at your business model, but you also play an important role in the creative destruction of capitalism: without you nipping at their heals, more established pharmaceuticals would have less incentive to create new products, and virtually no incentive to keep prices down. (And eventually, their “obscene profits” would lead to government price controls.) Finally, if you choose, your company may reach the level of research investment that you too may create completely new products, and any inferiority complex would be overcome.

Mylan Laboratories (MYL) has followed that third, less glamorous, route to growth. The firm, which was founded in 1961 in West Virginia, was only a distributor of pharmaceuticals until 1965, when it began manufacturing vitamins and antibiotics. Still a big presence (and power) in West Virginia, Mylan has since expanded to eight states and Puerto Rico, and is now headquartered in Pittsburgh. Mylan is headed by Milan Puskar. As one might guess from his first name, he is the company’s founder as well as its chairman, CEO, and president. You can forgive his apparently slow start in the “real” pharmaceuticals business when you consider he was only 26 when he founded Mylan.

Mylan develops and manufactures a wide variety of mostly generic pharmaceuticals, but its core generic products are supplemented by a growing presence in branded pharmaceuticals (including reformulations of existing drugs), with a focus on medicines in the cardiology, neurology, and dermatology/wound-care areas. The firm also makes specialized films for transdermal drug delivery and wound or burn care.

Mylan Laboratories is divided into four business units: Mylan Pharmaceuticals is their generic division, currently with 118 prescription products (tablets, capsules, liquids, and transdermal patches). Mylan Technologies is their division for contract manufacturing, compounding, extrusions, and coatings, especially for transdermal drug delivery and skin dressings.

The part of the firm that might seem the stodgiest: UDL Laboratories (which Mylan acquired in 1996) is the country’s leading manufacturer of “unit dose products”–blister packs. Blister packs may seem like trivial or even nuisance products, but they’re important for inventory control, especially for drugs that might be stolen and abused. (A lot of their product line consists of pain medicine.) Blister packs are also relatively child-resistant, they can have barcodes, expiration dates and directions printed right on the back, and they make it much easier to follow a regular or complex pill-taking regimen. (Do you think the birth control pill would have a 99% effectiveness rate if it came in bottles?) By preventing overdoses and surreptitious theft, and reminding users when pills have and haven’t been taken, blister packs may be the perfect example of a simple, unheralded product that may do more good for medicine than just about any single drug “breakthrough.”

But Mylan is moving into the “breakthrough” area as well. This smaller and more volatile, but potentially faster-growing, area is covered by Bertek Pharmaceuticals, Mylan’s division for branded products, including the Biobrane line of wound dressings, which they acquired in 1993. Mylan’s goal is for Bertek’s branded products to reach 50% of Mylan’s overall revenues, up from 12% for the latest quarter. At a recent share price of $28, and 126 million shares outstanding, Mylan has a $3.5 billion market cap. That’s just about in the middle of the S&P 400 mid-cap range, and not surprisingly, Mylan is found in that index.

With a trailing P/E of 15 times earnings of $1.85, the stock is actually cheaper than the average for the value half of the mid-cap index, and just half of the weighted-average trailing P/E of 30 for the 18 stocks found in the PPH Pharmaceutical HOLDRS. Looking ahead, Mylan expects to report earnings of $2.02 a share for its fiscal year ending March 31, 2002, and $2.05 to $2.09 a share for the next year. No blockbuster growth in the short run; but you’re not paying too much for what looks like a reasonable reward.