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Prescription for Success?

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With an aging population, health care, especially the production of pharmaceuticals and medical devices, is a growth industry that we all know about. In fact, it’s perhaps the only major growth industry other than information technology. And while the constant innovation and brutal price competition in the information technology industry have meant narrowing margins and a huge downside for any firm caught just slightly behind the times, pharmaceuticals have, until now, cruised along without such difficulties. Only lately have many major pharmaceutical companies been feeling the sting of tough price competition from generic drugs and of manufacturing glitches that have led to under- or overstocked shelves.

One of the most appealing things about investing in health care is that health is probably the commodity for which demand is least quenchable. As families get richer, they move from owning no cars, to one car, to two or perhaps even three cars, but there is little desire to move much beyond one car per adult. In contrast, many people, particularly older individuals, can conceive of an essentially limitless desire for drugs to make them feel or perform better, as well as, of course, to cure debilitating and fatal disease. The average death rate remains 100%, of course, and that’s not a hindrance to medicine–it is its sustainer.

There are, of course, risks to health care investments. Looking at individual pharmaceutical firms that populate Merrill Lynch’s pharmaceuticals HOLDRS (PPH), an ugly downside can arise from FDA action and inaction on drug approvals, patent expirations, drugs taken off the market for adverse effects, drugs made obsolete by newer drugs, and liability for drugs that prove dangerous.

These generally company-specific risks can be reduced through diversification. But there are also industry-wide risks. Most notably, as boomers age, their dominance of politics may lead to increased pressure for socialized medicine, specifically “free” prescription drugs for seniors. This was made apparent in 1992 and 1993 as Hillarycare loomed, deflating high pharmaceutical stock prices, then itself deflating in the face of broad political opposition. Of course, there’s no guarantee that next time we won’t see European- or Canadian-style price controls.

Still, pharmaceuticals and other sectors of health care remain large, growing, and profitable areas in which to seek investments. There’s a good chance you or some of your clients will want to invest in health care, or pharmaceuticals in particular, but you probably won’t want to be tracking FDA approvals and analysts’ recommendations on a daily basis. An exchange-traded fund (ETF) can offer diversification relatively cheaply in even a relatively modest portfolio.

For other broad sectors, the S&P sector SPDR (Standard & Poor’s Depositary Receipt) is an obvious first choice. But, surprisingly, there isn’t a health care sector parsed from the overall SPDR. S&P’s SPDRs divide the market into just nine major sectors, yet they split health care up between two different funds: Pharmaceuticals are put into the consumer staples (XLP) sector fund (in fact, the XLP’s top 3 positions are Pfizer, Johnson & Johnson, and Merck), and medical services (e.g., United HealthGroup, HCA) are put in the consumer services (XLV) sector fund.

Fortunately, Merrill Lynch’s HOLDRS (short for HOLding Company Depository ReceiptS) include a pharmaceutical sector fund, PPH. HOLDRS are somewhat different than SPDRs, as noted below. Compared to most other ETF options and sector mutual funds, HOLDRs do have relatively small stock counts. There are currently 18 companies included in the PPH; enough to inject pretty much all of the benefits of diversification. Naturally, diversification is limited by the sector itself, and the PPH’s stock weightings (pretty close to market-cap weightings) reflects this: 91% of assets were recently in the fund’s top 8 stocks.

Sector Alternatives

While my first choice for this area is the PPH, there are several other health care ETF options. You might choose one of them either because you want a somewhat different sector representation, or because of HOLDRS’ requirement that purchases be made in 100-share round lots (in this case recently selling for just under $10,000).

The ETF that comes closest in holdings to the PPH is Morgan Stanley’s Pharmaceutical BOXES (RXB), but there are several reasons to prefer the PPH. While BOXES (Basket Opportunity eXchangeablE Securities) are baskets of stocks that trade like other ETFs on the Amex, the Morgan Stanley ETF holds only 15 stocks, and unlike most other ETFs is not market-cap-weighted, having approximately equal weightings in each stock. The Morgan Stanley ETF is also much smaller than the PPH, with a recent market cap of $55 million and a much wider bid/ask spread. The other health care ETFs are either somewhat wider in scope or more aggressive and narrow.

The iShares Dow Jones U.S. Healthcare Sector Index Fund (IYH) and iShares S&P Global Healthcare Sector Index Fund (IXJ) each invest in the full range of health care stocks. The domestic IYH holds 187 stocks, with 62% in pharmaceuticals firms, 17% in medical products, 12% in biotechnology, and 9% in healthcare providers. And the global IXJ (29% foreign holdings) has fewer positions (66), and so is a bit more weighted in the largest companies, and thus in pharmaceuticals, with 72% in that sector.

On the biotechnology front, we covered the Merrill Lynch Biotechnology HOLDR (BBH) back in the January 2002 issue. But biotechnology stocks are suited to more aggressive investors than are the pharmaceuticals (arguably biotech and pharmaceuticals are the same industry, but in the same way that Ferrari and Ford both build cars). There’s also an iShares Nasdaq Biotechnology Index Fund (IBB); it’s much smaller ($7 million market cap versus $500 million for the BBH) but actually trades with pretty healthy volume and liquidity. And of course, if you want active management and aren’t averse to the tax consequences of turnover, the health care sector has numerous mutual funds to choose from. (See the next section for one I think complements the PPH well.)

As with most index investments, the PPH’s stocks were picked pretty much automatically due to their sector, market cap, and liquidity, and not any investigation of investment promise. That may sound haphazard, but index investing and market-cap weighting has a pretty good record against most stock-pickers. While the HOLDRS will not actively change their holdings, the number, names, and types of holdings will change with mergers, acquisitions, and other changes in the underlying stocks.

Finally, a termination of the HOLDR is possible, most likely if the number of stocks falls below nine, if 75% of the shares vote to terminate, or if the HOLDR is delisted from the Amex (but with over six million HOLDRS outstanding, with a market cap of $600 million, that seems unlikely for the foreseeable future). Shareholders would then receive the underlying stocks, but this would not be a taxable event. Prescription: For tax-efficient growth portfolios, the PPH could make you look smarter than the average single health care stock pick or actively managed health care fund. That should help you keep a healthy relationship with your clients for years to come.

Mutual Fund

A Dose of Reality

Forget bedside manner: Craig Callahan manages Icon Healthcare by the numbers

Icon Healthcare (ICHCX) is not your run-of-the-mill sector fund–not by a long shot. While most actively managed sector funds concentrate in major pharmaceuticals or biotechnology companies, you won’t find them here. And, while most ETFs that are worth more than a click follow the actively managed fund bias toward large-cap, major pharmaceuticals (or biotechs–see our review of Merrill Lynch’s Biotech HOLDRS in our January 2002 issue), manager Craig Callahan tilts in contrarian direction based on a proprietary valuation system. The fact that Callahan’s fund has a different tilt makes it a potential complement to the PPH, for example. True, his investment thesis meets its antithesis in the PPH–but we think a profitable synthesis of the two shouldn’t be ruled out.

Most health care sector funds concentrate in one industry (say, major pharmaceuticals), or one sub-industry (HMOs, or medical equipment). Your fund rotates from one to the other. What’s the trigger? We believe the U.S. market goes through themes. That is, certain industries and sectors lead for one- to two-year periods usually, and then that leadership ends, and then new leadership emerges. We use valuation to capture industry leadership. We sell stocks in industries that are overpriced and buy those that are underpriced in the belief that they’re on the springboard to be the next leaders. We do that for the whole U.S. market, and we populate our health care fund with the health care portion of our U.S. system, just like we populate our energy fund with the energy portion of our U.S. system. We’re not health care specialists, we’re running this one valuation system capturing industry themes and populating our sector funds with our favorite industries. So, in our health care fund you will get a real contrast to a health care index, and relative to many of the exchange-traded funds which do market cap index weighting. We will be tilted heavily toward our favorite industries within health care.

Do valuations matter? How do you compute them? On the valuation side, we compute value based on a methodology that most people overlook, even though its proponent, Benjamin Graham, is widely known. Most people think of Graham in terms of price-to-book, P/E ratio, and dividend yield. He realized the deficiencies of those techniques, and developed an intrinsic value equation that he published in 1962. He called it his “central value formula.” I’ve modified that, but that’s what we use. We don’t use P/E, price-to-book, or price-to-sales, or any of those value-type criteria. We never use them. We just use our valuation equation.

Here’s what goes into it: For a company, we take their average earnings and a forward looking growth rate in earnings. We consider beta, and the AAA bond yield. So it has all the fundamentals of finance. What do they earn? How will it grow? And then we discount those future earnings back to the present value considering risk and interest rates.

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.