Like the vast majority of asset classes, health care
stocks suffered a tough year in 2002, with the average mutual fund invested
in the sector dropping by 29.9%. The $734-million AIM Global Health Care
Fund/A (GGHCX), managed by Michael Yellen did relatively better, falling
22.7% on the year. Over the longer term, however, the picture is brighter.
For the three-year period ended 2002, the fund gained 7.2% on an average
annualized basis, versus a decline of 1.3% for its health care fund peers.
For the ten-year period, the fund returned 11.2% annualized, versus 10.8%
for its peers.
Once considered a defensive investment, health care stocks now appear
to be more affected by macroeconomic factors. However, the sector is broadly
diversified, including everything from big drug manufacturers to small firms
that make gauzes and stents. As a result, sub-sectors within health care
have different characteristics, and behave differently as well.
Yellen, a strictly bottom-up, value-oriented stock picker, is keeping
much of his money in the familiar, big-cap, blue-chip drug makers. Many of
these companies are at near-historic lows in terms of valuations, and as
people in the developed world continue to age in record numbers, they will
need more medicines and medical care. As a result, Yellen sees strong
outperformance from these stocks. His portfolio, which was launched in 1989,
carries an overall ranking of 4 Stars by Standard & Poor's.
The Full Interview:
S&P: What hurt health care and pharmaceutical stocks in 2002?
YELLEN: It was somewhat surprising that the health care sector
performed as poorly as it did in 2002, given that this has traditionally
been viewed as a defensive investment. The bulk of most health care funds
are invested in the large-cap, blue-chip, U.S. drug names, and these stocks
under-performed significantly last year.
Familiar companies like Merck (MRK), Schering-Plough (SGP), Bristol-Myers
(BMY), Eli Lilly (LLY) and Pfizer (PFE) all endured poor years. However,
their problems were due primarily to company-specific issues.
S&P: Can you give me an example?
YELLEN: Bristol-Myers, which plunged something like 54% in price,
has been hurt badly by a continuing series of problems. They just received
the bad news that they have to stop selling their anti-depressant drug,
Dutonin, in Europe. In 2002, Bristol's stock was severely damaged by the
havoc surrounding Erbitux, the colorectal drug manufactured by ImClone
Systems (IMCL), which Bristol purchased a 20% stake in.
Schering-Plough was hit very hard in 2002 because its main drug,
Claritin, an allergy treatment, went off-patent in December, thereby leading
to a potentially rapid decline in prescription sales.
Generally speaking, most of the big drug stocks missed their earnings
targets in 2002. Even companies that had better longer-term fundamentals
[like Pfizer and Johnson & Johnson (JNJ), which did not cut their earnings
guidances all year] traded down in sympathy with the group.
S&P: How did that affect your performance overall?
YELLEN: Our fund was actually not that badly hurt by the weakness
among the big drug stocks because we did not bulk up on them until the
middle of the year, after most of the damage had already been done.
What hurt us the most was our overweighting in hospital stocks, which
plunged in the fourth quarter. Tenet Healthcare (THC) collapsed in that last
quarter due to the controversy surrounding Medicare payments, and their
problems brought down the whole hospital sector.
On the biotech side, valuations were still quite high going into 2002.
This is a sector that will not perform well in a downward market. There was
a lot of negative news regarding biotech products. Given how volatile and
speculative biotech still is, it's not surprising they did so poorly in
The only bright spot in 2002 might have been with some medical technology
stocks, including the orthopedic and cardiac areas, which did reasonably
well, notably Boston Scientific (BSX) and Medtronic Inc. (MDT).
S&P: What are your top ten holdings?
YELLEN: As of December 31, our top ten stocks consisted of
Pharmacia Corp. (PHA), 7.1%; Pfizer Inc. (PFE), 6.0%; Community Health
Systems Inc. (CYH), 5.3%; Aventis (AVE), 5.2%; HCA Inc. (HCA), 5.1%; St.
Jude Medical Inc., 5.0%; Merck & Co. (MRK), 4.9%; Bristol-Myers Squibb (BMY),
4.8%; Amgen (AMGN), 4.7%; and Tenet Healthcare Corp. (THC), 4.6%. These ten
represented 52.7% of the portfolio's total assets as of the end of December.
We have 109 holdings overall.
S&P: What are your top sectors within health care?
YELLEN: Our largest sub-sectors as of December 31 were
pharmaceuticals, 49.5%; health care facilities, 19.5%; biotechnology, 8.2%;
health care equipment, 7.9%; diversified chemicals, 7.3%; managed health
care, 1.5%; and health care supplies, 1.5%.
S&P: What is your geographic allocation?
YELLEN: As the end of the year 71.2% of our assets were invested
in U.S. stocks. We also had 7.4% in France, 6.4% in Japan, and 4.3% in
S&P: You mentioned the problems at Bristol-Myers, yet it is one of
your largest holdings.
YELLEN: We bought most of our position in Bristol-Myers in the
middle of last year, after the stock suffered the worst of the damage.
There's no getting around that Bristol is currently a screwed-up company
with problems on all fronts. We are certainly not bullish on Bristol, but
given its low valuation, the stock's 4.5% yield is very attractive.
Moreover, many investors see it as an obvious acquisition target, something
I don't think will necessarily happen.
S&P: Tell me about Pfizer, the world's largest drug company.
YELLEN: Pfizer has very strong fundamentals. The stock price
weakened in 2002, in tandem with the pharmaceutical sector as a whole. We
also own Pharmacia, which Pfizer will soon be acquiring. Therefore, it is by
far our largest holding.
Pfizer faces very little exposure to patent expiration issues over the
next five years. They have a very good and stable product pipeline,
including their blockbuster Lipitor. In addition, they are far outspending
their competitors in terms of marketing and R&D. The Pharmacia acquisition
will give them some scope for cost cutting.
We think Pfizer can deliver 17%-18% annual earnings growth for the
foreseeable future. Pfizer currently trades at a P/E multiple that is at a
discount to the overall market and to the drug sector. This just doesn't
make any sense. There's very little risk here with this stock.
S&P: Many patents are expiring on blockbuster drugs, opening up
competition from the low-cost generic drug-makers. Are you concerned about
YELLEN: Patent expiration is definitely a serious factor that the
large-cap drug companies are having to face. However, in absolute terms, the
dollar sales amount of products lost to patent expiry peaked in 2002,
something on the order of $6 or $7 billion. If you look over the next couple
of years, these sales figures will decline pretty meaningfully, to something
like $2 or $3 billion by 2005. So, at the margins, the situation gets better
for the large-cap drug companies the next two or three years.
By 2006, more drug patents will expire, but given that we've seen new
products launched the past few years and expect a new roll-out of drugs over
the next few years, the dollar sales volume for the industry as a whole
should be increasing. In terms of earnings disappointments, I think we have
seen the worst of it in 2002. Given aging demographics in the developed
world and low stock price valuations, we still believe the large-cap drug
sector will provide relative outperformance.
S&P: You mentioned Tenet Healthcare (THC), which is facing a host
of legal battles. Why is it still in your fund?
YELLEN: Tenet Healthcare (THC) is under investigation for Medicare
billing and is facing a myriad of lawsuits. However, we think the company
can overcome these problems, and we have actually added to our position in
the stock. Given its valuation [P/E of about 7.6], I think all the potential
risks have already been discounted in the stock's price.
In addition, the company has taken many steps to rectify its legal
problems, and they've been quite candid with the investment community about
their strategy. I think the potential liabilities against Tenet will be
manageable. As the smoke clears, I think the stock will recover, and I trust
the management team will ably address all these issues. As such, we think
Tenet is a good long-term value.
If you compare the situation surrounding Tenet with what Columbia HCA
went through five or six years ago, it's not nearly as serious. And bear in
mind that back then, under a cloud of Federal probes, Columbia HCA's stock
bottomed out at a level that was higher than where Tenet trades today.
S&P: How do you view the HMOs?
YELLEN: We think United Healthcare (UNH) is the best run,
best-managed HMO with the best earnings visibility, the strongest
fundamentals, and least risk going forward. The HMO sector sold off in the
fourth quarter of last year, but it was one of the top-performing health
care groups in 2002.
However, we have some concerns with the fundamentals of HMOs as a whole.
We think they might be in a late-stage cycle of growth, and they will be
hard pressed to receive 15% to 20% premium rate increases from their
corporate clients, thus leading to declining margins.
The jury is still out on HMOs. Although we felt their fundamentals were
peaking in 2002, they have held up pretty well and delivered impressive
earnings across the board.
S&P: Tell me about one of your major foreign holdings.
YELLEN: Our biggest European holding is Aventis S.A. (AVE), a
French-based multi-national drug company with three main products: Allegra/Telfast,
an allergy drug; Lovenox/Clexane, an anti-thrombosis agent; and Taxotere, a
chemotherapy agent. The European Union recently approved the use of Taxotere
as a first-line treatment for patients with advanced non-small cell lung
cancer. The FDA granted a similar approval in December. Like its U.S.
counterparts, however, Aventis is facing such problems as trying to develop
new products and new growth from existing product lines to offset the loss
of sales of drugs which are going off-patent.
The company's stock is down about 40% from its 52-week high. This is
primarily due to concerns about Allegra, which may be hurt by
non-prescription sales of Claritin, a similar drug manufactured by
Schering-Plough [Schering began selling Claritin over-the-counter in the
U.S. in December]. However, we think the risk posed by Claritin has been
over-discounted with respect to Aventis' stock price. Overall, this company
will likely be one of the fastest growing foreign multi-national drug firms.