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The Appeal of Biotech

The manager of Eaton Vance Worldwide Health Sciences discusses the outlook for pharmaceutical and biotech stocks and names some promising firms.

Sam Isaly, manager of Eaton Vance Worldwide Health Sciences (ETHSX), is probably the most astute fund manager at ferreting out the best buys among pharmaceutical and biotech stocks. And right now, Isaly is pounding the table on behalf of biotech.

I wouldn't buy the Eaton Vance fund. It carries a 5.75% sales charge on the class A shares, and annual expenses are 1.56%. But I pay close attention to what Isaly says. Reason: He has a long record of being right. Over the past ten, 15 and 20 years, the fund has returned an annualized 14%, 16% and 15%, respectively. The fund ranks in the top 10% among health funds over the past ten years.

Unlike most health fund managers, Isaly, 61, sticks to pharmaceutical and biotech firms. Long term, he argues, these kinds of companies can deliver big profits because they can obtain patents for medications that save lives.

The problem with big pharma, of course, is that in recent years the industry giants have produced fewer blockbuster drugs (defined as drugs generating at least $1 billion in annual sales). "We don't know what creates discovery productivity, but for the most part, big pharma isn't demonstrating it," Isaly says. Indeed, some big drug makers have become so bureaucratic that research scientists are sometimes told to continue working on failed projects. "Meanwhile, what big pharma is doing is losing big patents," Isaly notes.

Federal approval of new drugs is actually down from the early 1990s. What's more, about half the new drugs clearing regulatory hurdles are now biotech drugs. The upshot: Isaly is bullish on biotech giants Amgen (AMGN), Genentech (DNA) and MedImmune (MEDI). "These firms are growing 20% a year, and their price-earnings ratios are around 25." That means their price-earnings-to-growth (PEG) ratios are around 1.2. "That's lower than the PEG ratios ever have been for these companies," he says. Some of the companies had revenue misses in the first quarter, which spooked traders, but "earnings were pretty much on target."

Isaly currently has about 30% of his fund in big pharma, 30% in big biotech, 15% in specialty pharma and 25% in small biotech stocks. In all, his universe of eligible names totals about 300 stocks. He works with ten analysts and managers -- evenly divided between scientists and investment types.

Isaly's favorite stock is Novartis (NVS), the Swiss-based drug maker, which has, perhaps, the most productive research scientists in the industry, coupled with management that has made savvy acquisitions. Cancer drug Gleevec and hypertension drug Diovan are among its blockbusters. The company recently acquired the 58% of biotech giant Chiron that it didn't already own. Novartis is also making big strides in selling generic medicines.

Among big pharma names, he also likes Schering-Plough (SGP). It's a turnaround, and a candidate for consolidation -- whether as a takeover candidate or as an acquirer. CEO Fred Hassan has made big strides in rebuilding the company since coming aboard in 2003. Schering had been hard hit by the patent expiration of Claritin and a string of regulatory problems.

On the make

Small biotech firms are the trickiest to buy, albeit the most exciting, because they typically are losing money and their futures rest with one or two potential drugs. "We look for good management first," Isaly says. "Then we look for good science."

Isaly notes that big drug makers are buying up small biotech companies, and executives promise to increase the pace of their acquisitions. "They're going to become far more active," he says. "That's going to jazz up the market for smaller biotechs."

Vertex (VERTX) is one of Isaly's biggest holdings among smaller biotechs. It has a promising drug in phase two trials for hepatitis C. "If it works, it could be a multibillion dollar drug," he says. The firm is still losing money, but Isaly expects the hepatitis drug to be on the market in 2008 or 2009 -- "if there are no problems."

Millennium Pharmaceuticals (MLNM) is a little further along. It has a cancer drug on the market. Though the drug, Velcade, faces competition, Isaly still expects sales to grow. He thinks the company will break even this year or next. What's more, Isaly has great respect for the firm's researchers. "We think they're close on other promising drugs."

Opinions expressed in this column are those of the author.