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Biotech and Pharma Still Look Cheap

Dan Culloton

Dan Culloton: I'm Dan Culloton, Associate Director of Fund Analysis at Morningstar. I am here today with Diana Strandberg and Charles Pohl of Dodge & Cox Stock, Dodge & Cox International and Dodge & Cox Global. Thank you for visiting today.

Charles Pohl: Thanks for having us.

Diana Strandberg: Thanks for having us.

Culloton: Well, having the luxury of being able to invest across the globe in all of your funds, I thought I'd begin by asking you just, where are you finding better opportunities today across the equity landscape: internationally or domestically?

Strandberg: Well, I'd have to say that, we think about the opportunities on a bottom-up basis and where we are seeing a lot of attractive investment opportunities is in pharma and that would be both in Europe and the U.S. It's a global industry, where we think that the valuations as very attractive. Strong balance sheets. And where we see that investors are more pessimistic about their revenue growth prospectus because of questions about drug pipelines and the regulatory landscape. And where we see, from today's starting valuations, opportunities for revenue growth both in terms of drugs under development, emerging market opportunities and cost cutting and share repurchase opportunities to drive earnings and we think therefore stock prices.

Culloton: This is an area that hasn't worked for a number of years. Does that concern you at all that the fact that the turnaround in pharma and the resulting reward that would come from valuation improvement hasn't happened yet?

Pohl: Well, one of the things that has occurred, obviously, is that the stocks have underperformed and so the a valuation gap that is fairly substantial, has opened up between pharma and the rest of the market. With the pharma stocks selling in the 10 to 12 P/E multiple range, actually a few of them even cheaper, the major companies, and the market in the 14, 15 kind of range, depending on what earnings numbers you are using. So their underperformance has created a bigger valuation gap and we think that valuation gap does in fact make them more attractive than they were previously.

Strandberg: And you know, as we move very incrementally, but we are also persistent where we have investment conviction and our investment convictions rest on the fact that we are doing our own research. And so to the extent that they haven't worked in 2010, as Charles mentioned, the valuation opportunities have become more attractive. We have nibbled a little bit more. We hope we won't have to be persistent and patient, but we are willing to be and that's a hallmark of how we approach investing at the firm.

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Culloton: There must be a distinction within pharma, within this cheap basket of stocks, between companies that are impaired by the challenges that it faced and companies that really do have genuine opportunities for revenue and earnings growth. How do you differentiate between the two, what are you looking for on a good cheap pharma stock?

Pohl: Well, we do an extensive fundamental analysis of each of these companies. And in pharma, so much of the revenues and profitability of even very large companies often depend on a very small number of drug compounds. So, one thing that you have to realize is that there is a lot of uncertainty, and so you have to diversify across a number of different names, because you can't be sure about what the outcomes are going to be.

That said; there are things that we look for, a strong pipeline of compounds coming through the FDA approval process. So, at least, it look like there are some compounds that have the potential to be blockbuster drugs. That would attract us to a particular company.

Another thing is, if you take a look at the industry as a whole, one of the concerns has been, some of these blockbuster compounds coming off patent, and the damage that generic competition could do to profitability of some of these. There we think the risk is much greater for, so called, small molecule of compounds, which can be exactly, chemically replicated by a generic manufacturer. And there is less risk in the more complex, large molecule, protein compounds, because it's very difficult if not impossible to exactly replicate them.

So, even if they go off patent, the prospect for effective generic competition is greatly diminished. So, those franchises, the large molecule franchises are more attractive to us, and the companies that have those are comparatively more attractive to us than the ones that are heavily reliant on small molecule compounds that don't have much patent life left.

Culloton: And these are companies that are involved in biotechnology to some extent and it is surprising to hear value investors talking about biotechnology now. Especially anyone who's been paying attention to stocks and valuations over the last 10 years. It's reached that point where biotech stocks are now within your range.

Pohl: Yeah. It's an industry that's really fallen out of favor. If you went back a decade, a little more than a decade ago, there were a lot – there was lot of venture capital money going into starting up new biotech names. That has greatly diminished. The valuation multiples were very high. They were trading at large market multiple premiums, the large drug companies were. Now, they are selling at discounts, so there has been a huge change in the market's perception of these stocks, and now they actually have become value stocks.

Culloton: Yeah, and the same thing with technology, media and telecom, which has also increased as a portion of your portfolios over the years?

Pohl: Right. Those names, many of them back in the late 90s traded at very fancy valuations. And those valuation levels have diminished enormously over the last decade, yet on a look-forward basis, the fundamentals of some of those companies are quite good.

Strandberg: Valuation is one element, but what we really what to find is the opportunity to be part owners in a company that has growing earnings and cash flow. And when we think about, tech, media and telecom, an area of the portfolio for the international fund that we focused on last year was in telecom services. And in particular, we saw opportunities to invest in companies that had very strong franchises in the developing world, and especially in wireless data, which we believe has very attractive growth prospects, is likely to be the way that people obtain their Internet in many parts of the world, where fiber won't be laid in the network.

So, we are able to buy these companies at attractive valuations, where we see penetration growth opportunities, but then also services and application growth opportunities as well. And we couldn't touch these companies a decade ago from a valuation standpoint.