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Fund Manager Q&A

Health-Care Winners and Losers

Eaton Vance Worldwide Health Sciences portfolio manager Sam Isaly on the fund's largest holding, the impact of reform, and finding opportunity in Japan.

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Sam Isaly is the portfolio manager of  Eaton Vance Worldwide Health Sciences (ETHSX). He recently answered our questions about his strong convictions on  Novartis  (NVS) as well as the sale of  Johnson & Johnson  (JNJ) from the portfolio.

He also commented on the fund's exposure to Japanese health-care equities and the impact of health-care reform and other regulatory changes on the sector. Finally, he addressed some key criteria involved in evaluating a biotech firm's prospects.

1. Novartis is the fund's largest holding with a 6% stake as of Sept. 30, 2010. Why does it merit that kind of conviction? What do you view as your information edge in such a widely analyzed and held company?
Information edge is a better understanding than the market of near-term new-product potential and greater appreciation of the novelty of Novartis-discovered research. In other words, our proprietary view of the company's new-product cycle, such as recently launched products and late-stage pipeline opportunities, drives our conviction. One of the things that we do best is work with industry experts, so-called key opinion leaders who are experts in their chosen field of medicine. We tap into that collective psyche to help us determine which new products will be commercial successes. We incorporate this thinking into our forecasting techniques, which then drive our estimates.

Novartis' most recent drug launch, Gilenya, is an example. This drug is a novel, oral medication for the treatment of multiple sclerosis, a disease for which all other currently available medicines are injectable or infusable. Gilenya offers a clear convenience advantage with no compromise on efficacy. And the premium price appropriately reflects that value proposition, in our opinion. Wall Street estimates are wide, which creates an opportunity given our bullish view which is built on expert analysis, both internal and external, of this therapeutic category. We also applaud the diversity that the company has built, such as expanding its generics capabilities, creating a market leader in vaccines, and the recent acquisition of ophthalmic giant, Alcon. We also view new management changes as a key positive, in particular in the CEO and CFO roles.

2. Johnson & Johnson used to be a top-five holding in this portfolio, and that helped cushion this fund when the sector was roiled during the debate over health-care reform. As of Sept. 30, 2010, this holding is no longer represented in the portfolio. What changed, in your view?
Our positive view on Johnson & Johnson originally stemmed from two points: one, the firm's early exit from its patent cliff when compared with its large-cap Pharma peer group and two, a new-product cycle to drive revenues and earnings post-cliff. Johnson & Johnson had the misfortune of having two blockbuster products go off patent in 2008 and 2009. These two drugs, Risperdal (for schizophrenia) and Topamax (for epilepsy), represented nearly $8 billion in sales or 13% of total revenues for the company. The earnings impact was more severe.

Despite that headwind, we foresaw an accelerating revenues and earnings story that would have played out in the back half of 2010--as the last patent expiration would come to anniversary--but just when the rest of the industry was hitting their own patent expirations. We wanted to be in front of it and anticipate the anticipators but it did not happen. Management missteps in the consumer business (including product recalls), recessionary reduction in demand in the firm's device businesses, greater-than-expected financial hits from the new U.S. health-care reform, and deteriorating pricing environment in Europe all conspired to sap the earnings recovery story.

Additionally, Johnson & Johnson's new-product cycle became muted. New drug launches such as Simponi (for arthritis), Invega (for schizophrenia), and Stelara (for psoriasis) underwhelmed, and important late-stage product development was significantly delayed, such as with Bapineuzumab (for Alzheimer's) and Rivaroxaban (for stroke prevention). Lack of management urgency to alter the course did not materialize. We look to invest in companies that can execute. Johnson & Johnson failed to do so.

3. It's not unusual to see European pharmaceuticals companies in a health-care fund, but your Japanese pharmaceutical holdings are more unusual. What do you like about them?
We believe we have a unique edge in investing in Japanese equities. As a firm, we have been conducting primary due diligence in Japan for more than 15 years, which includes semiannual visits to Tokyo and Osaka, the two main centers for the pharmaceutical industry in Japan. This has allowed us to develop relationships with multiple management teams, an important consideration with respect to cultural norms in Japan when conducting information-gathering efforts. We believe this primary due diligence and face-to-face interaction with management is a competitive advantage in investing in Japanese stocks.

As of Sept. 30, 2010, our holdings reflected particularly good opportunities in two selected stocks and one broad secular theme. Mitsubishi Tanabe is entering an unprecedented new-product cycle which includes both global megablockbuster products (outlicensed to large pharmaceutical companies) and inlicensed blockbuster products for the domestic Japanese and Asian markets. For example, the leveraged play on Gilenya is Mitsubishi Tanabe, the company that discovered the molecule. The royalties on Gilenya alone could be transformative. But the company also has pipeline assets for diabetes, hepatitis, and arthritis, to name just a few.

Another holding is Shionogi, a company that is in a different state of its product life cycle. The company's earnings are underpinned by a royalty stream from  AstraZeneca (AZN) on the global blockbuster cholesterol drug, Crestor, now in its eighth year in the market. We have invested in Shionogi before but exited when we felt the valuation became full. However, when the stock overcorrected more than 40% on the heels of a U.S. acquisition gone bad, we felt the stock was suddenly a value play. Crestor global sales are annualizing at almost $6 billion and still growing more than 20%, and patent expiration remains more than five years away. Emerging pipeline opportunities in HIV and obesity could also boost the share price.

Finally, we are invested in three major Japanese generic drug manufactures--Sawai Pharmaceuticals, Towa Pharma, and Nichi-iko Pharma. This is a secular investment that we identified five years ago. Historically, generic drugs have been shunned in Japan because of the brand culture that is pervasive there and the notion that generic drugs are cheap and nasty. The result has been an underpenetration of generic drugs in Japan compared with Western markets, by a factor as much one fifth. But fiscal concerns and aging demographics in Japan forced federal action, and the government began to institute legislation to promote and provide the incentive for generic drug usage in 2006.

The result has been a dramatic increase in generic usage and an acceleration of revenues and earnings for these generic drug makers. While the low-hanging fruit may have been picked, we believe there may be yet another round of legislation to come in 2012 that could enable the growth of this sector to continue. These companies are all expanding their top and bottom lines between 15% and 30%. There is no other health-care sector that can make that same proclamation.


4. What do you think will be the impact of health-care reform on your industry? Which subsectors will be the biggest beneficiaries, and which will be the biggest losers? What are some other changes that you anticipate within this sector as a result of changes in health-care regulations?
Perhaps the most important aspect that the passage of the health-care reform bill in 2010 wrought was closure. That may sound ironic given the recent attempt to repeal the bill, but the sector suffered in the months ahead of this bill becoming law as speculation was rampant as to what it may include or not include. Thus, passage was an overhang removed.

We view the Patient Protection and Affordable Care Act (combined known as ACA) as a positive for the broad health-care industry because of the absence of any meaningful negatives. For example, the ACA does not include any strict price-control provisions, does not install the federal government as a major buyer (that is, price setter) of drugs, and does not include a public option (an insurance plan that could see government become a significantly larger payer). While pharmaceutical, biotechnology, and medical-device companies will help pay for the bill through various provisions, they are minor in totality. And these various fees will be offset by the most obvious positive of the ACA, namely the 30 million additional individuals that will now have coverage, resulting in a potential consumption boon.

In our view, branded drug makers and the profitable biotechnology companies are winners by the absence of any draconian measures in ACA. Generic drug makers are clear winners. The commercial HMOs are winners as early reform mandates are manageable, and the ACA will mandate the private sector to cover new lives. Losers in this sector come primarily in the services areas, like imaging, home health, dialysis, and hospitals in which we have no exposure. However, beginning in 2014, Medicaid HMOs should benefit from the expansion of Medicaid, and hospitals will get reimbursement for previously uncompensated care.

5. What are the key criteria you focus on when evaluating a biotech firm's prospects? How do those criteria differ from your criteria for other subsectors within the health-care sector?
Biotech firms are generally more reliant on pipeline products in development compared with more mature pharmaceutical companies. They often depend on only one or two key drug candidates. Therefore a major driving factor for our investment decision for such companies is our internal assessment of the odds of technical success for these drug candidates in clinical trials.

To this end, we do thorough due diligence on these potential products through review of clinical and preclinical data and consultations with key physicians and scientists knowledgeable about these drugs and the potential market opportunity. As potential revenue from these drugs can be years away, we forecast the future market opportunity in light of how we expect these markets to evolve over time, considering other potential competitors, and we discount back for time as well as for the risk of failure at various stages of development.

The majority of biotech companies are unprofitable, often with little or no meaningful revenue, so we must be very mindful of their ability to finance, and we must consider the amount of dilution required to bring these companies to profitability in our valuations. We also believe that strong, experienced management teams are particularly important for success in the biotech sector. Furthermore, as many of these biotech companies with one or two products on the market are attractive acquisition targets for major pharmaceutical firms, we must also consider the strategic value and potential synergies that could be realized if the firm were acquired at a price in line with our valuation assessment.  

This commentary may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.

The views expressed in this commentary are those of Orbimed Advisors and are current only through the date/period stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

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Mutual funds are offered through Eaton Vance Distributors, Inc.

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Esther Pak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.