GEOFF COLVIN: While stocks in general are up this year, one sector in particular, biotechnology, has been hotter than a Bunsen burner. A major reason: new drugs with breakthrough potential for treating cancer, AIDS, and other ailments. What promising new treatments are coming out of the labs next, and where can investors still find opportunity?
Linda Miller manages the John Hancock Biotechnology Fund, up a scorching 40 percent so far this year. Evan McCulloch manages the Franklin Biotechnology Discovery Fund, up 35 percent this year. He joins us from San Francisco.
A lot of investors worry that biotech companies are dangerous, speculative, volatile. In fact some people have asked me, how
are these any different from Internet companies? What would you respond to them? Evan, let's start with you.
McCULLOCH: Yeah, I would like to say that when the Internet came along, it was largely an unproven business model, and it turned out to be not a very good one, because there are very low barriers to entry.
But with at least even the smallest biotechology company, we know this is a tried-and-true business model. Companies like Pfizer and J&J and Abbott have been developing and marketing drugs for 100 years. We know that if you cross the finish line with a drug and you get it to market, you'll be guaranteed with very high barriers to entry, at very high margins, and almost market exclusivity in a number of cases.
So, yes, some of the smaller companies can be higher risk, but we do, how we manage that in our funds, we hold lower or smaller positions in those funds, minimizing the downside. But in some of the larger companies, like Amgen and Genentech that have diversified portfolios, yes, that's what you'll see in our top 10.
COLVIN: Linda, who should be in these funds? What kind of investors?
MILLER: Well, I think investors that have an outlook that's long term in orientation.
Clearly, healthcare investing is, I think, a very strong area. Demographics are working for you, in terms of the population is getting older. Technology is working for you, in terms of the rapid pace of change in the field and everything that's come out of genomics, proteomics and so on. So I think people looking for a dynamic of change, huge market opportunities, both in the U.S. and around the world. So for me, everyone should own something in the healthcare field.
Biotechnology is clearly to some extent more speculative. The stocks are much more volatile. So I think it's got to be someone with a long-term orientation who's willing to take some risk and ride the ups and downs in this field. But nonetheless, it's going to be big business for a long time.
COLVIN: That's for sure, and so it sounds like at least a portion of somebody's portfolio belongs in this kind of thing.
MILLER: If they can tolerate the risks. You know, as you say, this sector is up 40 percent this year. It wasn't up 40 percent last year.
COLVIN: No, it's been very up and down.
MILLER: So it's been very up and down. I think over time we'll see more ups than downs, but nonetheless, you have to ride it out on the long term.
COLVIN: Evan, what do you see in this sector on the horizon that makes you so optimistic about it now?
EVAN McCULLOCH: The thing that we're the most excited about right now, is the number of new drug launches we've seen, not only year to date. We've see about 11 year to date. But we're also expecting about 18 new drugs to be approved over the next 18 months. Beyond that, there are over 1,000 products in clinical trials right now. So there's going to be a ton of exciting new developments over the next 10 years really.
COLVIN: Well, let's get into them. Linda, Genentech is one of your big holdings. Now they have a cancer drug called Avastin, which has already been shown modestly effective against colon cancer. A new study published just yesterday in The New England Journal of Medicine shows its effectiveness against kidney cancer as well. Now this works in the following way: a cancer tumor sends out substances that bring it a blood supply so it can grow, and what Avastin does is block those substances so the tumor won't get a blood supply, and therefore won't grow. What does this mean for Genentech?
LINDA MILLER: Well, scientists have theorized about that principle for a long time. This is the first time that really this opportunity has been reduced to practice. It's a totally new mechanism for treating cancers, solid tumors, and especially some of the big solid tumors, like colon cancer. What will it mean? It means that this is the first of a, probably a new generation of products that will enter the cancer field. And our fund has really identified the cancer field as a major opportunity for biotechnology.
We also like the area of infectious disease, particularly viral diseases and vaccines. And that's probably the two key themes we see today as the near-term opportunities in biotech.
COLVIN: What do you see specifically in the field of cancer drugs that's coming up besides Avastin?
MILLER: Oh, besides Avastin there are a number of interesting compounds. One that just recently got a record-breaking approval from the FDA is called Velcade. Today it's for a smaller indication certainly than Avastin appears to be. And a little company that's developing it called
Millennium is also a holding, more speculative in our fund, but when you see the FDA turn around so quickly on an approval, in weeks as opposed to months and years, that gets investors excited, including us.
COLVIN: Yeah, I believe, Evan, that that's of interest to you as well, right? What else do you see happening in the way of cancer drugs?
McCULLOCH: One of the compounds that we think is the most interesting are the small molecule drugs for non-small cell lung cancer. We saw Iressa, which is one of AstraZeneca's drugs approved earlier this year. But OSI Pharmaceuticals and Genentech are developing a similar drug perhaps with better trial design and a more potent molecule, and we think that will have very important implications longer term as well.
COLVIN: It's fascinating. Now there's another company that I know is of interest to you, a holding of yours, Gilead Sciences, and they have a drug, an anti-AIDS drug called Viread. Now this one works by entering cells that are susceptible to HIV, then interfering with the replication of the HIV virus, and this limits the progression of the disease. Now what's the outlook for
Gilead on that basis?
McCULLOCH: Well, Gilead is largely being driven by sales of Viread right now. It was launched a couple of years ago and continues to sell very, very well, although it does have a better resistance profile. The primary advantage of Viread is that it's only one pill, once a day. And this is in contrast to other similar drugs that are multiple pills, taken multiple times a day, and oftentimes there are food restrictions or otherwise. One of the interesting things that we think about, we like about Gilead is they just launched another drug called Emtriva. Now in approximately a year to a year and a half, we expect them to introduce a one pill combination of Emtriva and Viread.
COLVIN: They're both AIDS drugs.
McCULLOCH: They're both AIDS drugs. And that is very important because in HIV patients you need to help drive compliance, and better compliance really keeps viral levels down and reduces resistance and allows these patients to have their viral load controlled over a number of years.
COLVIN: Who else in the field of AIDS drugs is interesting these days?
McCULLOCH: Well, Trimeris introduced a new drug earlier this year called Fuzeon, and this is very interesting because it's a totally new class of HIV drugs. Now it's unclear on how well this will commercialize, because it is injectable and it is extremely high cost, but it is a very,
very important option for patients who really have no other options. Once they've exhausted all the other treatment options, at least now we have another drug that's available to them and will help control their HIV.
COLVIN: Linda, lets talk about other drugs that will change people's lives. We've talked about cancer and AIDS, but what else is exciting on the horizon?
MILLER: I think there are a number of other areas in biotechnology besides cancer and viral diseases. I mentioned vaccines earlier, which follow in the infectious disease area. And there's a little company, Medimmune, that's developing with Wyeth FluMist, which is a new flu vaccine.
COLVIN: That you don't have to inject, right?
MILLER: You don't have to inject. We'll see how big the market for that develops over time, but I think that the marketplace is ready for alternatives to injection. We also like some companies that are developing products outside of cancer and viral diseases. Neurocrine Biosciences has a new sleeping pill that we will begin to see more phase III or advance clinical
trial results. They have a big partnership with Pfizer. And of course on a marketing front where you need muscle, Pfizer will be there we think very successfully. And I think insomnia is something that is probably an under-served marketplace, not one where, you know, it's like AIDS or cancer where you truly can come up with breakthroughs. But there are big market opportunities outside of those fields as well.
COLVIN: Yeah. As far as I can tell, the main holding in both of your funds is Amgen. Evan, what do you like about it?
McCULLOCH: What we like about Amgen is the fact that it's being driven largely by three marketed products, and that's Neulasta, Aranesp and Enbrel. Not only is Enbrel doing very well in rheumatoid arthritis, but we think it's going to be the class leader in psoriasis as well. And it's pretty low risk, because they don't have a lot of, they're not relying on a lot of drugs that are in the clinic or at the FDA right now for future growth. We think the valuations are very attractive, we think management is excellent, and they also have close to $5 billion in cash on the balance sheet, which we think they'll use to acquire some smaller companies and augment their pipeline.
COLVIN: Linda, what are your views on Amgen?
MILLER: Amgen is one of our top holdings, as well, I think for the same reasons that Evan mentioned, and I'll mention another reason. We see the large-cap pharmaceutical companies as under a lot of pressure, because their products are becoming off patent, they're getting vulnerable to generic risk. Right now for the biotech industry, there's not a path for generics to come to the marketplace. The FDA has really halted that issue, and we don't see existing inline products -- great products like Aranesp and others, Enbrel -- having any generic threat. So they may have more competition down the line, but they won't suffer the fate of some of the products in the pharmaceutical field that have come off patent and have had major disappointments in terms of revenues and earnings for the big pharma companies.
COLVIN: Linda, thanks so much. Evan, thank you so much for your views.
MILLER: It's been my pleasure.
McCULLOCH: Thank you.
Bond discussion
KAREN GIBBS: James Grant is widely considered Wall Street's bond and interest rate guru, and he joins us to explain what's behind this move in rates. Jim joins us from the New York Stock Exchange. Jim, welcome.
JIM GRANT: Thank you, Karen. Nice to be here.
GIBBS: Well, what is behind this recent jump in interest rates?
GRANT: The thing most immediately behind was the wrong price, three-point-something percent was absolutely too low a yield on an obligation of the U.S. Treasury. So it was a little bit like Nasdaq in March of 2000. The question really wasn't, "Why did it go down?" The question was,
"Why was it there (in the first place)?"
GIBBS: So you say this bond bubble is similar to the Net bubble of the late '90s. Do we have a villain a la say Grubman or Henry Blodget?
GRANT: Oh, in the bond market we are much too genteel to have scoundrels, but we do have perpetrators in the shape of our Federal Reserve system, in my estimation at least. The Fed since last fall has been talking about deflation, that state of being in which prices sag. The Fed doesn't like that, although certainly Wal-Mart seems to have done okay by everyday low prices, but the Fed won't have it. And it has told the bond market in very explicit language it won't put up with no inflation. It wants to restore the inflation rate at something a little bit more lilting than 1.5 or 2 or 2.5 percent.
And if you think about it, the bond market would hear of almost anything rather than that. It's a desperately poor message to have been delivered to the bond market, and at great length the bond market realized that the Fed is intent on doing what it doesn't want to be one, that is to bring back inflation at some rate much higher than right now.
GIBBS: Well, what's wrong with a little bit of inflation in this market?
GRANT: If you are holding a U.S. Treasury security at 2 percent or 3 percent, and if the inflation rate goes to 4 percent, a lot is wrong with that./p>
GIBBS: Do you think investors who have taken money out of the stock market and poured it into bond funds are aware of the risk that is associated with rising interest rates?
GRANT: No. Bonds, I'm afraid, are regarded by many as intrinsically safe, and the truth is there is no intrinsically anything investment. At a price, equities are compelling; at another price, equities are to be avoided at all costs. Similarly with bonds. And of course the great paradox of markets and human nature is that the higher the price, the more beckoning the instrument. You know, nothing quite attracts people like a rising market. And sadly people poured money into the bond market at the wrong time. A recent survey was done, and the results showed that many investors, perhaps most, didn't know that when yields go up, prices go down, but that is the truth of the matter.
GIBBS: What's the implication now for investors? What are they to do?
GRANT: Bonds are a victim's asset. If you're a bondholder in a corporation, the corporation management is intent on pleasing the stockholders. They will trample all over the bondholders. If you are a Treasury bondholder, you are the victim of a Fed that is intent upon reflating the economy.
So I think that people ought to insist at all times, all places, and in all markets, on a margin of safety. They ought to be compensated for the risks ever present in financial assets. And at these level of yields, in my opinion, you're still not being compensated for those risks.
GIBBS: Where do you see the investment opportunities? Where would investors be compensated for the risks?
GRANT: I'm the world's leading authority on where stock prices are not going.
For what it's worth, in my own affairs I'm involved in Japan. We have a partnership that buys corporate equities in Japan at sometimes valuations less than net current assets. We think Japan's not going to fall off the face of the earth and that the Japanese stocks will finally acquit themselves pretty well. And we're buying them because we think there is a margin of safety. The market has been abandoned by almost everyone because it is now known that Japan can do nothing right. So my thinking is that you ought to do what others aren't doing if you find value there, and in Japan we think we've found value.
GIBBS: Well, gold is also seen as a traditional hedge against inflation. Is gold looking a little bit brighter to you?
GRANT: Sure, to me. And again, by way of full disclosure, I would have said this last year, the year before that, the year before that.
But I think that gold is an excellent way to hedge yourself against Alan Greenspan. The world is in thrall to the stewards of central banks, you know, and I figure these guys don't walk on water. They are as inclined as every mortal to make mistakes and their reputations are much bigger than their capacity. So I think that over the next several years the world will turn away especially from the U.S. dollar and seek other monetary assets, and one
of those assets I think will be gold bullion.
GIBBS: And finally, just one more question about mortgages, particularly because they're so closely tied to interest rates. Have we got a bubble there?
GRANT: I think we have a bubble in house market leverage. That is to say we have a rampant enthusiasm for borrowing against the roof over your head. And my only words of advice there, for what they're worth, is that house prices can go down just as they went up, and you ought not to borrow too much against a sure thing, because there ain't no such thing in life.
GIBBS: Jim Grant, thanks very much.
GRANT: Thank you, Karen.
Homegrown investing
KAREN GIBBS: Well, all investors are not as intrepid as Jim, willing to go all the way to Japan to chase stock market performance, so how about investing a little closer to home? Actually, a lot closer to home. It turns out that investments in local companies often outperform the rest of the stocks in a portfolio.
FORTUNE's David Rynecki has been looking into the phenomenon, and he joins us from a studio near his home in New York City. Hey, David.
DAVID RYNECKI: Hey, Karen.
GIBBS: Well, look, is this a new twist on an old theory?
RYNECKI: It sort of is. We've always told people, and Peter Lynch told us, that you should buy what you know. Well, these professors out of the University of Illinois did some research and found out that when people do buy what they know, buy their hometown stock, they actually, surprisingly, outperform the other stocks in their portfolio by about 3 percent.
GIBBS: So do we really know more about the home team?
RYNECKI: I think often we do.
There are examples like with Healthsouth and Worldcom where there was just out-and-out fraud. But for the most part, we're talking about hometown companies, where you see the CEO standing in line at the grocery store. Your friends might work for the company. And you get a good sense of, feel for the company. You're not going to able to know what's happening next quarter, but over time you know, "Is a good company or not?"
GIBBS: Can you give us some examples of companies that pop up on your radar screen?
RYNECKI: Sure, sure. I went around this week and I called a bunch of different local stockbrokers and research analysts to see what they're talking about and what their clients like.
Let's start with UMB Financial. This is a little company in Kansas City, Missouri. It does commercial banking. It's run by members of the Kemper family, a very established family. They're known as a conservative-type company, don't get in a lot of trouble, and they're owned primarily by locals.
GIBBS: Do you have any other examples?
RYNECKI: I think an example on a larger scale is actually BB&T, which surprised me. I wouldn't have thought that BB&T was a locally-owned company. But actually about 60 percent of the stock or more is held by individual investors. BB&T is another bank company located in Winston-Salem, North Carolina. Ironically, when my wife grew up in North Carolina, this was her hometown stock. And hopefully, her family bought stock, and I don't know if they did. It's continued to be a mom-and-pop stock, despite its national recognition.
GIBBS: Well, what do you think? Does it mean that regional brokers may be a little more savvy about local companies than the big boys in New York City?
RYNECKI: One thing I found is that they find it much easier to sell those stocks to people locally. I'm sure that if you talked to people in Jackson, Miss., they would find that their broker was very hot on Worldcom. It's an easier sell. At the same time, it's really also much simpler to understand what the company does when it's right next door.
GIBBS: Interesting that you mention Worldcom, because I want to ask, does this mean that we will see the meltdown (for local companies) coming a lot quicker than others?
RYNECKI: I think if people paid attention and they understood a little bit more about Bernie Ebbers and how he operated -- they didn't necessarily need to go into the accounting, but they could have looked at his personality by seeing him in the neighborhood, they could have understood a little bit more about what was happening with the company. I know, for example, Healthsouth, which I covered as a young reporter more than 10 years ago, was a very up-and-coming company. But even then, people in town knew that Richard Scrushy, the now-defamed CEO, was a little over the top in his ambitions. And I think that was really a telling sign that didn't come true until a decade later.
GIBBS: Well, Dave, always a pleasure. Thanks for joining us tonight.
RYNECKI: Thanks for having me.
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