Larry Feinberg, founder and president of Greenwich's Oracle Investment Management, has a simply fabulous record as a health sciences investor. Isn't used to coming in second, much less losing. No way, no how. So finding his funds under water last year for the only time in his career was nothing Larry enjoyed – or intends to repeat. His trading foibles now deconstructed as thoroughly as the basic research behind
his biotech and medical technology favorites, Larry is as committed as ever to companies-profitably-bringing leading edge bioscience to market. But he's a lot more attuned to pragmatically trading their shares, long and short, while waiting for a "rational" market.
What's he buying and selling? Read on. – KMW
What's new in your sleepy little corner of the business?
Sleepy! The entire business of "hedge funds," particularly in my arena, which is health care, has changed very dramatically in the 15 years since I started doing it for Odyssey Partners. Oracle Partners has been a standalone now-this is our 11th year. We have compounded at a 27 percent annualized rate of return-and that's after a little bit of a hiccup last year.
A little?
Okay, our first-ever losing year. I clearly underperformed for the first time in our 15-year history. Which is why we made some adjustments as a firm about a year ago – to address changing market conditions. It wasn't fun, but it was a learning experience – and what we learned was discipline. In the process, I reviewed what we're good at and what we were doing wrong. What we do right, unlike many of the so-called hedge funds out there, is that we are investors. This is a foreign concept to many people who have been involved in the market for the last several years, but we actually do invest based on the underlying fundamental trends level.
You're still fundamentally a smart aleck-
Surely you're not surprised. My point is that we are not speculators. Still, the major difficulty we ran into last year developed because I didn't respond quickly enough. The world has become a much different place for investors. We have always been very successful at finding trends at the industry level and at the sub-sector level, in generic drugs, HMOs, biotech or whatever-and then investing in the best companies and shorting the worst in those areas. What we didn't have previously was a discipline about when to take profits on the upside and when to stop losses on the downside that was appropriate in a highly volatile market environment. But we learned. When you have a tumultuous market, like we had not only on the way up in 1999-2000, but on the way down in '01-'02, you learn a lot.
You're telling me discipline is the difference?
Right. I still have seven investment professionals working with me, focusing on buying the best fundamental sectors and companies in health care and shorting companies that are sick or have bad business models or drugs that don't work. But we've realized that we are not as smart as the stock market. So when the market tells us we are wrong, we sell. The proof is we are up over 60 percent year-to-date and we've had just one down month in the last 12, since I put this new risk-management program into place.
Okay, tell me why you're different.
Experience, first of all. I started investing long and short in healthcare in 1989, when almost no one else was doing this. Now everybody is doing it, or trying to. But No. 2, we are not structured to be market neutral.
Haven't you been paying attention? That's what investors are supposed to want.
Well, put it this way: My answer to the inevitable question about whether we're market neutral used to be, "What, are you kidding?" Now my response is a little more measured: "We are not. We look for longs we can make money in. And, in every short position we take, we also look to make money-not just to hedge our long positions." But I have made one other adjustment in response to what we've been hearing from our investors, believe it or not: We actually started a more conservative fund at the beginning of September. It is called Oracle Global Healthcare. My head trader is co-managing it with me. We are using the same positions; we are just running a much less exposed portfolio. It never uses leverage. It is never more than 30 percent net long. It stays anywhere from 30 percent net short to 30 percent net long, making it a more conservative product, which is what I think institutional investors and more conservative high net worth investors are focusing on today. Personally, I don't necessarily believe it is the right vehicle for everyone. We are finding so many great investments that, with our new discipline in place, I personally still love having the flexibility of taking substantial positions- up to 10 percent of the portfolio -in my flagship hedge fund, Oracle Partners. But in this new fund, we won't put more than 5 percent of the portfolio in any position. But we haven't changed our focus and that is on fundamental research. We do our own work. We like to read Wall Street research, to hear what they are saying-because we typically do the opposite. That is not always true, but we do find that there is a tremendous amount of misinformation in the world-which creates very attractive buying and selling opportunities for us. For example, a few weeks ago, Morgan Stanley made a proclamation about what they believed a very important piece of data from a clinical study would show about Boston Scientific's (BSX) new drug-eluting stent.
Didn't think it would very favorable for the company, as I recall.
And they were totally wrong. But Boston Scientific's stock dropped approximately 20 percent on that forecast. We took advantage of it to establish a substantial investment position in the company. The stock is up about 25 percent since we bought it, and it should go substantially higher.
Didn't you own BSX before then?
We had invested in Boston Scientific about a year ago as their position in drug-eluding stents started becoming more visible to us. We actually bought the stock at 15. But we sold most of our stock around 50. Then it ran up to the high 60s before pulling back into the 50s again, with Morgan Stanley's help. So we bought a very large position in it again, when the stock sank on what has proven to be that very inaccurate information.
To be fair, there was a lot of skepticism about Boston Scientific's stent.
It was incredible. At a healthcare conference just before this data came out, I was told by basically every analyst on both the buyside and sellside that the data were going to be no good and that Johnson & Johnson's (JNJ) rival product had superior test data. Which was funny, because our research – which included talking to everyone involved – indicated that the Boston Scientific's data would be basically similar to what came out of what was called their TAXUS II study, which was similar to a Phase II. That wasn't a huge study but it was fairly large. We had no reason to believe the results of Taxus IV would be different. The clinicians said they had no reasons to believe the results would be different. The company had no reason to believe it would be different. And, in fact, it wasn't a lot different. Only Wall Street believed it would be different. But that created a tremendous opportunity for investors like us who do basic research. Actually, the proliferation of hedge funds in healthcare only seems to have encouraged a tremendous herd mentality.
Hasn't it also created some awfully crowded trades?
Sure, but there's no avoiding it. The information flow in the whole market is different. Back in 1980 when I started at Dean Witter as a health care analyst, I followed the major drug companies. When they reported earnings, it would take me two days to run a spreadsheet on our antiquated Apple II computers-but we were the only sellside research department that had personal computers.
So you're trading more-have become short-term-oriented, like everyone else?
Well, we still take core positions when we really believe in something. For instance, that very large position we recently bought in Boston Scientific again. But we do trade around the edges. I set stop-loss levels and target levels. We have a fundamental six-month target. We have a short-term target. We have a short-term stop-loss level, where we start selling. And if it keeps going down, we will just blow it out. This year in particular our greatest success has been to limit the damage in short positions that didn't work because they got so very crowded. So some stocks do get very crowded on the short side; sometimes literally half of the shares that actually trade are short.
Why not just bail out of shorts that draw a crowd?
It really depends. You've got to gauge investor sentiment. You've got to get a reading on who are the shorts, how big the short positions are, how badly you believe the company is fundamentally flawed. If we believe a product doesn't work or a business model is fatally flawed, we will stay short. But we will try to protect ourselves with options strategies if it starts to go up against us. Only when a short starts working will we actually press our position.
You could do a lot worse.
Absolutely. It's just such an effective strategy. Take for example the major drug stocks, which have been out of favor for a long time now. Pfizer (PFE) recently traded down, based on a spate of bad news, including the launch of AstraZeneca PLC's just-approved Crestor, the first real viable competitor for the world's largest-selling drug, Lipitor, Pfizer's cholesterol-reducing agent.
No minor event, that.
No question, Lipitor contributes a lot of sales. But is not the company. And there are some toxicity issues with Crestor. We don't believe it has as clean a profile as Lipitor. And yes, Viagra will have competition. What a shock. Pfizer does have a pipeline, has a lot of new products coming. We got interested as the stock traded down into the high 20s. It was effectively selling at 15 times next year's earnings-at a 20 percent discount to the market. But instead of going out and buying a large outright position in Pfizer, we bought a substantial option position several months out, in the Pfizer 30 calls. Now, the stock has bounced back above 30 and the position is starting to work. So we are actually buying the underlying shares. But we established our exposure with a very low-cost strategy, to minimize the pain, if we were wrong. Options for us are risk-management tools, allowing us to establish long or short positions with only a minimal dollar exposure.
You clearly don't want to scare away investors with more red ink-
For the first time in my career, my fund is in the doghouse a little bit. And it's not something I've enjoyed. Our bad performance last year – and the volatility related to it – are not what institutional investors are looking for in hedge funds. Most large institutional investors were absolutely traumatized during the massive bear market of 2000, 2001, 2002.
Yours has been one of the best-performing sectors this year.
Only parts of it. I don't have the numbers right in front of me, but the major drug stocks have to be down for the year. Granted, the biotechnology sector is up 40 percent 45 percent year-to-date. But we are still finding some tremendous values even there. That is our power alley: focusing on companies that we have known for many years that the Street generally doesn't understand correctly. Then there is merger and consolidation activity, new management teams. We look for changes like that. We visit these companies and get pretty close to their strategy; get a good idea of the underlying earnings power.
You're not taking marbles off the table in biotech?
In biotech in particular, everybody is saying it is too late. I agree it is very late in the game just to buy the biotech index, at least on a short-term basis. But over the intermediate term, the game is still just in the early innings for companies like IDEC Pharmaceuticals (IDPH), which is merging with Biogen (BGEN).
That is not a consensus view.
Look, IDEC was a darling of Wall Street for many years-it was one of our great stocks in the late '90s. We made over 10 times our money on it. Owned 10 percent of the company at one point. But we have been out of the stock for several years. They have a dominant drug in cancer called Rituxan. About a $1.5 billion drug that is still growing 30 percent-40 percent a year. It is starting to slow down a little – but not much. The real issue is the merger with Biogen, perhaps the most widely hated company in the biotech industry.
How come?
It is viewed as a company without growth prospects. We couldn't disagree more. Biogen's primary drug is Avonex, a beta interferon used for multiple sclerosis. It is the dominant drug in the marketplace. They have a 40 percent-plus market share globally. Competition is growing, particularly from Serona SA, the Swiss company. But Avonex sales still grow five percent -10 percent a year. It is a $1.1 billion drug this year. Hugely profitable- which is what is so great about the drug business and the biotech sector. The combined IDEC/Biogen will have dominant positions in cancer and in neurology, or in MS. And Biogen has also launched a new biotech drug, Amevive, to treat psoriasis. Nobody is exactly breaking the door down to get it, but it has the potential to be a $300-$500 million drug. More important is another new Biogen drug that Wall Street just seems to be neglecting. An anti-inflammatory, called Antegren. Biogen and Elan Corp. (ELN) have established a worldwide, exclusive collaboration to develop, manufacture, and commercialize Antegren, which is a humanized monoclonal antibody that recently completed Phase II clinical testing for multiple sclerosis. We believe it will be the next big, big product for multiple sclerosis, potentially a multi-billion dollar drug.
Won't it cannibalize Biogen's sales of Avonex, then?
That's an interesting question. It looks most likely that it will be used in conjunction with beta interferons. And the only one that it has been in a clinical study with for the last several years is Avonex. So if Antegren is a breakthrough new drug and if it does work best in conjunction with beta interferons, it could actually boost Avonex sales. The other beta interferons, from Chiron (CHIR) and Serona, are going to be several years behind in doing their clinicals for that combination therapy. In fact, Antegren could really lock up this franchise for Biogen. And, if it does turn out that Antegren is effective as a standalone, it will take share from everybody, not just Avonex. So yes, the Avonex franchise would shrink. But the Antegren franchise would grow to multiple billions of dollars, more than making up for it. And there are other indications for Antegren. It's amazing, but one of the explanations I've heard people give for being negative on this IDEC/Biogen deal is, "There is no pipeline." As I said to the chairman of IDEC the other day, "Yours is the only company I know with a potentially multi-billion dollar drug that people think has no pipeline." Granted, further down the pipeline, it doesn't have a huge array of new drugs, like Genentech (DNA), but this merger is creating the No. 2 or No. 3 biotech company in the world in terms of revenue base, in terms of critical mass. There will be at least $300 million of cost savings to be had by putting the two companies together, just on the SG&A side. That's what the companies are saying. My sense is that when this deal closes, they actually will have discovered more than $300 million in savings. Maybe their guidance will be raised. For next year, we are looking for $1.60-$1.70 in earnings as a minimum. That is a base this company should grow at 20 percent-25 percent with their existing product line. When you add in a blockbuster like Antegren, the numbers could really take off. I know this is a 60-70 stock in here, but it still has a chance to double in a rational market.
Have you seen one of those lately?
Clearly not. The biotech index is up 40 percent-45 percent year-to-date and IDEC is only up a tiny bit, maybe five percent. It really hasn't participated. People simply don't like the deal.
What got you interested?
We started sniffing around after the deal was announced. I've always thought Biogen was a tremendous asset, but under-managed, spending huge amounts on research and development. When I look at biotech companies, I look at their products and their sales and at how much they are spending in R&D. Our earnings estimate for next year for IDEC/Biogen, assumes 30 percent of revenues go to R&D. So its actual earnings power in traditional drug industry terms is actually 50 cents to a dollar a share higher. (Major drug companies spend about 10 percent of sales on R&D.) This is a tremendously undervalued asset. They are going to be acquiring and growing and doing all kinds of exciting things. Besides, I love companies that everybody hates because there is nobody left to sell. It is a strange phenomenon I've discovered over the last 25 years or so-
Tell me again why most analysts have turned their noses up at the deal?
Their hangup is that the rapidly growing company, IDEC, is buying a slower growing company. Wall Street hates that. But IDEC management is saying , "Hey, we have just one drug powering this company. It is great, but eventually it is going to slow down. Biogen is slower-growing right now but it has the potential to really pick up. The two companies together have tremendous critical mass, enormous cash flow and a proven, brilliant R&D team. One of the lessons I have learned over the last 15 years as one of the largest investors in biotech – and one of the more staunch supporters of the breakthroughs that are coming – is that the way to invest in biotechs still in clinical trials is private equity. You don't get rewarded in the stock market for taking risks in biotech.
What do you like, besides IDEC/Biogen?
Another biotech that has underperformed very dramatically this year. It is just a fabulous company, even if a very controversial situation: MedImmune Inc. (MEDI).
Then why MedImmune?
Its big drug, Synagis, was the first monoclonal antibody successfully developed to combat an infectious disease. It is used to prevent a serious lower respiratory tract disease caused by respiratory syncytial virus (RSV) in babies. It has become close to a billion-dollar drug and continues to grow. MEDI also has other products that are doing well. The big new story-and controversy-is over their nasal spray flu vaccine. They just got FDA approval to launch FluMist, and put ads in places like the Wall Street Journal. Everyone is short this stock because no one, according to Wall Street analysts and according to numerous short sellers, would possibly pay $50 to $55 for a spray flu vaccine when you can get a shot for $10 or $15.
Except true needle-phobics.
Well, not necessarily so. A major trend in healthcare is what I call consumerization, consumer-driven healthcare. More and more of the decisions are going to be made by you and me because insurance companies aren't paying for a whole range of things. That is already happening. It is a reason we are seeing a slowdown in utilization, seeing more drugs going over-the-counter. The government is pushing it. So yes, people are needle-phobic. But we've been having discussions with MedImmune and their marketing partner, Wyeth (WYE), previewing their marketing programs. We are going to start seeing ads on TV in the next few weeks that are going to change people's minds about whether they are going to use FluMist. This is a direct-to-the-consumer sale. Wall Street analysts are surveying doctors and (surprise!) the doctors are saying, "We are not going to use this." Well, they probably aren't. Because the people who are going to administer FluMist aren't going to be doctors. FluMist is going to be distributed primarily through drugstores-permitting pharmacists to regain some standing as an important component of the healthcare delivery system. That's how it was when I was a kid growing up in the drugstore business.
Your pharmacy degree isn't biasing your view, is it?
I never was a registered pharmacist, but I started working in pharmacies at age 13; later on actually ran a small chain of pharmacies backed by my family. My dad was a pharmacist and the president of the Vermont Pharmacy Board. I came to New York to get an MBA because my girlfriend (who is now my wife) was going to law school here. Then I was supposed to go back and run the pharmacy business. But I fell in love with the stock market, so we stayed. Anyway, people used to go to drug stores and ask pharmacists for health care advice. FluMist could be the leading edge of a sea change with people going to a drugstore for the flu vaccine.
That could be more convenient than trying to schedule an appointment with a doctor, but if FluMist costs three times as much as a shot in doctor's office-
That's the real issue. Are people, in an economy that has been through a bear market and a recession, going to pay $55 for a shot that costs $15? My 7 ? year old daughter is going to be getting FluMist because last time I took her in for a shot it was like the world was ending. It cost me more than $55 in ice cream cones afterwards.
Only in Greenwich!
Because of the price disparity, my gut feel was that FluMist wouldn't fly-until I saw the ads, until I saw how many people are afraid of needles, until I realized that only 10 percent of the U.S. population has even bothered, historically, to get a flu shot. And until I recognized that the flu is a huge cost center for insurance companies and managed care providers. What is starting to happen is that insurers are stepping up and saying they'll pay for FluMist. The approved target market for FluMist is people between the ages of 5 and 49. That is something like 150 or 160 million people. And the market will grow as they prove its safety and efficacy for infants and the elderly.
I do so appreciate being lumped in the latter category!
Sorry! But my point is that right now, about 10 percent of the target market, or 15 or 16 million people in this country have insurance coverage for FluMist.
Thanks, Larry.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co., L.P., Greenwich, Conn. http://welling.weedenco.com