A Guru of Health Stocks Sizes Up Best Bets

As manager of the $22 billion Vanguard Health Care fund (VGHCX), Ed Owens has put together one of the best records in the business. The fund’s average annual return of more than 17 percent since 1984 is tops among health care funds. This year, Owens is having a harder time, with the fund down 29 percent. But with his health care picks holding up better than the overall market, that still beats the 42 percent decline for the S&P 500.

Senior writer Dyan Machan sat down with Owens, 62, in his Boston office to find out where he sees health care stocks going next.

SmartMoney: Health-care stocks have underperformed in the past five years. Just recently they moved up. What gives?

Owens: A flight to safety. With the panic selling, the sector becomes a short-term safe haven.

SM: What is poised to do well even when there isn’t panic-driven buying?

EO: Forest Laboratories (FRX) is selling at seven times earnings because its $2 billion antidepressant, Lexapro, is going off patent in 2012. But it has six treatments in development to replace that lost revenue, including a drug for constipation. Constipation is a huge category with few treatments. So far it looks great.

SM: Anyone else?

EO: I’m pretty high on managed-care companies: Aetna (AET), UnitedHealth (UNH), Cigna (CI) and a smaller player, Coventry Health Care (CVH). They were all blasted when they undershot 2008-09 earnings estimates that were too high. But it’s hard to imagine the government offering universal coverage without their help.

SM: And you like smaller biotech firms too?

EO: Vertex Pharmaceuticals (VRTX) has the first drug for hepatitis C that directly attacks the virus. But it’s one to two years from being on market. Amylin isn’t profitable, but it has two drugs for type 2 diabetes on the market. OSI Pharmaceutical (OSIP) gets a roughly 2 percent royalty for a diabetes drug sold by Merck, and it also has a cancer drug marketed by Genentech (DNA). And Onyx (ONXX) has a cancer drug with Bayer as a partner.

SM: What’s down the road for health care?

EO: Science is on the verge of breakthroughs in a couple of categories, and I expect there will be another period of outperformance that could last for most of this decade. I’m most excited about Alzheimer’s. More than 10 percent of people over 80 years old will get Alzheimer’s. That could translate into $10 billion to $20 billion in Alzheimer’s-related treatment sales. Currently Wyeth Pharmaceuticals (WYE) and Elan (ELN) have drugs in later stage trails. Eli Lilly (LLY) and Pfizer (PFE) are slightly behind.

SM: That’s good news. So health care is in great shape!

It’s not perfect. You have a cluster of big companies falling off a patent cliff in 2011-12. Most drugs have a 10-year life span and normally there are constant, rolling replacements. Not this time, however. The Food and Drug Administration has not been approving the replacements. So while the demographics are good until 2025, we’ve been in an anxious period because of 2011-12.

SM: The FDA is a pit bull?

It’s a big concern. The agency is slowing the growth of pharma companies right now. Holding back Schering-Plough’s (SGP) anesthesia drug, sugammadex, in August is an egregious example. I’m optimistic the pendulum will swing back the other way. Without this FDA impediment, P/E ratios would be a couple of points higher for drug companies. That would add 10-15 percent to share prices on the large companies. For smaller companies, it’s even more dramatic.

SM: You have a very good track record as a portfolio manager. But don’t some great stocks get away from you?

My specialty is missing good stocks. I have a token position in Johnson & Johnson (JNJ). My worst mistake in the last 12-24 months was not owning a lot of it. I missed Amgen’s (AMGN) big growth period in 1990s, a real sore point for me. But you don’t have to catch everything. Don’t have to be 100 percent right. You don’t need to be right much more than half the time if your trading costs are low.

SM: What’s another secret?

My mother told me buy low and sell high. It was a family joke and a naïve statement, but completely filled with truth. You have to get ahead of the curve to see the products in development that will change a company’s trajectory of growth. What we do best is to know ahead of time when the outlook will change and then we act.

SM: Can you give an example?

We bought OSI Pharmaceuticals long after it made a horrendously stupid acquisition buying Eyetech three years ago. OSI was crushed. We invested in a stock that had been $50 a share at $25 a share. We think it’ll do just fine because the diabetes drug it makes in conjunction with Merck will continue to do well as will OSI’s own cancer drug.

SM: Do you need to know more medicine than a doctor?

I know medicine from a different angle than a doctor. A doctor looks at a person and figures what he has. I have broader knowledge from a higher level than most doctors. I’m in a better position to predict what a doctor is going to do than he is.

SM: Where do you get your information?

EO: We meet with five managements a day. I will talk to companies’ chief scientists, and we read all of the top journals. Then I browse another dozen.

SM: Like what?

EO: I can’t think of them. [Smiling] I’m becoming one of my Alzheimer’s patients.

This article from the November issue was updated for online publication on October 28.