Innovation, Demand and Regulations
Alger Health Sciences Fund
Author: Ticker Magazine
Last Update: Feb 04, 11:21 AM EST
|As one of the largest sectors of the economy, healthcare continues to grow driven by demand and innovation. However, the healthcare space is far from easy to navigate due to its dependence on government regulations, an unavoidable part of innovation. Teresa McRoberts, portfolio manager of the Alger Health Sciences Fund, focuses on key new products and pursues long-term growth, while being cognizant of the idiosyncratic risks in the sector.
ďWe believe healthcare is driven by innovation, demand and government regulations. That makes it a very idiosyncratic group. We look for innovation and new products that can generate alpha, because a good new product can be extremely profitable for a long time.Ē
Q: Who makes the decision to include a name in the portfolio?
There are five people in the healthcare group and we talk all the time. When team members visit a company, they send me an e-mail and call me. But ultimately it is my decision to buy the stock. If we already own many stocks of a certain risk type, I may decide not to add another one. If we want to buy a stock, we probably have to sell another. So I am the person who makes decisions about portfolio structure.
The firm has people with deep and broad knowledge of the space and thatís extremely important. All these people have worked together well for four years; that team is a big asset for the fund. In a highly regulated space with a lot of history, the experience and the knowledge are crucial.
Q: What is your research process?
We spend a lot of time focusing on fundamentals and new products, because it is important to evaluate how these products will be received. We also follow the changes coming from Washington that might be positive or negative for a company. Itís an area with a lot of change.
On the other hand, once a product is approved, the patent lasts for 10 or more years. So, there is long patent life plus the barriers from regulatory approval. These barriers mean that once you have a successful new product, you are not going to get competition for a while and itís going to be reimbursed. Thatís why when a product works, it can be a very positive, long-term trend for a company.
We also look at valuation and the real question is about earnings and the quality of the product. For products we really like, usually Wall Street may not be as optimistic as we are, so the published earnings numbers are usually too low. When there is a successful new product, companies beat their numbers with great regularity. So, even if a stock looks expensive, we have to reflect what we really think is going to happen to this company, not just the Wall Street estimates.
Equally important is risk-reward, because if the data doesnít work out, the stocks can go down by a lot. Also, there are litigation concerns. One of the biggest companies in the space recently declined 10% over a concern about a potential product liability issue. That is not the first time litigation or a concern about a product has caused a large company to have a big hit, so we always have to be cognizant. Small biotech companies can have highly volatile reactions to news Ė success can mean a stock doubling fairly quickly, but disappointment can mean a drop of over 50%.
So on the small-cap side binary risk must be managed carefully and we generally limit our stock exposure at 30 to 50 basis points to mitigate that small stock binary risk. We have to evaluate each situation to make a decision and we have to be prepared to deal with different situations in a highly regulated space. Of course, when it works, itís a very positive phase, but we are cognizant of the risks and we have managed to navigate them well over the years.
Q: Can you illustrate the research process with an example?
Illumina, Inc. sells instruments and consumables for genomic sequencing. I purchased it originally in 2000 and although I havenít held the stock continuously, Iíve watched the company evolve. Right now we have a big stake in Illumina. We believe we are finally entering a period when genomic sequencing is going to grow rapidly. Years ago sequencing a human genome was $100,000 then it was a $10,000 genome, but now we are down to a $1,000 genome. Soon weíll probably be at a few hundred dollar genome. There is so much information that can be gleaned from an individualís genome. That information will be turned into useful clinical data over the coming years.
The U.S. is conducting a study called All of Us, in which several million patients will be screened over the next few years. Around the world, there are 40 or 50 countries screening their population to trying to identify new information that is relevant for the health of their citizens. They are looking for information about genetically-based diseases, from cancer to heart diseases to schizophrenia to rare disease. The drug companies will be able to use these findings for their research on specific diseases and to see whether or not the treatments are helping. Over the last years we have had a handful of drugs approved for specific mutations for cancers; this is becoming more common.
Illumina has no real competition and is selling instruments and reagents to many different research groups, from the Broad Institute to the NIH; it has a big project in China. The trend has been going on for a several years and, eventually, weíll likely reach the stage when every baby is sequenced at birth, so we will know more. We have just started to see the developments in sequencing.
A few years ago a new product was launched that we believed could potentially lead to the several hundred dollar genome. We talked to customers, big and small genomic labs, hospitals doing sequencing and academic institutions. I have talked to customers from every side, including non-profit, for-profit, clinical and non-clinical customers. They all said this is becoming ubiquitous and there is demand to sequence everything.
Itís a great story and the research process is about understanding the product, the demand, the customers, how the company will bring the pricing down and how it is going to work. We spent a lot of time and energy on the idea and we are not done. Every few months we go back to research more and to see if anything has changed.
Q: Would you describe your portfolio construction process? Do you have a benchmark?
Although there are no strict rules on capital allocation, I aim to ensure diversification and to avoid taking too much risk. I examine the portfolio both bottom-up and top-down to evaluate not only individual names, but also our exposure to specific areas and to decide if I need to shift assets. I donít try to be totally balanced, but to prevent the risk getting too extreme in any direction. In smaller companies, the allocation is generally limited to 30 to 50 basis points.
Q: What is your sell discipline?
We would generally sell a stock on two occasions. First, if the story plays out, which does happen. We sell stocks when they hit our target price. Another part of our sell discipline is related to external events. Healthcare is not a static space and the entire thesis can go away because of external events like new legislation or ruling or data. Sometimes we may decide that Washington is not going to be particularly friendly to parts of our space and we may sell some of the stocks to lessen the risk. Even if we like a stock, there is an opportunity cost of sticking with it. We may come back to the stock later, when the event or the issue is over.
Q: How do you define and manage risk?
We define two types of risks in healthcare - known and unexpected. For the known risk, we can assess the risk/reward based on the data. We control that risk through position sizing. Obviously, we donít take a risk unless we believe there is a reward for it and we can size what the reward is.
In terms of the unknown, or unexpected risks, there is a possible black swan event for every single stock. If something unexpected or negative happens, we have to react appropriately. Sometimes that means selling a position, but if decide that it is a short-term event, we may decide not to sell.
Being uncomfortable with the management is a factor that could keep us away from a stock. We may also stay away from a stock if we think that we canít assess the risk properly, if the range of outcomes is too broad, or if the downside is much more than the upside. So we carefully consider all these risks.
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