Q:  What is your investment philosophy for running the fund? A: Sectoral Asset Management, the sub-advisor of the fund, is focused on biotech and healthcare investments only. At this point, we focus on biotechnology and the large-cap pharmaceuticals, generics and specialty pharmaceuticals. The firm is entirely bottom up in its research process and has a fundamental investment approach. The specific focus of this fund is the biotech sector, although tactically we can invest in pharmaceuticals – meaning large cap pharma, generics and specialty pharma. Q:  How do you select companies within the biotech and pharmaceutical areas? What gives you an edge in that area? A: Biotech and drug-development healthcare is a very complex field. Specialization is a prerequisite to invest because of the complexity and the heterogeneity of this area, and because of the difficulty in bringing a drug to the market. You need to focus deeply on that process; the research requires an in-depth analysis, which gets you to primary research and analyses of drug prospects and their mechanisms of action. Also, our long-term experience in this sector gives us an edge. S.A.M. has a 12 year audited track record in biotech investing. We do a lot of company visits and speak with company managements, chief executives, and chief scientific officers to get a sense of how they approach drug development to address a particular disease. We also have a scientific advisor network of experts from around the world that helps us in that process. Another important characteristic is that healthcare is internationalizing and there is great research taking place both in the U.S. and outside of the U.S., so a global approach to investment is necessary. I believe that those are the key elements that give us an edge. Q:  Could you describe the trends in healthcare that make it an exciting area for an investor? A: First, there is an aging population in the U.S., in particular. As you get older, your requirements for medical intervention go up and drug utilization increases. The need for innovative treatments is quite significant. Those are fairly important long-term trends that underpin the biotech sector in particular. I think that oncology and virology are two areas that are attracting investors’ attention right now. In oncology, a number of years ago, Genentech announced its results on Avastin for colorectal cancer and since then, some other companies have also showed promising results in novel approaches to the treatment of cancer. These new approaches attack particular and specific processes of cancer in a targeted way. When I speak of novel approaches, I don't mean the standard, dirty chemotherapy drugs, but so-called targeted therapies which attack particular steps in the process of cancer. In virology, HIV treatment would be a good example. Over the last few years, we've seen some great rationalization in HIV drug regimens and now we're beginning to see the development focus shift towards new ways of treating HIV. There is also the treatment of Hepatitis C, where novel approaches are being developed. We've seen some fairly significant breakthroughs in both areas over the last few years, which have given us confidence and comfort with regard to the treatment of those diseases, but there is still a lot of work to be done. Q:  Are there scientific breakthroughs in oncology that are being commercialized? A: Yes, it is the advent of targeted therapies such as Genentech’s Avastin (a monoclonoal antibody against VEGF) and Imclone’s Erbitux (a monoclonal antibody against the EGF receptor). Chemotherapy is not going to vanish as a treatment, but we're seeing the evolution of therapies targeting particular parts of the cancer process. In that way some of broad-base side effects of non-targeted therapies are avoided. Of course, there is a lot of work to be done; cancer is quite a heterogeneous disease and we're by no means anywhere close to curing it. Q:  Could you attach a market size to the breakthroughs in oncology and targeted therapy? What would be the potential revenue or the number of users? A: Genentech’s Avastin is approved for first line colorectal cancer. Imclone’s Erbitux is approved for colorectal cancer (in those individuals that have failed irinotecan, a chemotherapy) and head and neck cancer. In the US, there are about 145,000 colorectal and 60,000 head & neck new cancer cases each year. Q:  How does investing in biotech differ from investing in pharmaceutical stocks? A: The risks, and hence, the rewards of investing in biotech stocks are much greater than investing in pharmaceuticals. Biotech stocks are typically much smaller in size and much earlier in company evolution. Large pharmaceuticals typically have many products on the market (selling billions of dollars worth of drugs) and they have well-developed sales organization and R&D engines. Many of them are fairly diversified in terms of therapeutic areas and are involved in different disease types. On the other hand, biotech companies (especially the mid and small-caps) don't necessarily have drugs on the market. If they do, it may be only one or two drugs, but in general, they don't have revenues or sales infrastructures. The bulk of their energy is spent on bringing their first or second drug to market. Another interesting difference between the two sectors is the type of drugs they develop. Pharmaceutical companies have traditionally developed chemical drugs for which generic companies can easily create generic, low-cost versions. From a scientific and chemistry standpoint, it’s a fairly simple and straightforward process. Biotech companies tend to focus more on the biologic drugs, where it is almost impossible at this point to create generic copies because the science to do so doesn’t exist. “Biologics” are the proteins within the body that may be modified; it's the antibodies that have been tweaked to address a particular disease target, etc. Creating generic versions of these drugs is still largely uncharted territory. Although generic companies are moving in that direction, it is still far away and that's a fundamental difference between the pharmaceuticals and the biotechs. Q:  How many stocks do you follow in each of these sectors? A: There are probably about 800 listed healthcare companies worldwide: 15 major pharmaceuticals excluding Japan, 600 biotech companies, and 160 specialty pharma and generic companies. That's the worldwide universe which we boil down to about 150 or 200 companies. In constructing our universe, we first make sure that the blue chips and the main index components are there and the rest is from our internal research history. Although numerically we cover 150 to 200 companies from a total of 800, we cover about 80% of the universe in terms of market cap. Q:  Does that mean that you'd invest anywhere in the world? For example, do you see an investment opportunity in Israel, Ireland, or India, where companies have had some breakthroughs and some legal challenges as well? A: The firm has a global approach to investment. The industry is structured in such as way that 60% of the health care is in the U.S., 20% is in Europe, and 20% is in the rest of the world. Not having a U.S. focus is obviously a bit difficult. We follow the areas that you mentioned and the fund is able to invest there, so yes, it is an investment opportunity. Q:  Could you describe your research process? How do you collect and analyze the information and prioritize the stocks that you select? A: The first step is idea generation and this can come from many places For example, ideas come from our scientific advisory network, which keeps us abreast of what's occurring in their therapeutic areas. Speaking to companies can also be a great source of ideas - not only from a companyspecific perspective - but also from a competitive perspective. Scientific literature also gives us potential investment candidates. This is followed by a screening process. When we conduct due diligence on a particular company, we look into scientific questions like the particular drug targets that they are addressing, the type of drug being developed, are the drug targets validated or not, etc. We also conduct management visits at this point. It is an in-depth research process and in the last year we conducted about 300 company visits through on-site visits, broker conferences, or in our Montreal offices. Then we forecast the prospects of the particular drug based on disease prevalence, expected usage rates and prices, and this feeds into company valuation. Then, if something is undervalued, we'd take a long position and if it is overvalued, it would potentially be a short position. Q:  What kind of metrics do you use for the valuation of the biotech companies? A: It depends on the segment of the biotech sector you are looking at. We divide the industry into three groups. In the large-cap area, these are the companies with market cap of more than $5 billion, with products on the markets, sales force, and profits. We typically analyze those companies based on earnings. The next group is the mid-cap segment (companies in the $1 to $5 billion market-cap range), which we consider to be our sweet spot. Typically, these companies are in the last stage of drug development, or Phase 3, which involves efficacy studies. A great part of the drug development risk is behind them because in Phase 1 and 2 they've already passed the safety and the dosing studies, which determine if the drug is dangerous, if it has side effects, etc. These companies obviously don’t have sales as they are either in the last stages of drug development or in the early stages of marketing, where the operating expenses exceed the sales. We value these on price to future sales metrics. The final group is the small-cap companies, with market cap of less $1 billion. These companies are early in the drug development cycle and to value them, we have to assess the technology value in and above their assets. Q:  In your opinion, what mistakes can a fund manager make when investing in this very difficult segment? A: I think that the biggest risk is clinical development risk. Statistically, one of every 5,000 drug candidates makes it to the market, so the risk of failure is quite significant. That's why a broad-based approach is not the optimal way of investing in biotech; you need to be quite selective. We run very concentrated portfolios; Quaker Biotech holds anywhere between 25 and 35 names. There is some diversification benefit, but also careful selection of investment candidates is paramount. We like to call the Quaker Biotech fund a “best ideas fund.” Q:  What is the average turnover of the fund? A: Turnover can be high, maybe about 100%, because biotech is a volatile sector that is rapidly evolving. The turnover is a function of the positions that we build and whether investments played out or not. It's a very news-driven sector, where drug prospects can change quickly based on the company’s own development or the competitive perspective, so it is quite a dynamic sector where a lot can change in a short time. Q:  What risk-control mechanisms do you have in place? A: As I mentioned, the biggest risk is that of clinical failure and we control that by being very selective in our investments. The good thing about Quaker Biotech is that we go up to 25% short in the portfolio if we think that valuation is excessive or if we don’t believe in the technology of the company, for example. We can also manage the exposure within the portfolio and raise cash, so that's another important risk management tool. Q:  Can you give us a couple of examples that illustrate your stock selection process both the long and the short sides? A: Alexion (Nasdaq: ALXN) is a company focused on complement inhibition. They had two sets of Phase III results coming out over the last few months: one for CABG and one for a rare blood disorder abbreviated “PNH”. Unfortunately, their drug candidate in CABG did not work while their other one, in PNH, showed a dramatic clinical benefit in terms of reducing the need for blood transfusions. On the short side I can discuss Idenix (Nasdaq: IDIX) which we shorted after our analysis suggested that the opt-in decision of its pharma partner, Novartis (Virt-x: NOVN), for a drug candidate in hepatitis C was largely priced into the stock. As it turned out, on top of this, we were also somewhat fortunate since Idenix management announced that its higher drug doses were associated with some gastrointestinal toxicities.