Q: What is the history and core mission of the fund?

I have been managing the Alger Health Sciences Fund for four years.  It has been managed as a diversified fund since its inception in 2002. Our core mission is to deliver the best performance possible for our investors, so the fund does not hug its benchmark. Within healthcare, there’s usually a subsector that is doing better than another subsector, and we tend to gravitate towards it.

We 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. Over the years, we have seen many instances where a new product was expected to generate $100 million or $200 million, but turned out to be 10 or 20 times bigger. 

Even in the 2000-2002 bear market, some healthcare stocks did extremely well – actually going up. We search for healthcare stocks offering an innovation that patients and/or physicians will value. If someone has found a new way to meet the demands of patients and doctors, that is usually a good business. So, healthcare is a great place to find alpha and deliver superior performance, but given the complex nature of healthcare, an experienced manager with deep knowledge of both the financial side as well as the regulatory side is essential. 

Q: Why should investors consider the healthcare sector?

Healthcare is a core sector of our economy, comprising 15% to 18% of the GDP. As a nation, we spend a lot of money on healthcare and demand is a major driver. Demographically, about 10,000 people a day age into Medicare. That trend has continued in the last four or five years and will continue for another four or five years.

As we age, we use more healthcare, so demand is driven by demographics. There is a growing demand in the emerging markets as these economies develop. In addition, the Affordable Care Act, or Obamacare, gave access to subsidized health insurance or Medicaid to approximately 20 million people in total. With access to health insurance, more people are accessing healthcare. 

The demand is always there; the question is whether it is affordable and accessible. Over the last few years demand has increased and, as a result, the innovative products are doing better. I doubt that we will take away Medicaid from all the people who have gotten it through the ACA expansion. Overall, healthcare is too big and important to be ignored as an investment area.

Q: How important is the regulatory environment? Is the government a friend or a foe?

Washington can be a friend, a foe, or a non-factor. When there are no major regulatory changes, it can be a gentle background noise, an administrator of product approvals and Medicare payments. But at times the noise in Washington is quite loud.  The healthcare sector had a period of underperformance while the ACA was being debated by Congress and early in implementation. , but once it was settled and investors understood the significant increase in the access to healthcare products and services, the ACA actually had a positive effect on the stocks.

The FDA has been very positive for the industry. In 2018 it approved the greatest number of new products in its history. The FDA is very forward-thinking in terms of streamlining approvals and are trying to be efficient in communicating approval requirements, because they want new products out to patients quickly. Many stocks had positive stock performance because of the rapid FDA approvals of their products and we expect this to continue to be a positive for the next several years.  

On the other hand, the president has been critical of the pricing of pharmaceutical products and has proposed some new regulations to address pharmaceutical pricing. It is not easy to find the political balance between not scaring away investors in risky pharmaceutical development projects while trying to give patients and physicians new treatment options. Over the coming years, I expect that we’ll experiment with approaches to balance the conflicting demands of lower prices while continuing to innovate to help patients. Right now the news from Washington is not as disruptive as during the time of the ACA, when people were talking about restructuring 16% of the GDP.

Q: What core beliefs drive your investment philosophy?

We believe that healthcare is a growth area, driven by demographics and innovation. As long as illnesses need treating, curing, or better therapy, the growth should continue. I believe that healthcare is a long-term growth area and demand will continue to increase.

We differentiate ourselves by our long-term focus and the focus on new products. I invest only where I believe the new product is working and the story is intact. Healthcare is a diverse sector with many areas, but this is a growth fund at its core. In healthcare, growth means that we are helping somebody feel better. The sector is not just about the money; it is about helping someone feel better, live longer and have better quality of life.

Q: What are the key steps of your investment process? How do you generate ideas?

It’s rare to come across a name that I don’t know, because we have owned almost every major stock at some point. We are familiar with the core drivers of each stock, so our interest in a name can be prompted by new data or changing Washington regulations that we think is important for the stock.

The core factor is whether an event would lead to a change in the company’s fundamentals. Product companies go through clinical trials and FDA filings, so there are many public data points along the way. That allows us to refine our view and to carefully consider our investment. The same is true about the service companies, which are affected by Washington’s decisions. Given politics, many things that can happen in Washington and we must understand them.

The process really starts with understanding the positive drivers behind a stock. That usually is an event that we believe will make people excited. Some of our most successful investments have been in stocks that people were not focused on yet. We can be a little bit more patient and focus on things that are coming in years and potentially make outsized returns once the excitement comes.

Q: Do macroeconomic views influence your process?

We do look at the macro picture, although our process evaluates one company at a time. When the economy is slow, healthcare can be a defensive area, so I may want more of certain types of stocks. I understand that certain sectors work better in specific markets and I try to overweight them when appropriate. For me, the macro aspect is not just the economy, but also the political environment and the risk appetite, because the risk appetite drives the willingness to invest in biotech.

Q: What other factors have an impact on the team’s due diligence process?

Our analysts are focused on their individual subsectors. For the stocks that we own, we visit the companies in their offices several times a year. We also see them at conferences and listen to conference calls.

However, talking to the companies in this space is not enough. We also spend time at medical meetings and on Washington regulation to understand what might happen.

Recently one of our companies had impressive data. At the end of the presentation at the medical meeting, probably 5,000 doctors in the room stood up and applauded. That’s not a usual reaction and, therefore, we knew it was important data that was well received by the medical community. The first line of product approval is the doctors. We also listen to FDA panels when they review a new product that is being considered for approval. We have to invest that time and energy to understand where the product or service will fit when it comes out.

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 that’s 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. It’s 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 it’s going to be reimbursed. That’s 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 doesn’t 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 – 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, it’s 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 haven’t held the stock continuously, I’ve 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 we’ll probably be at a few hundred dollar genome. There is so much information that can be gleaned from an individual’s 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, we’ll 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.

It’s 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 don’t 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 don’t 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 can’t 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.