Q: This fund has outperformed the majority of its peers since inception in 1999. How did you accomplish this? Lester: When we started the fund in late 1999, we had largely bet on the healthcare services sector. We had a big position in hospitals, nursing homes, and assisted living companies. That bet worked out very well. That was post the Balanced Budget Act of 1997. At that time hospitals were in a dire financial situation. It turned out that the government actually reversed some of the legislation they made in 1998 and 1997 because of the dire financial situation of the hospitals. We ended up making quite a bit of money. In 2000 and 2001, we started rotating out of our services bet into pharmaceuticals and life sciences tools, to a large degree. Most recently, we've started to increase our position in biotechnology. From inception to the end of 2002, to the best of our knowledge we were one of the best performing healthcare funds. Q: You caught a wave based upon some legislation. You got out and switched to other companies in the sector. What do you mean by Life Sciences tools? Lester: It's equipment that researchers, whether it's pharmaceutical companies, biotechnology companies or researchers at academic institutions, use to look for new drug targets, new drug-type therapies or ideas. It's the picks and shovels, if you will, used in mining for new drugs. Q: Since you rotate holdings from sector to sector, what is the turnover like? Lester: Our turnover tends to go in waves. We tend to take one to as much as a three-to-five-year bet. What you'll see is similar to what we did in 1999. We'll make a bet on a particular sector and our turnover will be lower as we're holding those names. At some point, what we tend to do is change the composition in terms of its sector make up. Recently, our turnover in the first quarter has increased again as we started buying more biotechnology. Q: One thing I am curious about is the chemicals group. Those are foreign companies. How do they fit into the Life Sciences Series? Lester: Since the rating agencies classify them as chemicals, we have to do it for our fund description. Really, they are critical parts of life sciences companies. Lonza is a company that is involved in the manufacturing of pharmaceuticals; particularly, it has some of the world's largest and most state-of-the-art biotech drug manufacturing facilities. Although Syngenta is a chemical company, it's really about agrichemcials and biotech and bioengineered gene products. Herrmann: The third one is Akzo Nobel. Again, it has about a third of the pharmaceuticals in its business mix. More than half of its value, we would argue, is derived from the pharmaceuticals business. Q: Of the healthcare providers you have two left, one is WebMD, an Internet company. Why do you like it? Lester: With WebMD, part of the business that most people are familiar with is the Internet portal site where people can access that for all kinds of information. They also end up being the back end for a number of other portal's healthcare sites. For example, if you go to America Online and you access their healthcare information, what's really behind that is the WebMD databases. The other thing that WebMD has is that they're involved in the clearing of healthcare transactions. They have a large business that does claims processing. The other area they're in is selling healthcare software to individual doctor's practices to help them manage their business. There is the belief that these guys can bring a lot of this stuff together as we move into this de-health type of environment. They're going to have a good relationship and access to all of the individuals because everyone knows that their site is the site to go to for healthcare information on the Internet. Our data shows that people use the Internet for healthcare a lot. Q: Turning to the biotechnology sector, the Dec. 31, 2002 annual report shows 11% of total holdings. Is that roughly what it is now? Lester: No, it's more than double that. Actually it's about a quarter of the portfolio. Q: Although you've doubled the number of biotechnology stocks in the fund, it is such a huge sector of more than 300 public companies. How do you keep up? Lester: What we try to do is buy the leaders. Not necessarily the biggest in terms of sales and market cap, but the leaders in a particular field. For example, we've recently bought SangStat, one of the leading companies in transplant therapies. We have certain strategies that we employ and certain screening tools that we use. What these strategies and screening tools do is direct us toward companies with leading market share positions, high barriers to entry and sustainable high returns on capital. Companies like SangStat pop up on our screens and often times those are the companies that end up in our fund. Although there are lots of publicly traded companies, by refining our searches to companies with leading positions that also have to be well capitalized, we can narrow that universe down to something that is more manageable. Q: Is the research process proprietary? Herrmann: We use information from various data sources, but the formula itself, the recipe, is proprietary. Q: How would the screening process apply to the large pharmaceutical companies in the portfolio? Are the criteria different? Lester: The same strategies are used across various sectors. In the case of the large pharmaceutical companies, again it's looking for companies with leading positions, gaining market share and you're right it's easier to manage. But they're evaluated in a similar way. We value them using various methods such as discounted cash flow. Q: You have a staff of 20 people. Do they all research companies for the Life Sciences Fund? Lester: No. That is the entire research department here at Manning & Napier. We manage other mutual funds. We also have a big advisory business. We do a lot of the more traditional pension and 401(k) businesses. We do divide the analysts into different teams, based on sectors. In the life sciences area, we have six people. Healthcare is really important to us and we want to make sure that we're staffed really well. Q: Do you rely upon outside opinions from physicians concerning the efficacy, for example, of promising drug candidates in late stage development? Lester: To some degree, yes. We talk to physicians. We go to medical conferences. In some cases, it is good to talk about a specific drug. Less often it's asking them to place a bet on whether a drug works or doesn’t work while it's in clinical testing. More often it's to talk to them about what they like about a drug or a product, what they don’t like, what they think could be improved, how they might use it, what patients they might use it on. Also, we talk to them more generally and go to conferences to try to identify themes. Q: I noticed there are no generic drug makers in the fund. What other groups from the healthcare sector are you avoiding? Herrmann: Another group that has done fairly well that we don't feel is the time to chase is the healthcare providers and in particular the managed care companies. Most of them have done pretty well. We also look at those on a cyclical basis. These companies really don't offer any differentiated product, whether it's Aetna or Cigna or one of the Blues, essentially are offering the exact same network of doctors, the exact same options. It's really a commodity. Right now, they're at a point where pricing has been very good for them and they’ve got their margins up, but the employers are looking at ways to cut their costs. Obviously healthcare is something that we have to look at very seriously. We think that we're on the verge of a major change, quite frankly the ability of employers to constantly put up with this 15% and 20% premium hikes from managed care companies. Especially when we look at their income statements and see that their costs aren't going up that fast. We think this is probably going to be the last of the fat years for these guys and they're headed back to a down cycle. We cut our exposure in the healthcare provider space, which was already low, from 5% at the end of the year, to just under 3% now. We look at where our differences are with the market right now and that is one bet that we are actively making that is so far, contrary, but one that we think is coming to pass in the long run. It shows how we're willing to move our sector weightings around into positions that some other fund managers might consider extreme, but we don't. Lester: We really don't pay attention to managing to a benchmark, so we have flexibility. We basically had our whole fund in healthcare services in 1999 and even though we're more diversified now, we're opportunistic. When we see an opportunity we'll go after it. Q: The biotechnology indexes I track apparently bottomed out in July then moved sideways throughout the remainder of the year until interest picked up in 2003. Is that interest creating net inflows into the fund? Herrmann: Most of our existing clients at Manning & Napier are advisory clients. We don't market the fund very heavily through many third parties. We're looking to change that, of course. That is the people we want to reach. Q: You told us about your research, which is fundamentally based. Do you involve yourselves in quantitative research such as chart work? Lester: Yes, we have one of those guys in our shop. We would laugh at him if he weren't right so often, so we have to listen to him and take seriously what he has to say. Herrmann: I grew up doing a lot of chart work. My original position here back in the mid-80s was working on the trading desk. One of my part-time jobs was to keep up with all the charts on our stocks. I'm chart friendly, let’s say, as opposed to most fundamental analysts, especially the ones that were trained at some business school. It's takes them a while to get over to looking at that. We don't use it for picking stocks -maybe to throw some ideas our way, charts that have some interesting looking patterns. The things that we're looking for are stocks that have gone down a lot but are building a long base and start to pick up some insider buying. That's a technical analysis type screen that we would use for new ideas. What we mainly are using it for is to tactically time when we get into stocks and we also have used it effectively to change our position sizes basically moving more money into stocks that are doing better on a relative strength basis and out of stocks that are doing less well on a relative strength basis. When we think there is a major turning point in the market like we just recently had, we moved about eight million dollars out of our under performing stocks into our better performing, better looking stocks. We try to look for better ideas all the time. Q: How do you respond emotionally to the hype that constantly surrounds this sector? Lester: We've found that technology advancements tend to happen along a linear or exponential track. The public's fascination or the media's coverage or the investment community's appetite and enthusiasm for biotechnology tend to have cycles. Being a value oriented investment firm, you might imagine that we tend to increase our exposure when media coverage is low. We're cognizant that at certain points the excitement takes prices to the point where the valuations are unjustifiable. Herrmann: We try to take advantage of that. We stay away from a sector when there is a lot of hype about it. At lot of times we think that there is hype that ends up being real. A great example would be the genomics tools companies that we talked about. Human Genome was on the cover of Time magazine. Affymetrix and ABI were trading at 150 dollars a share. Everyone said they're going to change the world. The growth rate sequencing was going to be 30% a year. That wasn't true. But now, you're finding the other extreme. People are saying it's a big fad; sequencing is going to be a big zero. We don't think that is right, either. Yet the stocks are down 85%. We think that if you take a longer horizon, there is definitely going to be a change in the way drugs are discovered and the way clinical trials are done. Genomics is definitely in a direct collision course with drug development. It's going to change dramatically in the next ten years. These are the enabling tools that are going to allow that to happen. We've seen all these big waves in biotech and what seems to happen is when there is a discovery all these companies rush out to raise money. There is that period, three or four years after the hype where you can come in and have some of the sorting out done between the weak and the strong. That is when you want to get involved the technologies that have legs, like monoclonals. Lester: What happens at this point in the cycle that is coming up in the next year or so is that these companies are going to run into funding issues. A lot of them are going to get money from what must be a more informed buyer than the general public that bought the IPOs at an inflated place. The major pharmaceutical companies will start increasing their investments in these companies. There you have someone who has a much better knowledge of what companies and technologies are going to be long-term survivors. They have a better average than we do, and they certainly have a better batting average than the public that bought the IPO.