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Six money managers examine portfolio management strategies in the latest issue of The Wall Street Transcript, available at (212/952-7433) or http://www.twst.com/info/info550.htm

TWST: What led you to be interested in a basket of pharmaceutical stocks?

Mr. Ganucheau: Let me start out by saying that if you look at the pharmaceutical industry in general, in the past it has traded at a 25%-40% premium to the general market multiple, while today most trade in line with or significantly below the market. A premium has historically been assigned to them because of patents that they have on their products (which allow a sustainable annuity-like revenue stream and strong free cash flow), barriers to entry provided by high R&D budgets, and superior earnings and sales growth relative to the market. That’s why they’ve had a high relative p/e in the past.

But I don’t rely on the past to make my investment thesis today. Let’s look at the future. Again, relate the future to realistic expectations for the general market and we think that these companies, kind of as a group, can grow sales at 9%-10% over the longer term. They should be able to grow earnings in the 11%-13% range. Of course, I’m comparing this to a general market that I think will grow earnings in the 6%-7% range. The extra on top of that is that today I have dividend yields on some of these pharmaceutical companies that are twice the market level, and that provides an added level of return. Merck (NYSE:MRK) is a leading pharmaceutical company. They also own Merck-Medco, a pharmaceutical benefits manager (PBM) that services employers and insurers. Recently patent expirations on cardiovascular drugs, such as Vasotec, Mevacor and Prinivil, as well as the antiulcer drug Pepsid, have caused earnings expectations to fall, and that’s why you see 2002 earnings flat compared to 2001.

Recent concerns regarding Vioxx and increased risk of heart attacks have also pressured the stock, because Vioxx was expected to fuel growth. This year Merck is going to invest $2.9 billion in research and development, and we feel that they have kept their commitment to invest for the future, rather than trim this budget to meet short-term goals. We like to see management commitment to R&D. As R&D is somewhat discretionary, we like to see this increase in line with or faster than sales, so that we can see a growing free cash flow stream in the future. The price today should reflect the future capitalized earnings (free cash flow) stream, not the past track record. Cozaar, a cardiovascular drug; Fosamax, used for osteoporosis; Singulair, which treats asthma; and Vioxx, which helps arthritis, have driven growth in the recent past and should in the near future. Pending products such as Arcoxia, which treats arthritis and pain, and Zetia, which treats high cholesterol, along with others in the pipeline yet to be announced, should help drive long-term sales growth in our opinion around 9%, which should support earnings growth of over 11%. Management recently confirmed the strength of their pipeline and said that they expect to have 11 new products introduced by 2006. This is an example of how you have sporadic detail on the product pipeline. It may be dry for a while and people think there is no opportunity, and then fruit is borne by the research and development investment that has gone on for several years. Investors focusing on short-term fundamentals have driven Merck 30% off of its 52-week high and 42% off of its all-time high of $96. Earnings growth has stalled and the p/e ratio has been cut in half. We believe that is indicative of negative psychology and has presented a unique opportunity to buy Merck today at 16.3 times next year’s earnings, with a 2.5% dividend yield. This price today, if we look at a discounted cash flow model, implies an 11% discount rate. Given Merck’s free cash flow, solid fundamentals and above-market sales growth rates, this is very attractive. Remember, we’re comparing this to realistic expectations for the market of 6%-7% earnings growth, plus the 1.4% yield gets an 8.4% total return. Merck’s 11% earnings growth plus the 2.5% dividend yield, with a flat 16 price to earnings ratio (rather than increasing to the historical market premium), should produce a 13.5% total return. Well, I think that represents an opportunity to outperform the general market and really create wealth for people who take advantage of today’s negative psychology. If I assume that controversy surrounding Merck for short-term reasons fades, restoring a higher p/e multiple of 20, up 25%, then my investment appreciates 2.5 times in 6.6 years (11% growth doubles the earnings in 6.6 years, and the 25% increase in the p/e ratio makes it 2.5 times). This represents a 14.8% compounded annual price return, and adding the 2.5% dividend yield means my potential return is 17.3% over that 6.6-year period.

This special Investing Strategies Report includes:

1) Peter F. Ganucheau IV, Principal, Portfolio Manager/Analyst with GSB Investment Management, Inc., examines portfolio management strategies in this timely and deeply informative 11,400-word interview from The Wall Street Transcript.

2) William J. DeRosa Jr., Portfolio Manager with Badgley, Phelps and Bell, Inc., examines portfolio management strategies in this timely and deeply informative 4,500-word interview from The Wall Street Transcript.

3)Jonathan W. White, Senior Vice President and Chief Investment Strategist for Banknorth Investment Management Group, examines portfolio management strategies in this timely and deeply informative 3,100-word interview from The Wall Street Transcript.

4) Geoffrey R.B. Carey and Jane W. Korhonen, both Partner and Senior Portfolio Managers at Brown Investment Advisory & Trust Company, examine portfolio management strategies in this timely and deeply informative 3,500-word interview from The Wall Street Transcript.

5) Richard H. Earnest, Director for HighMark Capital Management, examines portfolio management strategies in this timely and deeply informative 4,900-word interview from The Wall Street Transcript.