(FORTUNE Magazine) – BETTING ON DRUG COMPANIES RECENTLY HAS BEEN A bitter pill for many investors. Not so, however, for veteran fund manager Sam Isaly, whose Eaton Vance Worldwide Health Sciences (ETHSX) has delivered a ten-year annualized return of 18%. But drug and biotech companies are off to a sluggish start in 2005. And if the FDA decides to get tough in the wake of the Vioxx debacle, Big Pharma and biotech companies could feel even more pain. Isaly (pronounced "eyes-lee") spoke with FORTUNE's Stephanie N. Mehta about the science of picking winning stocks, and what Wall Street and the drug business have in common.

What's the outlook for Big Pharma in 2005?

There are now about 15 Big Pharma guys left in this world. There's been about one deal a year in which one of the big guys disappears into the hands of another. Last year it was Sanofi and Aventis. Pfizer bought Pharmacia the year before that. So we would expect one to disappear in '05, and I don't know which one. The outlook for these fellas in '05 is okay. There is a wave of patent expiration that begins in 2006, but for '05 it's an okay year. In fact it's probably high-single-digits overall profit growth.

So you're more bullish on biotech companies right now?

The old dinosaurs have been superseded by the recently profitable, high-profile biotech companies. These are the new darlings--at least they are in our minds. We sometimes call them the ABCs--Amgen, Biogen, Chiron, etc. There are ten or 15 of them, and they are growing 20% a year for an extended period of time. They have this growth rate for two major reasons: They have recently approved products that have long patent lives, and the therapies they address are comparatively unpenetrated. That is, of the population that could use them, only a relatively small amount is currently doing so. The outlook for these guys is pretty good. In 2004 the earnings grew 20% and the share prices only grew 10%, so there was a valuation compression. And we would expect that stock market action would be at least in line with earnings this year. Then you've got all these guys who have not yet made a profit. But there will be far more biotech companies moving into profitability.

So what's the outlook? Big Pharma, maybe high single digits. But they're going into a period beyond '05 that is very rough upon expirations. Big biotech looks very strong for a long period of time. And these emerging biotechs are subject to the vagaries of science, in effect.

What are the big external factors that could affect investments in pharma and biotech?

The Bush reelection temporarily calmed investors with respect to putting money in the sector. Bush is less likely to move to what I'll call "discontinuous change." However, change is inevitable on a variety of fronts. Frankly, I rather thought importation of drugs from Canada or other places would die, but it seems Bush is keeping it alive. So that's an uncertainty, and it would put pressure on the overall price structure. The FDA will be skittish after suffering the Vioxx withdrawal by Merck. But that mostly applies to drugs intended for daily, long-term use in relatively less critical illnesses. So something for high blood pressure, pain and inflammation, perhaps diabetes, could have a very long look at the FDA because it is a chronic drug, a maintenance drug. The bar will be higher for those kinds of medications. On the other hand, treatments for intense, acute problems will still get approved okay.

How do you manage the risks of investing in biotechnology companies?

We spread our portfolio among big companies and small. So we have a few of these dinosaurs--five or so that we think are the best of the 15--and that comes to maybe 25% of the portfolio. We also moderate our position sizes. So it is true we try to keep our portfolio pretty tight, maybe 40 names, which would mean your average position size is 2.5%. But for the very high-risk companies we just won't have very big positions, maybe 1% or 2%.

You're a big Novartis (NVS, $48) fan. Why?

Novartis has high sales growth relative to the rest of the pharma sector. It is in the range of 10%, which a few years ago would have been considered slow but now is considered fast. Its valuation is moderate. The products that are contributing to the growth have long patent lives. And more important, we are impressed with the company's long-term ability to come up with new products.

What other names do you particularly like?

Well, I love all my children. Let's go with alphabet soup: NPS Pharmaceuticals (NPSP, $17) and OSI Pharmaceuticals (OSIP, $65). NPS has a moderate market value, something like $700 million. It has one product being marketed by Amgen, for side effects associated with dialysis, and another product, Preos, for the treatment of osteoporosis, which is being filed for approval in the next couple of months. We believe the drug in the hands of Amgen, which has the trademark name Sensipar, has the ultimate potential to be worth $1 billion, and NPS gets 10% of that. Preos has a similar potential, though it is not approved and does not have a marketing partner. We would anticipate NPS moving to profitability in 2007.

And what about OSI?

OSI has only one product, and it's called Tarceva, also recently approved. Genentech is the marketer in the U.S., and Roche is the marketer outside the U.S. OSI's market cap again is moderate, in the range of $1 billion, and its economics are very good in terms of its alliance agreements. They have a fifty-fifty profit split in the U.S. They get a 23% royalty outside the U.S., which is about as fat as you can get. The drug is used for lung cancer, and we think it will be widely used throughout the world, contributing to profitability for OSI in 2006.

Is Big Pharma more dependent on biotech for innovation, or are biotech companies more dependent on Big Pharma for distribution?

It's highly symbiotic. Products that need any sort of wide distribution have to move through Big Pharma. And Big Pharma needs product. I think they really are complementary skills. The discovery energy of the smaller companies is preserved, and the marketing muscle of Big Pharma is put to work.

Which is more competitive, Wall Street or science?

The world of science is every bit as competitive as the world of Wall Street, and my in-box is filled with résumés every morning of scientists who want to get into the money game.