Reducing portfolio positions - a wise move for 4Q and 1Q03

The market also witnessed a few earnings surprises, as several companies managed to beat consensus net income forecasts. However, the recurring theme was soft revenue growth, evidence that companies are tailoring their operations to suit the tougher and sluggish growth environment.

US Markets
US equity markets ended the week in positive territory despite some weaker than expected economic data and a great deal of volatility.

Declining revenues were also seen in the pharmaceutical sector, due to patent losses for blockbuster products over the past 12 months. Eli Lilly's (LLY, CSFB rating: Neutral) premier antidepressant, Prozac, continues to struggle against generic competition and Bristol-Myers Squibb (BMY, CSFB rating: Underperform) is witnessing the rapid decline in sales for its diabetes drug Glucophage, which went off patent during this year. We addressed this issue in the US Daily last week.

The industry also faces other challenges. The US has one of the most expensive healthcare systems in the world with costs continuing to rise rapidly, due to an ageing population. The US government has been trying to stem the rise in healthcare costs by proposing that generic drugs be introduced into the market at a more rapid rate. This generic drug bill could save the Americans $60 billion over 10 years. The issue over reducing healthcare costs is not new, but most attempts to cut costs have failed on account of the hefty clout the Pharmaceutical Industry carries in congress. We will standby to see how far Bush's ambitions to push the healthcare reforms will go. Thus far it seems that it will prove no more than a minor irritant for the pharmaceutical companies. It certainly is not in the government's best interest to undermine the industry's profitability, but it would seem that a balance has to be struck with regards to both the industry and the consumers.

Given the rapidly growing research and development costs, the industry's interests are clear - the protection of their products from competition for as long as possible through the filing of additional patents. This is where we believe the US government will intervene. The latest proposal is to limit the number of applications for patent extensions to a one-time 30-month extension. Current flaws in the legislation allow for companies to file for patent extensions more than once. We believe the amended legislation would serve to shorten product cycles and intensify the competition hence posing some risk to the industry.

Pharmaceutical companies have been able to grow at a 15-20% annual rate over the 1990, when new technologies and discoveries allowed for the rapid development of new therapies for diseases that prior to the industry boom were thought to be incurable. The sector looked to be a defensive and growing sector. Defensive because of the underlying demographics, which provide an expanding market, and growing because of the above average growth rates. However, it would seem that growth is abating, as the new drugs streaming into the market are essentially replacements for older generation drugs or new entrants into an area for which drugs are already on the market. The increased competition and the wide range of diseases covered by the existing drugs mean less and less business opportunities for the drug makers.

In order to weather the storm, the drug companies will be forced to find ways to further reduce costs and also to fill their pipelines. We believe a likely scenario could be a wave of consolidation, as was witnessed in the early 1990's with Pfizer having got the ball rolling with the Pharmacia acquisition this year. We are very likely to see some M&A activity over the near future if the drug makers continue to see sales decline in the face of generic competition.

We believe that in view of this, the Pharmaceutical sector valuations are quite high and we expect that at some point they will have to come closer to the market average, as the premium paid for the industry should dissipate due to historically high growth rates slipping. We would recommend that investors stay underweight pharmaceuticals and invest in the more defensive drug distributors, which profit from favourable demographics, but do not carry the risk involved with research and development. We believe the distributors have good earnings visibility. Our current recommendation in this area is AmerisourceBergen (ABC, CSFB rating: Outperform) for which we have a 12-month target price of $88.

European Equities

• The DJ Euro Stoxx 50 finished the week 2% lower.

• Despite the recent decline in the war premium on oil, we would hold on to our preferred oil stocks TotalFinaElf and ENI as they provide a hedge in the current instable geopolitical environment.

• The pharma sector was guided by 3Q result announcements from both sides of the Atlantic. We expect our two favourite stocks - Sanofi-Synthelabo and Aventis - to grow above the industry average of 9%.

Though earnings reports have so far exceeded expectations, it is important to bear in mind that this happened from a sharply reduced base. The positive surprises so far mainly stem from cost cutting rather than top line growth whereas the outlook remains, at best, mixed.

Outperformance in October has occurred in high risk stocks (technology and telecom). Possibly, investors were anticipating an economic recovery triggered by some rate cuts and were buying stocks which could grow quickly over the short-term. However, it is not clear if lower rates and stronger growth are around the corner. The short-term macro economic picture remains bleak and once investors realize that forecast for the 4Q and the 1Q03 are still too high, they could unwind these positions. Hence, we recommend reducing positions or at least sell some calls on individual positions that are considered core in a portfolio.

On the back of the easing tension in the Iraq conflict, oil prices continued to drop. The seemingly moderate language used by the US President has caused the war premium on oil to reduce. We continue to believe that the situation is far from being resolved and oil stocks form a decent hedge against a potential conflict in the Middle East. As such it is not surprising that the energy sector is the biggest overweight position held by institutions managing European money according to data from Frank Russell. Despite a 3.5% and 7% drop this week of TotalFinaElf (FP FP; EUR 136.9) and ENI (ENI IM; EUR 13.792), we would hold on to our preferred oil stocks.

The pharma sector was influenced by 3Q results of several pharma companies from both sides of the Atlantic and by President Bush's plans to make prescription drugs cheaper and allow generic drugs easier access to the market. Even though this might cause some short-term pressure on the sector we believe that the patent issue has been widely discussed in the market this year leading to the substantial losses of companies that are exposed to this subject.

GlaxoSmithKline (GSK LN; GBP 12.36) reported disappointing results. Pending US patent challenges of Paxil and the unproven nature of its R&D are the main drag of the stock. AstraZeneca's (AZN LN; GBP 23.65) 3Q profit fell 5% to USD 675m but it boosted its full-year earnings target in view of the continuing absence of Prilosec generics in the US and on the back of satisfying safety results for its most important new cholesterol drug Crestor.

For a European pharma play, we reiterate our preference for Sanofi-Synthelabo (SAN FP; EUR 61.1) and Aventis (AVE FP; EUR 59.3). With a better-balanced product pipeline we expect these stocks to outperform earnings growth of the industry (around 9%). Sanofi-Synthelabo's results were in line with analysts' expectations. Developed sales (including sales of Avapro and Plavix made by Bristol-Myers Squibb) came in 11% higher at EUR 7.144bn. Reported sales came in 15% higher at EUR 5.55bn. 3Q sales rose 13% to EUR 1.87bn. Although the figures do not seem to be that exciting at first sight, we have to keep in mind that the comparison with last year is very tough especially with regards to its blockbuster drug Plavix. In 2001, its marketing partner Bristol Myers built stocks deliberately with wholesalers. Consequently, this led to destocking during this year. Despite this, Plavix's developed sales grew 32%. The company also reiterated an increase in profit of more than 25% for the full year, which needs to be compared with the European sector average of around 9%.

On Tuesday, Aventis will report. CSFB expects revenue growth to increase by 3% to EUR 4,262m including a negative currency impact on sales. EPS is expected to rise by 17% to EU 0.69.

Adecco (ADEN VX; CHF 57.6) posted a 3Q profit of CHF 117m below analyst's expectations. Operating profit in the 3Q fell 42%. On a positive note, Adecco's gross margin exceeded the market's expectations. In view of the weakened global growth outlook and the high degree of uncertainty, we believe the stock could see some further downgrades. However, in the event of a stabilisation of economic forecasts, we see significant upside. Hence we would wait for a pullback and buy the stock at lower levels of around EUR 40.

Stora Enso (STERV FH; EUR 10.65) reported a clean 3Q02 pre-tax profit of EUR 197 million, which was nicely above the EUR 178 million consensus. However, due to a charge of EUR 1.230bln relating to the profit enhancement plan (announced on August 27, 2002) for the company's North American operations, the company reported a pre-tax loss of EUR 1.033bln. The outlook statement remains cautious although the company sees stability in some products and improvements in others. Stora Enso is more confident about a recovery in the USA than in Europe. We continue to believe that Stora Enso is very well placed for an economic recovery. The stock is attractively valued and offers a dividend yield of 4.22%. Stora Enso has never cut dividends so far.

Nestle (NESN VX; CHF 317.50) reported 9 months sales figures in line with analysts expectations and the management is also confident to achieve sales and profits above those of 2001. Sales increased by 6% to CHF 66.2bn, price increases had a positive impact of 1.4%, acquisitions added 8.5% and foreign exchange movements reduced sales by 7.3%. Real internal growth rate came in lower than expected at 3.4% mainly due to a deteriorating situation in South America. 9 month sales were fuelled by acquisitions of pet food maker Ralston Purina and ice cream maker Schoeller. By adding faster-growing products to its product range over the last two years, Nestle owns today one of the most dynamic food portfolios in the industry. In combination with an ongoing cost cutting program and efficiency improvements especially in business processes, we believe Nestle offers an attractive combination of top-line growth and margin improvement. As an international company reporting in Swiss Francs, Nestle will remain exposed to currency movements, however, we believe at current levels the negative influence is already priced in. For a long-term exposure in a defensive sector, Nestle's current valuations look attractive.

Pechiney (PEC FP; EUR 30.78) reported a 3Q loss of EUR 14m. Lower aluminium prices and a weakening USD affected the figures negatively. Given the fact that producers replied to lower prices with increased output, inventories reached a seven-year high. We maintain our hold on the stock.