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Investment Tips for a Treacherous Sector

By David Shook Never a sector for the faint of heart, biotech has been particularly punishing this year. In fact, companies such as Celera Genomics (CRA), once the darling of the genomics revolution, and ViroPharma (VPHM), a viral-disease research company, have more cash in the bank than total stock market value.

This phenomenon speaks volumes about biotech's cyclical nature. It's a highly volatile sector where federal approval for a new drug can send a stock soaring, and negative clinical data can do just the opposite -- slamming a stock's value in one trading day.

From 1998 to early 2000, high-flying biotech valuations made many investors rich. A price-to-earnings ratio of 100 or more wasn't uncommon for profitable biotechs when the sector hit its high in March, 2000. Since then, bad news has piled up, with hundreds of new companies rushing experimental drugs through clinical testing too quickly. As a result, investors have gradually lost faith in biotech.

PROCEED WITH CAUTION. The ImClone (IMCL) insider-trading scandal in December, 2001, proved to be a pivotal event -- providing fuel for the latest sell-off. The AMEX Biotech Index is off 54% from its 52-week high of 625 a year ago.

A radioactive sector for most investors? Perhaps. Deciding which companies make the best investments in this bear market is never easy. The correction this year seems much worse than many veteran investors had expected following the biotech boom of a few years ago.

"The pendulum tends to swing too far in either direction in the biotech cycle," says Kurt Von Emster, general partner at private money manager MPM Capital. "There has been a lot of negative news surrounding biotech this year, and there could be more," he says, citing the recent setbacks at companies such as Biogen (BGEN), whose stock jumped 20% on positive news about a drug, only to fall 20% a few weeks later on negative news about another treatment.

A few guidelines might help even risk-averse investors brave the biotech sector. While it has always been marked by extreme volatility, that doesn't mean everyone should simply run for cover. Biotech still offers some opportunities, if you keep a couple of things in mind:

Fill a Big Basket: First, don't just look for a single biotech that seems to be doing cool and important work. Unless you're a clinical physician with experience in molecular biology, you won't understand everything there is to know about these companies. And many stocks have their entire valuations pinned on a single drug. "I like to say these are basically drugs wrapped around a company," says analyst Von Emster. Outfits such as IDEC Pharmaceuticals (IDPH) and Gilead Sciences (GILD) have among the hottest stocks in the sector, largely due to just one drug.

Von Emster recommends that investors serious about biotech put a little money to work each month, selecting a large basket of companies with a bias toward ones with profits or recurring revenue streams, such as Genzyme (GENZ), Protein Design Labs (PDL), and Medimmune (MEDI). For those that still don't have sales, this may not be the time to buy, says Michael Sjostrom, chief investment officer for Sectoral Asset Management. He adds: "Don't bet everything on one horse. Diversify across at least five to six companies, or buy a fund."

Look for Big-Breakthrough Potential: That means focusing on the companies that are dedicated to meeting major unmet needs in science, instead of those spread thin among several different medical areas. Gilead Sciences has beaten the sector by a wide margin this year largely because of Viread, an antiviral drug for the treatment of HIV that could be biotech's most successful launch in the past year. With drug-resistant strains of the virus becoming more prevalent, AIDS is again an expanding crisis worldwide.

Viread seems to work well as a new weapon against the changing virus. "Gilead has done a brilliant job of divesting its pipeline outside of the core focus on anti-infectives," says a money manager for a New York hedge fund. "As a result, the company has held up well" -- down only 10% year-to-date, vs. a 48% drop in the biotech index.

Scios (SCIO) is another company dedicated to a particular slice of medical science. It has developed Natrecor, the first new drug for congestive heart failure in more than 10 years. Scios' stock is one of the few gainers this year, increasing 17%, to $27. Says Mark Monane, biotech analyst for Needham & Co.: "The assembled management team [at Scios] is experienced and deep, with backgrounds in medicine, academia, pharmaceutical sales and marketing, and business consulting."

He says you can spot a good biotech management team by its ability to guide a company through a very successful launch of a novel product, and then deliver sales growth quickly. Natrecor revenues have continued to exceed Scios' guidance. Monane now expects the company's second-quarter sales to meet or exceed his estimates of $18.4 million, and he expects Natrecor revenues to increase to $222 million by 2004, from $80 million this year.

Quick to Market? Monane also believes investors should look for companies that have products in late stages of development, simple drug-trial designs, and speed when it comes to commercializing drugs or medical devices, so investors don't get impatient. Take Exact Sciences (EXAS). It has developed a more effective and easier way to detect colon cancer. The DNA test screens stool samples for signs of genes associated with cancer, making it much easier for doctors to spot it.

Exact Sciences' Don Hardison says the company has already signed an agreement with Laboratory Corporation of America (LH) to use the tests for cancer screening nationwide. The LabCorp deal is worth as much as $75 million plus royalties to Exact Sciences, which had went public last year. "We're taking genomic discoveries and commercializing them quickly. We've kept our employees focused on this one project where we recognized a significant unmet need," says Hardison. "Now, we think this technology could go well beyond colorectal cancer. There are so many other cancers for which better screening is needed."

Stay a Little behind the Curve: Von Emster argues that it's not wise to try timing the bottom in this biotech cycle. More bad news could be coming that pummels the entire sector. Timing isn't everything, he says, but the cyclical nature of biotech investing usually makes it easier to jump in when stocks are rising. "The good time to buy these stocks is when they are all clearly on the way back up," he says. "If you miss the first 10% to 15% runup in the stock, so what," says Von Emster. It's usually not too late to buy a good biotech company when the sector is rebounding.

Watch Out for Promises of Future Profits: Last, be on the lookout for companies that claim to have "platform technologies" -- rather than tangible drugs or medical devices that can be sold for real money, says Sjostrom. This is the reason why Celera Genomics has gotten so clobbered.

While co-founder Craig Venter deserves much credit for sparking the genomics revolution shaping today's drug development, he has left Celera, and it's trying to transform itself into a drugmaker, from a "genomics platform technology" company. That's how many analysts described Celera when it was burning through tens of millions of dollars each year to beat the government in mapping the genome.

It's still not clear how Celera's massive genomics database can be turned into a profitable enterprise. Hence, the reason its cash in the bank is now higher than its stock market capitalization. Plus, investors seem to think Celera is burning through its funds too quickly without enough real products in the pipeline.

These guidelines are far from a complete handbook on biotech investing. Remember, this isn't the sector for those who get vertigo at the sign of rapid swings in stock prices. But it's worth noting that biotech historically has outperformed the broader market. This is something investors can't ignore, despite the calamity we've seen this year.

Even through all the bad news we've seen in biotech -- from the ImClone scandal to Biogen's wild twists in stock value -- savvy investors might still make money on the biotech frontier. Shook covers biotech for BusinessWeek Online in New York

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