Commentary: Biotech Investors: When Will They Ever Learn?

By Arlene Weintraub

From the looks of Wall Street, you might think the biotech industry had cured cancer. Not to mention diabetes, heart disease, and obesity. The NASDAQ Biotech Index, which tracks 75 companies working on treatments for those diseases and others, has soared 44% this year, vs. an 8% gain for the Standard & Poor's 500-stock index. Much of the runup occurred in June, after Genentech (DNA ) Inc. and ImClone Systems (IMCLE ) Inc. unveiled promising clinical trial data on drugs to treat colon cancer.

Some investors are gorging on biotechs because they think the technology will revolutionize medicine, and they want in on the ground floor. Long term, their vision of the future may be correct. But these latest cancer results don't yet represent a major victory against disease, and they certainly don't augur an end to volatility in biotech stocks. What they may portend is another stretch in which many biotech stocks are significantly overvalued.

Investors should get a grip on reality. Many small companies that were lifted on the latest news are strapped for cash and pursuing risky science that will take years to bear fruit. Even for big players, good trial data on a drug don't guarantee Food & Drug Administration approval. And once drugs do get approved, most of them face competition in the market.

These caveats aren't new, but they bear repeating. In the past year, investors have pushed 25 of the stocks in the NASDAQ Biotech Index to double-digit percentage gains. Of those companies, 19 have no profits to show. Because this sector is so sensitive to news, stocks react to fragmentary or erroneous information -- which abounds when big stories break. This spring, spurious tales of SARS cures turbocharged the shares of several biotech outfits.

The current mania brings back awkward memories of earlier bio booms. In late 1999 and early 2000, for example, biotech indexes soared 60% in five months on excitement over the mapping of the human genome. Then, the sector crashed as investors discovered it would take more than a few minutes -- or months -- to move from genome breakthrough to drugs. "People don't take the risk into account until it hits them in the face," says CIBC (BCM ) analyst Matthew Gellar.

There are signs that inflated biotech stocks may sock investors again. Many boosters argue that investors are paying for the future earnings as drugs hit their potential. But even by that standard, valuations are out of whack.

Just take a look at the metric known as the PEG ratio. That's a stock's price-to-earnings multiple divided by its projected three-to-five-year earnings-growth rate. In the past five years, the overall PEG for the biotech industry has ranged from 0.8 to 2.8, estimates Christopher J. Raymond, an analyst at Robert W. Baird & Co. Many stocks, including Genentech, are trading now at the high end of that range, meaning expectations are so inflated that the slightest disappointment could send them hurtling toward the floor. Paul Abel, manager of the Kinetics Medical Fund, began selling off shares of Genentech as they zoomed towards $70. At that price, Genentech's PEG was nearly 3, which seems astronomical, considering its new cancer drug, Avastin, hasn't even been cleared by the FDA. Genentech's nine closest peers had PEGs averaging 1.7.

Moreover, most companies in the sector are nowhere close to showing profits. Again, investors are ignoring important red flags. Some highfliers are burning cash so quickly they may not have enough to get them through the next three years. It can take at least that long to move from one research milestone to the next -- a necessity for raising more cash.

The reality is, for every winner there will be hundreds of losers with science that doesn't pan out. As Wall Street continues to take outsize bets on "the next big thing," biotech stocks will again swing from euphoric highs to nauseating lows. Most investors won't enjoy the ride.

Weintraub covers science and medicine from Los Angeles.

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