Why Biotech Stocks Are Sedated

Judging from Genentech Inc.'s (DNA ) stellar performance on Wall Street this year, biotech might seem like a can't-miss investing opportunity. Since January, Genentech's shares have rocketed 49.2%, to $81.25, fueled by positive news about its drugs to treat cancer and macular degeneration, a major cause of blindness. A strong showing from a sector leader often sends capital flooding into similar companies, lifting the whole group.

Elsewhere, though, investors are spitting out biotech stocks as if they were spoiled medicine. The American Stock Exchange Biotechnology Index, which counts Genentech among its members, has risen just 1.1% since January. The broader NASDAQ Biotechnology Index is down 11.7%. Even sexy-sounding biotech upstarts are struggling to find love on Wall Street: The 40 or so that have gone public since 2003 have dropped an average of 7% since their IPOs, according to Burrill & Co., a merchant banker covering life sciences.

It isn't hard to see why so many investors are taking a pass on biotech, even amid bona fide scientific advances. After years of getting burned by unfulfilled promises, they have become picky. Rather than buying stocks based on news about a firm's drug-development strategy, they're flocking to companies with actual products. "People aren't listening as much to the hype," says Dallas Webb, senior vice-president of equity research for financial-services provider Stanford Group Co.

Investors have certainly endured some nausea-inducing rides in biotech. Five years ago, as two separate scientific teams announced that they had finished decoding the human genome, investors glommed onto tiny Human Genome Sciences Inc. (HGSI ), pushing its stock 1,400% in a year, to a split-adjusted $138, though the company never produced a drug based on genomic discoveries. It now trades around $11 a share. Even investors who put money in biotech mutual funds took a bath. The NASDAQ Biotech Index gained 148% in 1999 and 2000, then plummeted 54% over the following two years.

The days when investors rushed into the sector based on one company's successful clinical trial are long gone. Consider Abgenix Inc. (ABGX ), a contender in cancer drugs. On May 17, the Fremont (Calif.) company announced that in a Phase Two trial its drug was effective in colon cancer patients who failed to respond to chemotherapy. Abgenix, which has a development deal with the world's largest biotech, Amgen Inc. (AMGN ), will release more trial data later this year. Yet investors couldn't care less: Abgenix is trading only slightly above its 52-week low of $6.45 a share.

Biotech investors also have been crushed by the Food & Drug Administration's recent crackdown on drug safety. "Not only are they afraid the FDA will be cautious about approving new drugs, but they're afraid [the agency] will attack drugs that are already on the market," explains Alex Zisson, a partner at venture-capital firm Thomas, McNerney & Partners. The consequences can be bleak, as Biogen Idec Inc. (BIIB ) shareholders learned. On Feb. 28, Biogen pulled its drug for multiple sclerosis, Tysabri, off the market when a couple of patients developed a potentially fatal side effect. Shares nosedived 42.5%, to $38.65, that day.

Investors might regain some confidence in the biotech sector if the small, non-marquee names start scoring some successes. Unfortunately, the vast majority of biotech companies still don't have any FDA-approved products -- which means they remain years away from profitability.

When companies do deliver the goods, the market can still respond swiftly. Up-and-comer Celgene Corp. (CELG ) has jumped 59.7% this year, to $42, largely because of strong sales of Thalomid, used to treat leprosy. A variation of the drug has recently shown promise in treating some forms of cancer.

But such successes are rare. And few people today view small companies as opportunities. "It's much more of a show-me environment," says Caroline Stewart, senior biotech analyst for IRG Research. Show investors the products. Only then will the payoff seem as real as the science.

By Arlene Weintraub in New York

    Before it's here, it's on the Bloomberg Terminal.