Biotech To The Future!

What makes biotechnology stocks so tempting to investors? Sharon Seiler, a biotechnology analyst with specialty investment bank Punk, Ziegel & Co., says that biotechnology is founded on the principle that "you could take rational biological approaches to drug development." This approach contrasts with the traditional trial-and-error process that pharmaceutical companies have pursued for decades, although the rise of biotechnology has helped many pharmaceutical companies adopt more "biologic" methods in their own drug development process.

And while many of these biologic approaches began with things such as protein therapeutics (treatment based on the use of blood plasma, for example), biotechnology now includes the search for actual biological targets (places in the body where chemicals or biologic agents effect change at the molecular level). It is this search that gives so many researchers, doctors, and patients the hope that biotechnology may move medicine from mostly treating diseases to actually anticipating and preventing diseases before they strike.

This is also what has driven so many investors - individual and institutional, venture capital and retail - toward the biotechnology sector. As Bill Snider, general partner and cofounder of Emerging Technology Partners, a venture capital firm specializing in genomic companies notes, "The point of all this research and discovery is to come up with a compound you can patent as a drug and get a temporary monopoly to sell it." It is the possibility of hundreds of little monopolies on drugs that treat everything from the flu and Hiv to cancer and debilitating genetic disorders that has dollar signs flashing in the eyes of those who understand the huge profit potential of biotechnology.

But it is potential only, not a certainty; as many analysts, money managers, and others familiar with the growing biotechnology industry insist, savvy investing in biotechnology companies is no mean feat for stock market newbies. Adds Snider, "[People] don't have a way to truly verify whether certain advancements in biotechnology are real. ... Ford can hype up a car," he explains, but it's only after potential customers test-drive it that the results come in. "In this field, it's not possible to do that in a mainstream way," he maintains. Evan McCulloch is even more emphatic: He believes biotechnology is an "extremely difficult sector for the average investor" to invest in.

BIOTECH-BOUND

What makes biotechnology such a tricky arena for the average investor? Most obviously, the (necessarily) abundant scientific discourse is one factor that can make it trying for the average layperson to understand just what any individual biotechnology company is up to. As difficult as it might have been for investors to understand microprocessors, network routers, and fiber optics, those concepts are virtually grammar-school primers compared to terms such as immunoglobulin, viral entry inhibitors, and phase II clinical trials.

The biotechnological learning curve is made all the more problematic by the hype that often surrounds this form of research. In the same way that a new wireless solution or a new processing benchmark is cause for celebration and bullishness on the part of technology investors, a headline heralding "Cancer cure?" sends many biotech investors running for their brokers, often before attempting to read the rest of the story.

Talking about the susceptibility of the biotech industry to media hype, Seiler laughs: "If I had a penny for every drug that cured tumors in mice, I'd be basking on a beach in Aruba." Seiler sees the possibility of superior treatments for maladies such as cancer and HIV as especially beguiling to many - both patients and investors - desperately longing for a blockbuster wonder drug. Noting oncology studies, for example, Seiler admits there is a great deal of anecdotal evidence in support of various treatments. But often those results fall apart when a real controlled trial is done. "You have to be very careful," Seiler says, "when somebody tells you that [a drug] is effective. Effective based on what data?"

Tom Porter, general partner and cofounder of EDF Ventures, a venture capital firm with significant investments in a number of biotechnology companies, including GenVec and Selective Genetics, opines that one of the best ways for investors to learn about an arena as complicated as biotechnology might be to spend less time on the science page of the local newspaper and more time reading analysts' reports. "Find out who the best biotech analysts are," he suggests.

As far as Porter is concerned, the best biotechnology analysts are capable of discussing both specific companies as well as the biotechnology sector as a whole. "And they do this in plain, everyday language that investors need to be able to read and understand."

BIOTECH BASICS

Generally, biotechnology products go through a regular series of steps from inception to market. A preclinical phase of research, testing, and discovery is followed by a series of clinical trials if the earliest experiments go well.

There are three phases to the clinical trials. Phase I is generally a "safety-only" test during which the company seeks to ascertain the effects of the drug on a limited number of subjects. Both general safety and the possibility and extent of any side effects must be uncovered here.

If the Federal Food and Drug Administration (FDA) decides that the drug is generally safe after a review of the phase I data, a phase II trial is held. Here, more specific effectiveness is judged on a larger group of patients than in phase I.

Phase III is considered by some to be the "make or break" point in the drug approval process. General safety having been established in phase I and a satisfactory level of effectiveness in phase II on a larger, but still limited subject group in a clinical setting, phase III trials involve both a larger test subject group as well as expanded criteria, such as the improvement in the patient's overall life and health condition outside of the clinic. It is usually after a successful phase III test that a drug will be guaranteed at least a fair hearing before the FDA advisory board.

Investors must carefully evaluate the results of successful clinical trials before committing capital to biotechnology companies. A good phase II trial is only cause for celebration if it is followed by a successful phase III trial. And a successful phase III trial can be almost completely ruined by a poorly timed or poorly executed market launch strategy. Snider notes that "the FDA is very careful before they allow people to put drugs on the market ... [the FDA's] process is to be as efficient as possible." He notes that "the main objective of the FDA is safety," but he is somewhat concerned about the length of time the process takes: "[The time] is a big deal. [The FDA] does need to be faster because it does take a long time and cost a lot of money and can prevent a lot of things from being developed."

Seiler is a bit more sanguine on the length of time that the FDA takes, stating that the FDA is "quicker than it used to be" and suggesting that the dramatic rise in applications for new clinical trials may have caught the agency understaffed. Seiler also provides another possible reason for complaints about the FDA: "It's easier for [companies] to say, OWell, we had this great drug and we did great trials and the FDA doesn't want to approve it,' than to say OWell, our drug had marginal effect and we really did poorly in our clinical trials, and now the FDA doesn't want to approve it.'"

CHOOSING AMONG BIOTECHS

What should individual investors look for in biotechnology companies? Analysts, venture capitalists, and biotech mutual fund managers all seem to agree that biotech companies need cash - and lots of it. Eli Neusner, director of research for MetaMarkets.com, notes that many biotechs, especially the smaller ones, spend "years plugging away" in research and development before ever bringing a single product to market. As such, biotechnology companies need a "large cash position" in order to "weather out" the time between research and development and profitability.

Brian Younger, portfolio manager of the Fidelity Select Biotechnology Fund, agrees that "lots of cash" is vital to biotech companies. But Younger also wants to see accelerating revenue and earnings growth, particularly from the established, already-profitable biotechnology companies. He draws a sharp distinction between the established biotechs, such as Amgen (AMGN), Biogen (BGEN), and Immunex (IMNX), and some of the newer, "earlier-stage" biotechnology companies that may have few products in the pipeline and even fewer, if any, in the marketplace. Younger strongly cautions individual investors to avoid these smaller earlier-stage biotechs about which little may be known and for which no track record of successful clinical trials and/or product launches may exist.

Savvy management is another major factor to look for in biotech companies. Says Snider: "You have to span the bridge of both science and business. Ideally, you're looking for a management team that has both a reasonably long history of business experience and also [has] some first-class scientists involved. You cannot be an effective company in this field without top science. And at the same time, just having top science doesn't make a good investment." McCulloch adds he likes to see managers with background in pharmaceutical work, as well as experience in managing large companies. As such, he is comfortable with the traditional corporate management structure - with chief financial officer (CFO), chief operating officer (COO), and chief executive officer (CEO) - with a chief science officer who is often the founder of the company and has stepped aside from day-to-day leadership to focus on the company's research and development.

As if having good competitive products and effective managerial leadership were not difficult enough, Seiler suggests that there are certain conditions for which it is more difficult to develop drugs. As someone who tends to follow companies developing treatments for cancer and infectious disease, Seiler is more comfortable with companies whose clinical trials are likely to have very well-defined endpoints and benchmarks. "If you are doing a vaccine trial or a trial of an antiviral or an antibiotic or an antifungal, everybody agrees what the endpoint should be. ... You want to look for a clear, clinical route to market, a well-defined condition where people agree on what the trial results should be."

Seiler contrasts this with areas such as wound-healing, commenting, "There have been a thousand products in development for wound-healing and it's not necessarily that products don't work, it's just very hard to show that they do work. Do you measure how quickly the wound heals? How fully it heals? Some combination of both?"

The issue of the product pipeline is also a daunting one. If a company only has one or two products in development or on the market, then the risks of that company being edged out by competitors and having no other products as backup are far greater. Suggests Seiler, "One way to invest in biotech that's not quite so risky is to look for companies that have a portfolio of products and aren't dependent on the success of just one."

BIOTECH FUNDS INSTEAD?

A less risky way to invest in biotechnology is to avoid individual biotech companies altogether and invest in biotech mutual funds instead. Both Evan McCulloch of Franklin and Brian Younger of Fidelity make this point with some conviction. Citing the fact that biotechnology is "easily hyped," Younger points out that, unlike many other mutual funds (including other sector funds), there is a real advantage to knowledge when investing with a biotechnology mutual fund, a premium not present when the average investor tries to make his or her own investments. "You can really lose all of your money by [just] owning one biotech stock," argues Younger. "Whereas in a biotech mutual fund, that's just not going to happen."

In terms of questions to ask when selecting among biotechnology mutual funds, both McCulloch and Younger strike similar chords: