Playing the Biotech Games

When it comes to games, the Olympics have nothing on the stock market.

I was in a group conversation with a doctor some years ago when we started in on the stock market. I don't know what triggered it, but suddenly she said, "You play games" in tones full of contempt. I was just sitting there --- this broadside seemingly came out of nowhere. I could have responded, "Yes, and when you have a bad day, somebody dies."

But I didn't. (Very nice of me.)

This is, incidentally, a lady who has made a lot of money from the stock market. But she may not understand the connection between the market and human health.

So what games are we playing today?

Hmmmm. Last week's game was end-of-quarter markups for many mutual funds, and doublings of biotech IPOs that have come out of their quiet period. (August is the end of the quarter for mutual funds like ours that run on a November fiscal year, which many of them do. Whatever we hold that day is what will appear in our reports to shareholders. So when you see stocks squirt upward on the last day of November, February, May and August, remember what's really going on. Nobody wants to be busted by Cramer!)

TSC's Ian McDonald wrote a great piece Aug. 30 about the rash of new health care funds that have started in the past several months. (Judging by the number of calls I've been getting from recruiters, Ian's numbers are low.) This is in the context of a biotech stock sector in which at least $10 billion in new funds has flowed into what was 350 public companies. Add in 50-plus IPOs in the past nine months --- 25 of them last month -- and you can see why the latest game has been to buy the IPO stocks when they come out of the quiet period (i.e., when analysts start publishing on them).

At least, that was the game. Now, because the sector's hot and folks like Ben Holmes have been reminding people when quiet periods end, the game is to buy these biotech IPOs a few days in advance of the first reports. Under this heading, I had a very entertaining conversation with a top analyst last week. He told me which companies he would initiate coverage on this week when the quiet periods end. Not only that, his salesman later told me much the same thing.

Incredible.

If I may digress briefly, there was another little game last week that I didn't understand at the time but would very much like to. Gabe Hoffman made a point in Columnist Conversation last Thursday about Protein Design Labs Inc.'s (PDLI:Nasdaq - news - boards) plunge: The recent 8-K and S-3 filings caused some analysts to lower their estimates. But for a stock with a $4 billion market cap to drop $17 in the last 1 1/2 hours of trading on Aug. 31 meant $675 million had to evaporate on a day when everything else in biotech was going up.

Protein Design Labs was virtually the only red on my screen that afternoon, and it was so red. (On nearly 4 million shares, I might add, which is more than double the normal daily volume for that stock.) Who wanted it out of their portfolio for the end of the quarter so badly that they were willing to tank it in such a fashion? As of the June filing, Fidelity had 4 million shares, Invesco had 2.7 million, etc. But I doubt they were the guilty parties. Alternatively, who wanted to make someone else look bad and therefore started a run on one of their target's major holdings?

Dis one I don't get. But I would like to.

Now, on to this week's games.

Game One is the unwinding of last week's silliness in marking up biotech stocks. Len Yaffe at Banc of America Securities (the former Montgomery Securities) tanked pharmaceuticals Tuesday when he pointed out that drug companies will have a tough time growing 10% this year. Len is a super guy and very funny, but he was pointing out the obvious here. Anyone who doesn't know about the lack-of-growth crisis in pharma has been under a rock for the past several years. (Cramoo, why do you keep buying these lames when you can have much more fun in biotech?)

Meanwhile, Gore and Bush can be accused of piling on as they duke it out over who will be more generous on prescription-drug benefits. (How's that for a mixed sports metaphor?) Bush may have outlined his little drug plan Tuesday, but it's not like anyone didn't know these two were going to hammer drug stocks this fall while whaling on each other. If the winner follows through, the net effect will be drug price controls. This should primarily affect drugs paid for by Medicare, which caters almost entirely to the over-65 crowd.

By contrast, biotech drugs are most often used by people in their 40s and 50s, are seldom reimbursed by Medicare and are therefore unlikely to get hit with price controls. Moreover, biotech has yet to sprout much in the way of generic versions of lifesaving drugs: For example, if you have cancer and you need Amgen's (AMGN:Nasdaq - news - boards) Epogen at the moment, that's pretty much your only option. But this privileged status hasn't prevented biotech stocks from being sideswiped in this latest rout, dropping 8% in the past two days.

Moreover, the small but sovereign state of Maine recently implemented drug price controls, so everybody who sells anything drug-related is nervous about a social trend forming.

Or as my pappy the World War II captain says, "When they raid the house of ill reputie, they take the piano player, too."

Game Two this week is Amgen. Final witnesses are being heard or have been heard in Amgen's patent-infringement case against Transkaryotic Therapies (TKTX:Nasdaq - news - boards) for that self-same drug Epogen, which is used to treat anemia. I'm in the small minority that thinks Transkaryotic will win, but I'm not putting big money on it. If Transkaryotic does win, the pro-Amgen types will say it doesn't matter anyway because Amgen has a full pipeline coming onstream and its long-acting version of erythropoietin (NESP) is about to supersede Epogen anyway. Besides, Transkaryotic will appeal.

However, Amgen is 25% of the Nasdaq Biotech Index by weight --- and when Amgen hiccups, the IXB swoons. Moreover, this case is extremely important because pharmaceutical companies can come up with many variations on a drug, and thus generic drug companies flourish. But nature optimized each of the estimated 10,000 to 1 million proteins in your body. A "variation" on that protein's structure generally won't cut it. So there haven't really been any generic biotech companies per se --- and this ruling could open the door to a flood of them.

This week's final game may be the most immediate: the BioCentury/Carson Group conference. Coming this Thursday (Sept.7), it's the first biotech financial conference of the fall season. It is especially fun because it's not sponsored by a brokerage firm; hence, every sell-side analyst can attend.

At first glance, the conference looks harmless enough. But last year, this conference was the venue in which Genentech and Idec Pharmaceuticals (IDPH:Nasdaq - news - boards) let it be known that sales of their monoclonal antibody Rituxan were light. That revelation started a biotech sag that lasted until late October. This year, it may work in reverse. The stocks are conveniently tanking in advance.

As of last Friday, the AMEX Biotech Index (BTK) was up 100.78% year to date while the Nasdaq Biotech Index was up 56.55%. Which meant they were vulnerable to some well-deserved profit-taking. Any bad news that gets muttered at the conference has already been somewhat discounted, and any good news could turn these stocks around.

Incidentally, have you noticed that these two indices made one whopping round trip this year? (Much like the Internet stocks, which bottomed on April 13, 1998, and then proceeded to double over the succeeding months.) But the fact that the AMEX Biotech Index was up so much more than the Nasdaq Biotech Index makes it clear how narrow much of this advance has been. It's only in the past two weeks that the Nasdaq index has really gotten off its haunches and started moving, as momentum shifted from New York Stock Exchange stocks back to the Nasdaq.

The final question for today is, are those double tops we see forming in the AMEX and IXB biotech indices? Or will biotech blast back up and through? I think the overwhelming number of medical and financial conferences this autumn, with the associated news flow they typically generate, will ultimately drive these stocks higher despite all the efforts of Bush and Gore combined.

But there is no doubt that a lot of big general funds were 9% in health care a year ago and are now 25% in health care. Upshot: They're unlikely to allocate much more to the sector unless the economy goes down the toilet. And with $10 billion or more coming off lockup this fall, not to mention as many more biotech IPOs as investment bankers can jam out the door, I expect we'll see a wee bit more supply than demand.

GBS, where are you when we need you?

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Lissa Morgenthaler runs the Monterey Murphy New World Biotechnology Fund, and has written on biotech for various publications, including Barron's and Michael Murphy's California Technology Stock Letter for more than 15 years. At time of publication, Morgenthaler was long Transkaryotic Therapies and Protein Design Labs, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Morgenthaler appreciates your feedback and invites you to send it to Lissa Morgenthaler .