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Don't Lump Biotechs With Big Pharma

Gregg Greenberg

Litigation risk, generic competition and pipeline problems are causing investors to just say no to large-cap drug stocks. But should they also steer clear of biotech companies for the same reasons?

As demonstrated last week when Merck(MRK Quote) shares were stung after a judge ruled its first federal Vioxx case a mistrial, large-cap pharmaceutical companies can be stuck trading according to outside factors rather than earnings potential.

But don't lump biotechs in with the big boys just because they both peddle drugs, says Stephan Patten, manager of the $20 million (QBPAX Quote)Quaker Biotech Pharma-Healthcare fund. Patten says the challenges facing big-cap pharma won't rub off on biotechs, which he says don't face the same threat from juries, or, for that matter, generic drugs. And biotechs are gaining strength in the merger world, as evidenced by Amgen's (AMGN Quote) agreement last week to buy Abgenix (ABGX Quote) in a $2.2 billion deal, though buyouts aren't necessarily one of Patten's reasons for investing.

Patten's fund is up 2% year to date and 14.2% annually over the past three years, after taking into account its fairly pricey 2.3% expense ratio.

TheStreet.com chatted with Patten about big-cap pharma's problems and his favorite biotech stocks.

Will the problems afflicting large-cap pharma ever start trickling down to biotech?

Large-cap pharmaceuticals face a number of challenges, in particular patent expirations and challenges, therapeutic substitution by generics, and sparse late-stage pipelines. The vast majority of biotech companies remain unaffected by these issues.

Firstly, biotech companies are generally more immune to generic challenges and, therefore, therapeutic substitution, than are traditional pharmaceutical companies. This stems from the fact that pharmaceutical companies typically develop chemical drugs -- of which generic versions can be made quite easily. While on the other hand, the biotech industry typically makes biologic drugs -- of which generic copies are still extremely difficult to make. At some point in time in the future, the US and Europe will likely allow biologic generics to come, but the requirements for approval will involve a much longer and more costly development path.

Secondly, R&D productivity at large pharma has not been as successful as the industry had hoped. Partly in response to this, large pharma partners -- and sometimes acquires -- biotech companies to augment their pipelines. While this succeeds in filling in their pipelines, usually it does so at a higher cost and lower margins. In the biotech industry, we have seen instances where developing a second successful drug has proven as challenging if not more challenging than developing the first one.

In response to these and other challenges, some pharmaceutical companies have begun restructuring efforts to streamline costs.

How do you choose stocks for your fund?

The Quaker Biotech Pharma-Healthcare fund is a long/short fund, with a net long bias. We take a "best ideas" approach to managing it and thus do not hold any default positions. Typically, we only hold between 20 and 40 names. As far as we know, we are the only biotech mutual fund with the ability to short.

Our investment process is bottom-up and fundamental. Given the novelty, complexity and heterogeneity of the biotech industry, we believe that specific risk is the most important risk component. Primary research and close contact with companies are key to our investment success. We conduct scientific due diligence with the assistance of our Scientific Advisory Network, company visits, and our own primary research, modeling and valuation in this process.

Lots of people buy biotech based on take-out speculation. Is this part of your thought process?

No. We invest in biotech companies on their own merits -- good prospects for their development or marketed products, etc. If one of our holdings should happen to get acquired then so much the better, but acquisition expectations do not form a part of our investment case.

With an area this speculative, does valuation matter?

Valuation is critically important. Understanding the market's expectations for approval/non-approval or Phase III success/failure for any particular product vis-à-vis our own expectations forms the basis of long or short positions.

For example, if the market is not pricing in a high probability of success for a particular product and our due diligence has indicated a reasonable chance, we would initiate a long position. In the reverse situation, a short position would be appropriate.

What are some hot sectors in biotech?

Cancer companies have attracted a lot of attention over the last few years -- ever since Genentech's(DNA Quote) Avastin drug for colorectal cancer showed a survival benefit in 2003. More recently, vaccine companies and hepatitis C companies have been catching investor's interests.

Vaccine companies have been attracting attention for a variety of reasons: the great cancer prevention potential demonstrated by the new HPV vaccines from companies like Merck and GlaxoSmithKline (GSK Quote), a renewed interest in influenza vaccination after last years manufacturing shortfall, worries about pandemic flu, and finally, large pharma's M&A activity in this segment has not hurt.

Hepatitis C companies have also been attracting investor interest because of, firstly, the large infected and untreated HepC population and, secondly, the great advances in anti-viral treatment of HepC, approaches that have been shown to be effective in HIV.

What are some of your favorite stocks and why?

I like Neurocrine Biosciences(NBIX Quote) which is a San Diego-based company that will be teaming with Pfizer to launch a treatment for insomnia next year. We also like Cotherix(CTRX Quote) which has launched an innovatively administered treatment for a rare blood vessel disorder called pulmonary arterial hypertension.

Isn't it dangerous to invest in companies that pin their hopes on a single drug?

Drug development is estimated to have a success rate of one in 5,000 candidates that begin preclinical/animal testing. So it is quite a risky endeavor. But, getting back to the importance of valuation, investing in companies with all their eggs in one basket can be risky if the market is pricing in a high hope for success.

On the other hand, this could also be a good short candidate for the Quaker fund. Also, holding several long positions in one-product companies does provide a diversification benefit. Finally, this is not the only way to invest in biotech companies. Some solid performers this year have been diversified non-binary biotech companies like Gilead (GILD Quote), Amgen and Genzyme(GENZ Quote).

What are your expectations for biotech in 2006?

We expect biotech performance at least in line with earnings growth, which for large-cap companies is about 20% per annum. I say "at least" because this was our expectation for 2005, and year to date we are flat despite the 20% consistent earnings growth that I mentioned previously.

Valuations at 33 times 2006 estimates are not stretched when one considers that the pharmaceutical industry is growing about three-times slower at about 7%, is trading at 16 times, which is only half the biotech multiple. We would however expect the market to remain very selective, so the difference between the winners and the losers will continue to be substantial.

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