Don't Lump Biotechs With Big Pharma

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) 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), 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) 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) 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), Amgen and Genzyme(GENZ).

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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