Inaugural Insights on the Biotech Sector

Welcome to TheStreet.com's new column on the biotech and pharmaceutical health care sectors. The aim is to give readers an insight into these complex, fast-moving industries from the perspective of a buy-side professional.

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Separating the Biotech Wheat From the Chaff

Investing in this sector is not without risk, of course -- the Amex Biotech Index (BTK.X) has tumbled almost 30% since its March 6 peak, while the much larger Nasdaq Biotech Index (IXBTX) has fallen about 26%. Nevertheless, I strongly believe that biotechnology is the sector for the 21st century, because it has the greatest potential to change the world as we know it, and it will affect every single one of our lives.

We are also at a critical inflection point for the biotechnology industry. After a wrenching 6 1/2-year bear market for biotech that, by August 1998, saw the Amex Biotech Index decline more than 50% from its peak in January 1992, the index has appreciated some fourfold in the past 18 months.

After years of high-profile clinical disappointments, in 2000, for the first time, the biotechnology industry will submit more new drug applications to the Food and Drug Administration than all of the large pharmaceutical companies combined. It may only be a matter of time before the market capitalization of the entire biotechnology industry -- which was only $80 billion in mid-1998, less than half the market capitalization of Merck (MRK), surpasses the combined market capitalization of the entire pharmaceutical industry.

Both biotechs and the big pharmaceuticals offer this promise, of course, but biotechnology stocks are by far the more rewarding of the two, and the hardest stocks to pick. For starters, there are hundreds and hundreds of publicly traded biotechnology companies. Most of these companies have little or no analyst coverage, are relatively thinly traded and inefficiently priced.

The level of risk is exponentially higher in biotechnology than any other sector. The stocks are always susceptible to a huge blowup until the drug is approved, commercialized, and successfully used in a large patient population for at least one year. A blowup that knocks anywhere from 25%-90% off the share value can happen when a lead product shows disappointing clinical results -- witness what happened to Cellegy Pharmaceuticals (CLGY) in November.

Or, a partner drops a program, as happened to DepoMed (DMI) last April;

This can even happen with an already approved drug which is both commercialized and demonstrates an initial huge success -- but then shows some unforeseen side effects, as happened with Interneuron Pharmaceuticals' (IPIC) Redux in mid-1996. The share price has yet to recover from that debacle.

There are literally hundreds and hundreds of questions investors need to ask, covering topics like clinical data, competitive products approved and under development, pharmacology, method of action as well as trial design and endpoints. These questions about a biotechnology company's experimental drugs absolutely need to be answered before an investor can be reasonably sure it will be successful and not fail in clinical trials, be rejected by the FDA or fail in the marketplace.

Inevitably, some of these may be questions investors just can't get answered because the information isn't yet available. And yet any one of these considerations may result in the drug failing in clinical trials, be rejected by the FDA, or simply not succeed in the marketplace.

Another major challenge to investing in this field is that when it comes to pertinent information, the scientific community often finds out first. If patients experience unforeseen adverse effects in a clinical trial, forcing an end to the trial and the drug's development, word gets around and the stock could begin moving down even before the company can put together a press release. If terminally ill cancer patients show unexpected survival times in clinical trials, the news often leaks out months before the trial ends, pushing the stock higher. Sometimes the best-connected institutional investors hear about it first, but most don't.

This is why, unfortunately, Peter Lynch's methods for individual investors have absolutely no place in biotechnology. You can't eat a biotechnology company's chicken sandwiches or try on its clothes to see if you should buy the stock. Just because your doctor prescribes more Prozac than any other anti-depressant doesn't mean that Eli Lilly (LLY) is a good investment.

In the spirit of TheStreet.Com, this column will not feed you a sugar-coated version of things. It will tell it like it is, even if it's not pretty. I will also share the expertise of others, including a few biotechnology hedge fund managers and analysts who I believe are the best in this business.

I will try my very best to communicate in a clear and responsible manner the tools, methodology and thought processes that I use every day to identify critical events for companies and their probable outcomes.

I'd also like to know what you are interested in. I welcome your questions and may use them as the basis for future columns. So just drop me a line.

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