Even though neither Johnson & Johnson ( JNJ) nor Alza ( AZA) is a pure biotechnology stock, I think the announcement that Johnson & Johnson will buy Alza for $10.5 billion in stock is great news for biotechnology investors.

The deal confirms, in my opinion, that despite the stomach-churning volatility in the sector over the past year, the fundamentals driving the long-term appreciation in the value of biotech stocks remain intact.

That's not small comfort, either. In the past year, biotechnology stocks have ridden a roller-coaster course that makes the path of the Nasdaq Composite Index look almost sane. After peaking just shy of 800 on March 6, 2000, the American Stock Exchange Biotech Index fell to just a little more than 405 by April 17 -- a 50% drop in just more than a month. By late summer, though, the index was closing back in on 800. In what is now, in retrospect, a clear triple top, the index closed at 773 on Aug. 31, 801 on Sept. 28 and 786 on Nov. 2. By March 21, 2001, however, it was back at 423, having repeated the ride it took in 2000 from 800 to 400. On March 27, the index closed at 474.

I've been following the recent debates among analysts over whether the March 21 low marks some kind of a double-bottom in the sector. Frankly, I don't have any idea if that's the case, and I suspect that it's no more possible to call the exact bottom in a sector than it is to pinpoint the exact bottom in the market as a whole.

But fortunately, the "buy and forget" strategy that I use for the portfolio of biotechnology stocks that I've been putting together for Jubak's Journal since 1998 doesn't rely on calling bottoms and tops. Following that strategy, it's enough for me to know that biotechnology stocks are relatively cheap right now -- and that the fundamentals driving the appreciation of these stocks over the long term are still intact.

Betting on the Future

Which brings me back to the Johnson & Johnson/Alza deal. Why does this convince me that the sector is still a good long-term bet despite its recent volatility? Because the willingness of big drug companies such as Johnson & Johnson, Merck ( MRK), Pfizer ( PFE), Eli Lilly ( LLY) and others to pay biotechnology companies to find new drugs, and then often to buy those companies when the research pans out, is the single most important factor in supporting the stock prices of biotechnology companies.

Oh, it's great when a biotechnology company such as Cor Therapeutics ( CORR) actually gets a drug approved by the Food and Drug Administration, launches a successful attack on the market and racks up significant sales. Integrilin, Cor Therapeutics' drug for angina, has recorded more than $100 million in sales over the past 12 months and is now the top drug -- by one measure, anyway -- in a three-drug market.

But most biotech companies have to be valued on their drugs-in-progress. Even a company such as Cor Therapeutics deserves a market capitalization of $1.3 billion only if its pipeline contains at least a few future winners. Biotechnology companies depend on the big drug companies to strike research and development partnerships that will help them finance the most promising of these drugs -- in exchange for a piece of the future action. Investors, in turn, depend on these deals for information on which drugs in development might be the most valuable when they finally reach the market. Investors also depend on the occasional acquisition of an entire drug development company to value a development-stage biotechnology company.

You can see how this works pretty clearly in the purchase of Alza. Johnson & Johnson is paying $10.5 billion to buy Alza, a company that analysts project will have $1.2 billion in revenue in 2001. The deal fills a growth hole in the big drug company's current drug lineup. Pharmaceuticals accounted for about 40% of Johnson & Johnson's overall sales in 2000 and about 60% of the company's profits. But Johnson & Johnson has had several promising products fizzle in development recently, and blockbuster drugs such as Procrit/Eprex for anemia and Risperdal, an antipsychotic, are about to face tough new competition.

In buying Alza, Johnson & Johnson gets ownership of promising drugs such as Concerta, a treatment for attention deficit disorder, and Ditropan XL, an incontinence drug, that Alza doesn't have the money or the sales force to fully market. Plus Alza's drug-delivery technologies will give Johnson & Johnson a way to improve the efficacy of its existing drugs and perhaps a way to extend their lives in the market. (Johnson & Johnson has gone this route before, having bought biotech leader Centocor in an earlier deal.)

The trends that have driven stock prices higher in the biotechnology sector in the past -- and that will do so again in the future -- are on exhibit in this deal. Big drug companies are still hungry for new products to fill holes in their pipelines and will pay top dollar for promising compounds. And they will pay even more for drugs that are far along or at the end of their clinical trials. That's not a minor point. Biotechnology companies, after years of bringing almost no drugs to clinical trials, now have scores of candidates ready for the Food and Drug Administration.

A Sky's-the-Limit Future

My four-rule biotechnology strategy is based on the real potential and the real risk of investing in this sector. I think biotechnology has a sky's-the-limit future. Some of the companies using these technologies will produce drugs that will rack up $1 billion in annual sales. Every investor, in my opinion, should have some money in the sector.

But I also know that predicting precisely which companies will wind up owning $1 billion drugs, and which will end up blowing $1 billion in investors' capital on the drug-industry equivalent of dry holes, is extremely difficult. And I know that the long lead time from research program to drug test, and the incredible volatility of stocks in this sector, can wear out the nerves of even the steeliest investor.

That's why I've built my biotechnology portfolio around these four principles:

  • Buy enabling technologies. Look for companies that have mastered a research approach that is likely to lead to scores of potential drugs.
  • Buy products in the pipeline. Look for companies with a solid calendar of potentially positive news on drug tests and approvals.
  • Buy cash. Look for companies that have cash in hand or a proven record of raising cash to reduce the danger that they might run out of money at just the wrong moment.
  • Buy cheap stocks. Build a portfolio of inexpensive but promising companies, rather than trying to hit a home run by guessing who'll be the next Amgen (AMGN) or chasing the current market favorite.
  • Portfolio Review

    From the time I began constructing this portfolio in September 1998 until last August, I used these rules to pick 10 stocks to fill out a portfolio. Now that the list is complete, I'm going to concentrate on fine-tuning it every six months or so by replacing the stocks of companies that have lost their way -- or that simply look less promising -- with the occasional newcomer. In this column, for example, I'm going to make one new pick and drop one stock, Microcide Pharmaceuticals ( MCDE), from the list.

    First up -- Cell Genesys ( CEGE).

    Cell Genesys (CEGE)
    Date Price
    3/27/01 $14.69
    8/11/00 23.94
    2/15/00 23.13
    9/24/99 7.88
    (pick price)
    Market cap: $501 million
    Gain since 9/24/99 pick: 86%

    Cell Genesys is awash in patents -- 260 granted with 320 pending -- and cash -- $260 million at the end of the December quarter (plus $190 million in Abgenix ( ABGX) stock at the March 27 price. And its science doesn't seem to be doing too badly, either. Cell Genesys concentrates on gene therapy, and its vaccines work by using modified genes to treat diseases such as cancer and hemophilia. On March 7, the company announced it had initiated a Phase I/II clinical trial of its GVAX cancer vaccine for multiple myeloma, the second-most-common hematological malignancy in the U.S. The same GVAX technology has also shown antitumor activity in an initial Phase II trial in patients with advanced metastatic prostate cancer. The company has a total of four GVAX drugs in either Phase I or Phase II trials, and an additional four gene therapy candidates at the preclinical stage.

    Cor Therapeutics (CORR)
    Date Price
    3/27/01 $24.47
    8/11/00 46.50
    2/15/00 24.36
    3/4/99 4.84
    (pick price)
    Market cap: $1.3 billion
    Gain since 3/4/99 pick: 406%

    Cor Therapeutics has been under attack lately as a one-drug company. Every biotechnology company should be so lucky. Cor Therapeutics now projects that Integrilin, the company's platelet blocker used to treat unstable angina and for patients undergoing heart surgery, will show revenue of $245 million to $260 million in 2001. The drug will have, the company estimates, about 20% of the market measured by dollars of sales, and 45% of the market measured by patients taking the drug vs. its two major competitors.

    Cor Therapeutics and its marketing partner, Schering-Plough ( SGP) are also working hard to extend Integrilin's market to other cardiovascular conditions such as myocardial infarction. But Integrilin isn't the company's only drug. Cromafiban, a drug with the potential to treat stroke and peripheral vascular disease is currently in Phase II trials. Other drug candidates to treat pulmonary embolism and stroke are currently working their way toward clinical trials. Cor Therapeutics had $340 million in cash and cash equivalents at the end of December 2000.

    Hyseq (HYSQ)
    Date Price
    3/27/01 $8.94
    8/11/00 36.75
    (pick price)
    Market cap: $122 million
    Loss since 8/11/00 pick: 76%

    There's a new wave of hybrid genomic platform companies that sell equipment, but also hope to make money out of developing drugs using the new knowledge about the specifics of the human genome to target drugs to individuals or groups of individuals. Hyseq ( HYSZ) is my favorite of this group for two reasons: The company owns a huge data base of rarely expressed human genes, and it recently added George Rathmann, the founder of Amgen and Icos, as chairman.

    Rathman, who joined the company in February 2000, knows from experience how to guide a biotechnology company down the long road from promising technology to marketable drugs. He's been instrumental in focusing the company on the goal of bringing two compounds into clinical trials each year. Right now, the company projects that it will take its first two candidates into the clinic late this year. Keeping that pace up for a long time shouldn't be too hard for Hyseq, either. Rarely expressed genes are often triggers that control complex biochemical processes, which makes them ideal drug targets.

    Hyseq has four partnerships currently -- with Chiron ( CHIR), BASF Aktiengesellshaft ( BF), the pharmaceutical division of Kirin Brewery ( KNBWY) and the University of California at San Francisco -- to identify drug targets. The company is currently meeting its cash needs through a line of credit from Rathmann and will have to go back to the capital markets some time this year.

    Icos (ICOS)
    Date Price
    3/27/01 $48.13
    8/11/00 53.75
    2/15/00 35.50
    9/25/98 17.75
    (pick price)
    Market cap: $2.3 billion
    Gain since 9/25/98 pick: 171%

    It's easy to forget that Icos ( ICOS) isn't a one-drug company. The company's Viagra-killer, Cialis (IC351), gets most of the attention, of course. Trials on male sexual dysfunction continue on track -- it looks like the drug has fewer side effects and better onset than Viagra, with an application to the Food and Drug Administration likely in the second half of 2001. (Trials for female sexual dysfunction are now in Phase II.) In addition, though, Pafase, the company's drug to treat sepsis, a cascading collapse of the body's immune system in response to a severe infection, is set to go into Phase III trials this spring. (There is no current adequate treatment for sepsis. More than 30% of the 750,000 annual cases in the United States end in death.) The company will also put Sitaxsentan, a drug to treat pulmonary hypertension, into Phase III trials this spring. A second drug for sepsis, IC14, has just entered Phase I trials. Icos finished December 20000 with $229 million in cash or cash equivalents.

    Read part 2 , to learn about the rest of Jubak's picks.
    At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Brocade, Hyseq, Icos, Isis Pharmaceuticals, Ribozyme Pharmaceuticals, Vertex Pharmaceuticals and Vical.