NEW YORK (CNN/Money) -
What kind of bizarro world is this?
You'd think pharmaceuticals, one of the more defensive market sectors, would be a solid performer in this year's tough market while biotech stocks, which are just oozing with risk, would be total dogs.
After all, big pharma stocks tend to trade at reasonable valuations and offer investors the security of juicy dividends while many biotechs are unprofitable and have tiny revenue streams.
But the Philadelphia Drug Index has fallen more than 10 percent this year. The Amex Biotech Index, on the other hand, is up 1 percent this year, a respectable return given how the overall market has fared.
Large pharmaceuticals, most notably Pfizer and Merck, have been pummeled due to health concerns about some of their existing drugs. Of the 14 stocks in the Philadelphia Drug Index, only Johnson & Johnson is having a solid year, with shares up nearly 11 percent.
But there are several big winners in biotech. Biogen IDEC has surged 54 percent. Enzon Pharmaceuticals and Celgene are both up more than 30 percent. And a company called Imclone Systems (where have we heard of that company before, hmmm?) is up nearly 23 percent.
Biotechs may have more bang for the buck
So can biotechs continue to outperform the established drug giants? It looks that way.
Michael Sjostrom, co-manager of the Quaker Biotech Pharma-Healthcare fund, said that large drug companies are facing increased competition from generic drug makers as many key drugs are coming off patent protection. That's an issue that younger biotechs don't have to face.
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He adds that biotechs should probably continue to outperform larger drug companies since the biotechs are, by and large, the companies that are working on most of the promising new medications.
"Most large cap pharmas have run into research & development productivity issues and are unable to come up with significant amount of new products," he said. "But this weakness is the strength of the biotech industry."
In addition, the valuation gap between pharma stocks and biotechs isn't nearly as great as it once was. Twelve of the seventeen biotechs in the Amex Biotech Index are expected to post a profit in 2005 and they are trading at an average of 33 times 2005 estimates.
Sure, that is still a big premium to the average P/E of 20 for the stocks in the Philadelphia Drug Index.
But when you consider that the biotechs are expected to post an average annual earnings increase of 24 percent over the next few years while the estimated long-term growth rate for drug stocks is only 11 percent, this premium doesn't seem that outlandish. The biotechs are trading at a PEG ratio (P/E divided by the long-term growth rate) of just 1.4 while the drugs have a PEG of 1.8.
Risks could make some investors ill
Of course, this doesn't mean that biotechs are now necessarily "safer" than larger drug companies. Shares of smaller biotechs are often rocked when companies announce disappointing clinical trial data. And the more mature biotechs, companies that already have drugs on the market, certainly can face the wrath of Wall Street as well.
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Take Chiron. Its stock has plunged nearly 45 percent this year and most of the decline took place after the company said earlier this month that it would not be able to supply its flu vaccine Fluvirin to the U.S. for this flu season.
And even though the biotech industry is starting to grow up, investors tend to focus more on the promise of future drugs for biotech firms as opposed to current earnings and sales. That makes the stocks more speculative than big pharma companies.
"The pipeline is the source for future cash flow and that's how these companies trade," said Soham Pandya, an analyst with Susquehanna Financial Group.
To that end, Pandya points out that two of the sectors' biggest winners this year, Biogen and OSI Pharmaceuticals, which has nearly doubled, have done well mainly due to excitement about new drugs. (He does not own either stock and his firm has no banking ties to the companies.)
Biogen is hoping to have a drug for multiple sclerosis approved by the Food and Drug Administration by the end of the year, Pandya said. And OSI is working on a drug to treat lung cancer that has shown some encouraging signs in clinical tests.
But the two companies are in very different stages. Biogen is one of the sector's larger players, with a market value of nearly $20 billion. The company is profitable and is expected to generate nearly $2.5 billion in revenue in 2005. OSI, on the other hand, isn't expected to make money in this fiscal year or next and has a market value of just $2.8 billion.
Sjostrom said that he is more likely to invest in biotechs that are already profitable. "That's the best mix between risk and potential reward. We're careful with early stage companies," he said.
With that in mind, Sjostrom said that Celgene is one of his top picks. The company, expected to earn 58 cents a share next year, makes the drug Thalomid, which is used to treat leprosy. But Sjostrom said the company is seeking to get approval from the FDA to market the drug as a treatment for a form of blood cancer as well.
Sjostrom's also taking a gamble on Chiron. He said he bought the stock after it took its big hit and thinks that there's a good chance the company will be able to solve its manufacturing problems in time to have its flu shot available for the 2005-2006 flu season in the U.S.
But Pandya said that because of the many risks associated with biotechs, individual investors should not try and buy just one or two biotechs. That's because many biotechs wind up never getting drugs to the market.
"We've always advocated a portfolio approach. Buy a mix of larger companies with earnings and smaller, more speculative companies," he said.
So for the average investor who is interested in the sector but doesn't have the money, or medical knowledge, to really highlight the top names, a smarter move is to look at a biotech mutual fund or a more diversified healthcare fund.