Does it Pay to Bet on Biotech? For every Amgen or Genentech, 24 other beaker babies never earn a dime. But some very specific knowledge can help turn the odds in your favor.
By Michelle Leder

(Business 2.0) – It's hard to find a riskier bunch of stocks than biotechs. Consider the roller-coaster ride experienced by investors in IntraBiotics, maker of an antimicrobial drug that it hopes will prevent a condition called ventilator-associated pneumonia. After the Palo Alto-based company announced last September that iseganan hydrochloride, the compound it had been testing for several years, had been fast-tracked for approval by the U.S. Food and Drug Administration, its stock more than doubled overnight. But on June 23, IntraBiotics announced that it was halting clinical trials because people taking the drug were dying more frequently than those taking a placebo. Within minutes the stock dropped by 70 percent.

Why would you even consider putting your hard-earned money into a stock like that--or anything else in such a volatile sector? Because every few years, along comes a company like Amgen or Genentech. An investor who'd put $1,000 into the former 15 years ago would be sitting on more than $60,000 today; anyone who invested in the latter when it was taken public five years ago would already have seen his money quadruple. "There aren't many places where you can have the eye-popping returns that you have with biotech," says David Miller, publisher of the respected newsletter "Biotech Monthly."

Certainly there's money to be made here--but if you don't know what you're doing, veteran biotech investors say, you're just as likely to lose your shirt. Spend any time talking to these folks and they quickly tick off the reasons biotech stocks are not for the faint of heart. For instance, only 10 percent of companies ever get a product to market, Miller says. Samuel Isaly, manager of the Eaton Vance Worldwide Health Sciences Fund, notes that a successful biotech company typically takes eight years to get from IPO to profitability--and that only about 40 of the nearly 1,000 companies in the sector's 25-year history have accomplished that.

How do you beat such long odds? It all comes down to doing what the biotechs themselves do: lots of research. Thankfully, though, you don't have to invent the wheel (or even a promising cure for psoriasis). You just have to do the same homework the pros do. Here's where the sector's top investors and analysts suggest you focus your studies.

COUNT ONLY CASH. Because most biotech companies go public long before they have a product to sell, there are usually no profits, and thus no price/earnings ratio or other reliable measure of value. So the only number that really matters, says Jill Kiersky, who follows the sector for Chicago-based research firm Morningstar, is cash on hand. If the company doesn't have enough money to navigate the FDA's labyrinthine approval process, how close its scientists are to finding a cure for cancer is irrelevant. Check the balance sheet for cash and cash equivalents, factoring out goodwill, which never pays the bills. Kiersky usually avoids any company with less than twice as much cash as the expenses listed on its income statement.

THINK LIKE THE FDA. Wall Street tends to focus on companies with potential blockbusters moving to phase 3 clinical trials, the final step in the FDA's approval process. So the smart money has already pushed up the price of these stocks. One strategy, says Evan McCulloch, lead manager of the Franklin Biotechnology Discovery Fund, is to search for companies with boring niche products that are throwing off enough cash to finance a more exciting product in early-stage testing. He also suggests learning whether the company has the ability to manufacture the drug and whether the company's leadership has the skill to maneuver through the bureaucracy. "Try to mimic the FDA decision-making," he says.

PICK THE RIGHT DISEASE. You want to invest in a company that's targeting a rare disorder, but not so rare that there won't be a big payoff. Companies chasing major markets like high blood pressure or diabetes tend to be well scrutinized by analysts, so their stock is most often priced to perfection--if not overpriced on hype. But lupus, an autoimmune disorder affecting 1.5 million Americans, currently has no effective treatment, and only La Jolla Pharmaceutical has a drug awaiting FDA approval. Curing cancer, meanwhile, is the holy grail, but though breast and prostate cancers get the most attention, there are more than 100 other kinds that may have promising treatments.

PLAY POLITICS. The character of the FDA changes with every new commissioner. The industry's recent boom coincided with the tenure of Mark McClellan, widely credited with fast-tracking new drugs to market. But he left in late March to oversee Medicare. The new interim chief, Lester Crawford, doesn't instill that kind of confidence, analysts say, and stock prices are off almost 21 percent since the April peak. President Bush isn't expected to expend political capital choosing a new boss before the November election, so Wall Street is in a wait-and-see mode at least until January. Use the next several months to study the industry and choose wisely.