(FORTUNE Magazine) – Since before ovinophiles even thought of altering the genes of their beloved farm animals, people have been putting their hopes into biotechnology stocks. Alas, it hasn't always paid. Over the past year, investors were far better off with their money in major drug companies like Merck, Pfizer, or Eli Lilly. And thus far in 1997, Merck is one of the Dow's best performers, up 18% through the beginning of March.

Still, setting aside all the hype about cloning, there is an intriguing case to be made that biotech offers a better investment opportunity than the big drugs. As Skip Klein, manager of T. Rowe Price's Health Sciences fund, argues: "The time is ripe to overweight the biotech group, particularly the smaller caps, relative to the big pharmaceuticals companies."

Look at Merck, the bellwether of big drug companies, which unlike all but a handful of biotechs creates cash rather than consumes it. Merck's prospects over the next couple of years look blindingly bright, thanks in part to its anticholesterol and osteoporosis drugs and the potential of pending medications for baldness and asthma. The weak link appears when you look further out: Merck's patents for many of its key drugs are set to expire around 2000. While many analysts note that Merck has replacement products waiting in the wings, Montgomery Securities' John Borzilleri projects a worst-case scenario in which Merck's earnings growth dwindles from 15% this year to 3% by 2001. "The patent risk remains unbelievable," he says direly.

So what about the biotech industry, which has a combined market cap less than Merck's alone? That is where the scientific innovation that fuels drug industry profits is shifting. The big pharmaceuticals themselves certainly recognize this. San Francisco research firm Recombinant Capital calculates that they poured $4.5 billion into deals with biotech companies last year, up from $650 million five years earlier. It takes biotech companies an average of five years to develop a new drug, according to a Montgomery analysis, vs. eight years or more for the pharmaceuticals giants. That leads to a cost of development that's less than half what the big guys are up against.

Moreover, biotech's drug pipeline is full to bursting. Fewer than 50 biotech drugs have been approved in the past 20 years, but analysts expect at least 50 more to come to market in the next four years alone. And that may just be the start: Last year the biotech industry threw $3.9 billion into research, while Merck spent $1.5 billion. Although only seven U.S. biotech companies showed a profit last year, Samuel Isaly, who runs the Eaton Vance Worldwide Health Sciences fund, projects that the number will increase sevenfold by 2000. The average $3.5 billion market cap of a profitable biotech company is ten times the size of one not yet in the black.

Of course, owning a stock like Merck is a much safer bet than buying a single biotech, and we'd caution investors against abandoning the drug sector. Even though biotechs have stronger balance sheets than ever before, buying their stocks remains a hit-or-miss proposition.

Still, there is opportunity bubbling up. That's why, with the help of more than half a dozen top mutual fund managers and biotech analysts--including Klein and Isaly, mentioned above, as well as Kurt von Emster, portfolio manager of Franklin Templeton's top-performing Global Health Care fund, and analyst Marc Ostro of UBS Securities--we've devised a portfolio of 13 promising biotech names (see table) that covers the arc of the industry, in terms of size, stage of development, and risk. "If you buy a basket and hit one or two right," says Ostro, "you can really make an ungodly amount of money."

The portfolio includes a broad array of companies, from pioneers in the use of recombinant DNA (Biogen) to experts in the newer fields of combinatorial chemistry (Pharmacopeia) and genomics (Millennium Pharmaceuticals, Genset). The latter two fields offer especially important research tools. If one thinks of drugs as chemical bullets searching out targets in the body, combinatorial chemistry increases the number of bullets and genomics improves the chances of finding the right target. (Affymetrix, another well-regarded genomics company, is profiled in our cover story.)

Other companies on the list improve old drugs by stripping out their side effects (Sepracor) or figuring out better ways to deliver drugs in the body (Liposome Co., Inhale Therapeutic Systems). Then there is Isis Pharmaceuticals, whose "antisense" technology cancels out the disease-causing messages of faulty RNA.

Of the larger ones, Centocor and Biogen are in the middle of substantial earnings upswings, while Genzyme is probably the best biotech value. Liposome is expected to turn a profit this year, and U.S. Bioscience next year. Most are driven more by news of products moving through clinical trials and partnership deals with the big drug companies than by the promise of specific earnings streams. And no, none of these companies have any plans to shake up the livestock industry anytime soon.