(MONEY Magazine) – There's a revolution going on. You may know it as cloned mice, or the Human Genome Project, or perhaps insect-resistant corn. It's a revolution with many fronts but one clear quest: unlocking the secrets of genes, the DNA strands that contain the code of life. The implications for humanity are staggering: the prevention of disease, the feeding of the world. The implications for you as an investor are less profound but still momentous: Biotechnology is America's most promising industry, and it's the stock market's next big thing.

Sure, you're thinking, I've heard that before. Well, think again. It's true that in the mid-1980s, biotech burst onto the scene with promises of miracle cures and big payoffs that rarely materialized. But today, the industry is broader and healthier than ever, thanks to four key developments: huge advances in the study of genes; abundant research capital; a more sympathetic Food and Drug Administration; and the burgeoning health-care demands of an aging U.S. population. The players are no longer just scientists and dreamers in university labs and small industrial parks; they include the CEOs of the biggest drug and chemical concerns in the world.

To be sure, identifying the companies that will profit most from the coming boom is no easy task. That's where this article comes in, as a guide to making your way on investing's new frontier. We'll give you an overview of the prospects for biotech's main segments: genomics, health-care biotech, big drugmakers and agricultural biotech. But we'll also present nine specific stocks--and five mutual funds (see page 85)--that we think will produce solid long-term gains.

That said, we're not suggesting that you dump today's Microsoft in a quixotic pursuit of tomor-row's big winner. Genomics and biotech drug stocks have serious short-term hurdles to overcome: They are mostly small-cap companies in a market where large-caps are king, and many of them have cost a lot of one-time believers a lot of money. Moreover, chasing the gene is risky business. Remember EntreMed? The small biotech drug firm shot up 600% in May after a New York Times article suggested, prematurely, that the company might have a cancer cure, only to crash when investors came to their senses.

Nonetheless, it's foolhardy not to at least consider putting a small portion of your assets into this sector. "The biotechnology revolution is in Stage 1," says William Scouten, director of the biotech center at Utah State University. Ultimately, he contends, "it will have more of an impact than the computer revolution."

The force that's driving biotech's coming boom is the rapidly advancing science of genomics, the study of how genes work. Humans have an estimated 100,000 genes made up of DNA sequences that carry the encoded instructions that produce hereditary characteristics, normal and mutated. If DNA is the software that runs life processes, then scientists want to search for bugs in the programs. Why? As defective software can crash a computer, defective DNA can make you sick. Understand the errors in the code, and you're on the way to a cure.

Knowledge of genes is doubling every 12 to 24 months. Indeed, scientists will soon finish mapping the complete sequence of DNA subunits in the human genome, or genetic code. That data will allow health-care providers to develop better treatments. For example, by analyzing genes associated with osteoporosis, SmithKline Beecham scientists have isolated an enzyme that contributes to the disease. By finding a way to inhibit the enzyme, they may be able to stop or reverse bone degeneration.

The potential market for such treatments is enormous, and it's growing. The number of Americans between 45 and 64 will increase 40% by 2010. Baby boomers will soon become obsessed with later-life chronic diseases. The health insurance industry already is. Consider: Five maladies--cardiovascular disease, cancer, Alzheimer's, diabetes and arthritis--account for nearly half the $1 trillion spent annually in the U.S. on health care, mainly to treat symptoms. Insurers, looking for ways to contain that tab, don't mind spending for drug treatments, which are cheaper than other therapies. And with biotech comes the possibility of not only controlling more diseases but curing more patients or preventing them from getting sick--and saving money for their insurers. A drug that cures, say, diabetes, could be worth tens of billions of dollars to its owners.

The prospect of such riches has attracted a new biotech banker, the global pharmaceutical company. To sustain their remarkable growth rates, these giants need new drugs, fast. So they're spending billions on scores of partnerships with biotech and genomics firms and on their own biotech-related R&D, creating a pool of cash that all but guarantees more drugs to fill biotech's pipeline. And unlike the computer industry, biotech is not likely to be dominated by one or two Microsoft-like giants. With so many diseases to cure, the number of potential winners is large.

The revolution won't stop at drugs. Pharmaceutical and chemical giants are pouring money into the agricultural side of biotech, buying seed producers and distributors to form a chain that will run from farm to dining room to drugstore. Engineered DNA can now keep food from spoiling or make it more nutritious. Someday soon, it will turn crops into factories. A genetically altered plant might produce a substitute for plastic or perhaps a vaccine for malaria.

It's heady stuff, and not all the promises will come to pass. But in the decades ahead, many will. Our discussion of biotech's players and prospects will give you the tools to start assessing an investment opportunity that's more complicated--and more promising--than any you've known.

GENOMICS Fueling the revolution

The faster scientists decode genes, the faster drug and agricultural researchers can use the information to target genetic diseases or develop enhanced crops. Genomics companies provide those researchers with decoded data and the software and other tools needed to manipulate them. That means the companies aren't betting on one innovative seed or drug--they're betting on all of them. "This is the foundation upon which medicine and agriculture are going to rest in the next century," says Elizabeth Silverman, a molecular biologist and BancAmerica Robertson Stephens biotech analyst.

While scientists are close to deciphering the human genome, that's only a first step. Because genetic variation is the key to many diseases, genes need to be analyzed again and again, from patients both healthy and sick. Big drug companies have already made it clear that they recognize the value of genomics. SmithKline Beecham alone has made a $125 million commitment to genomics pioneer Human Genome Sciences for "special access" to that company's database.

So how does an investor tap into this bounty? Carefully. The market for genetic data and technology could grow into the tens of billions of dollars over the next decade, says Jeremy Rifkin, a social critic and author of The Biotech Century. (See the interview with Rifkin on page 93.) But now there are just a dozen or so publicly traded genomics companies, and only one makes money. Still, there are ways to uncover tomorrow's successes. So here's our approach and the results it yielded.

We first looked for companies that have more than databases; we wanted patented technologies that make it easier for customers to analyze and manipulate genetic data. Then we made sure those patents had obvious commercial value, as evidenced by real paying customers, not just ones on a business plan. We also tried to find companies with product lines that weren't confined to big-ticket items that clients would buy only once. In addition, we wanted companies to have enough cash or committed revenues to fund research and other expenses for at least three years. Finally, we sought experienced management. If an outfit has yet to make money, you want to know that its executives have taken a business into the black before.

Our screen first led us to Incyte Pharmaceuticals, the lone profitable genomics firm. Like the federally sponsored Human Genome Project and other for-profit gene-sequencing companies, Incyte produces genetic databases. What sets it apart from the pack is the quality of the software it sells to mine the data. Pharmaceutical giant Rhone-Poulenc, for instance, is buying access to an Incyte microbial database that has the genome for Streptococcus pneumoniae, the major cause of pneumonia. Rhone-Poulenc's researchers are using Incyte software to search for ways to treat and prevent the disease. Incyte counts among its customers 21 of the top 50 pharmaceutical companies, which pay it an average of $5 million a year each. Down the road, the company also stands to receive royalties from products developed from its database.

On the agricultural side, Monsanto and others use Incyte software as they look for ways to improve crop yields as well as pest and disease resistance. Analyst Mike King of Vector Securities thinks that Incyte should see earnings increases of nearly 60% annually over the next four years. With that growth rate, he thinks the stock ought to be trading at 58 times estimated 1999 earnings of $1 per share. It traded at $36 in late July. (For snapshots of Incyte and other stocks we're recommending, see the table above.)

One of the most fascinating developments in genomics is the DNA biochip--the analysis of DNA on a glass wafer. The clear leader in the field is Affymetrix, which designs biochips and sells scanners that read them. By inducing a chemical reaction between synthetic DNA on the chip and a cell sample they want to test and then running the chip through the scanner, Affymetrix clients can spot genetic mutations in the sample. One example: Metabolex, a private biotech firm, uses chips to identify gene patterns associated with diabetes; by comparing samples from both diabetic and healthy patients, Metabolex hopes to identify new therapy targets. Affymetrix has 80 of its chip scanners placed with major companies such as Hoffmann-La Roche and agricultural seed firm Pioneer Hi-Bred. Those customers will keep coming back because new projects require new chips. One vote of confidence from a knowledgeable source: Pharmaceutical giant Glaxo Wellcome owns a third of Affymetrix.

Research and development expenses have kept Affymetrix in the red, but its patent position and continuing advances in chips should make it profitable by 2000. Revenues, which have risen steadily from $1.4 million in 1993, should top $50 million this year and reach $80 million in 1999, says Robertson Stephens' Elizabeth Silverman. Finally, it's worth noting that Affymetrix was co-founded by Alejandro Zaffaroni, who sold his last start-up to Glaxo for $500 million. Zaffaroni has retired, but co-founder Stephen Fodor is still with the company as CEO.

DRUG BIOTECH Rising from the dead

The stock market history of biotech drug companies goes back almost 20 years, but the seminal event was the 1989 run-up of market darling Amgen. Unfortunately, the tale gets fairly depressing from there. Optimists predicted an avalanche of billion-dollar drugs; instead, stocks went into a coma as Wall Street and the industry realized they had grossly underestimated the cost and difficulty of bringing drugs to market. The sector as a whole has barely moved since 1993.

But it should awaken soon. Biotech's pipeline is bursting with more than 2,200 drugs in development, including 234 awaiting approval from the Food and Drug Administration, according to Ernst & Young. And those approvals are starting to come at a faster pace: The average time for FDA review has fallen to 16 months, from 30 in 1991. Half the 65 biotech drugs now on the market have been approved since 1996.

As for funding, biotech drug companies raised $11.7 billion in 1997, according to San Francisco merchant bank Burrill & Co. The pace has continued, with $5.7 billion raised this year through June--and that's in an industry with a total market capitalization of less than $100 billion. What's more, the big pharmaceutical companies providing much of that financing have such an insatiable need for new drugs that biotech firms are in a strong negotiating position when cutting marketing and distribution deals. A few years ago, the big drug firm typically grabbed 75% or more of a drug's profits. Today the biotech company might retain 50%. Better capital and a bigger share of revenues will mean more profitable biotech companies. In 1986, there was just one; by 2000, there could be 50.

Despite all the above, investors have largely ignored biotech drug stocks. One reason is the success of other sectors. "If you can make 25% a year investing in Coke, why on earth would you buy a biotech stock?" asks SG Cowen Securities Corp. biotech analyst David Stone. The Internet, meanwhile, has captured the imagination of speculative investors. As a result, most biotech stocks, including those of profitable companies, are languishing at low relative valuations. That presents an opportunity to buy promising stocks on the cheap. We found three. The two profitable ones aren't bargains based on their price/earnings ratios, but all are expected to grow extremely quickly. As a result, they've been trading at very low PEG ratios (their forward-looking price/earnings ratios divided by their anticipated growth rates, a good way to value fast-growing stocks).

In coming up with our choices, we first looked for companies with drugs that weren't in a pitched battle for market share. We also wanted to see that there was a truly large market for those drugs. If a company is going to split profits with a distribution partner, even a $50-million-a-year market is a pittance, especially when it can cost $350 million to develop a drug. We also made sure that companies had the cash to sustain development--at least three times annual R&D costs. Collaboration with a pharmaceutical partner, which is a source of funds and an endorsement of efforts, was also important.

Finally, we sought out companies whose next big sellers were far enough along in the FDA approval process to make us confident about their getting to market. Hambrecht & Quist biotech analyst Richard van den Broek recommends waiting to invest until a drug has passed either Phase III testing, which is a placebo-controlled test in hospitals and clinics, or has won FDA approval. You'll miss a stock's early, speculative run, but you'll avoid many disasters--and still be positioned for significant gains. (Of course, these stocks are hardly risk-free.)

It may surprise you to learn that we're passing on the industry's big three: Amgen, Chiron and Genentech. The reason? We concluded that, given their pipelines, their stock prices fully reflect their earnings prospects. Here are two profitable companies and one still in the red that seem more enticing.

BioChem Pharma's 3TC drug is now the No. 1 treatment for HIV. Sales last year topped $700 million, of which BioChem receives 12% to 13%, the rest going to its marketing partner, Glaxo Wellcome. Time for the encore: BioChem and Glaxo completed Phase III trials and filed for approval in June to use the same drug (under the name lamivudine) to treat chronic hepatitis B, which affects 300 million sufferers. That use could push 3TC sales to $2.4 billion by 2001, according to SG Cowen's Stone. Jay Silverman, another BancAmerica Robertson Stephens analyst, thinks BioChem can sustain 30% to 40% earnings growth through 1999.

On the surface, it's too late to buy MedImmune, which is up 146% in the past year; in June, the FDA approved the company's new drug, Synagis, which treats a respiratory infection in premature infants. But it's not too late to ride the upside that could come from strong sales of Synagis.

Synagis' U.S. market potential exceeds $500 million, which would be split with MedImmune's marketing partner, Abbott Labs, but that estimate won't be tested until this winter, because the virus the drug fights is seasonal. If speculative biotech investors follow their usual patterns, they will soon be selling, but many earnings-driven investors won't yet be buying. That presents a good opportunity for long-term investors. Prudential Securities analyst Caroline Copithorne thinks Synagis will dwarf sales of the company's current products, which totaled $65 million in 1997. She predicts product revenues will more than double this year and increase 95% in 1999, pushing per-share earnings from 17[cents] to $2.05.

Our last biotech drug stock, Aviron, is an anomaly: It's a money loser that nevertheless had enough financial strength to have made it through Phase III trials without going to a pharmaceutical partner for help--and giving up a big chunk of future profits. Aviron has completed trials of its FluMist flu vaccine and filed for FDA approval in late June. Administered as a nasal spray--eliminating the unpleasantness of an injection--FluMist acts directly on the mucous lining in the nose and throat. Aviron hopes to market the drug for the 1999-2000 flu season.

"This is really big," says Kurt von Emster, manager of Franklin Biotechnology Discovery fund, "because there hasn't been a major development in flu vaccine treatments in over 20 years." (Aviron was von Emster's largest holding in late June.) There's enough positive buzz about the vaccine that Aviron was able to obtain venture funding and sell stock in 1996, even though it's not expected to make money until 2000. As a result, the company still has $139 million in cash to support annual R&D of $30 million. Aviron CEO J. Leighton Read says he'll take his time finding the right marketing partner. If FluMist is approved, Aviron will pocket a big piece of a potential $500 million market.

BIG PHARMA Funding the revolution

The average drug company's stock has quadrupled in the past five years, but big pharma, as it's known, is in danger of becoming a victim of its own success. Many of its best-selling drugs, including Zoloft and Prozac, will lose patent protection over the next five years, meaning profit margins on those drugs will all but evaporate. Moreover, because drug companies have grown so big, a new drug must have near-Viagra sales to jazz earnings. And conventional methods aren't likely to produce the stream of blockbuster drugs the industry needs. Andersen Consulting estimates that a top-tier drug company would have to put out five new drugs a year with sales of $350 million each to maintain the 13% annual growth rate the industry has racked up in the '90s. Yet from 1990 to 1994, the top makers launched an average of one new drug every two years.

Big drug companies are hoping biotech can pump up their pipelines quickly and help them find the magic pills that have eluded them. "Pharmaceutical companies have one thing on their side--an abundance of cash--and one thing that's working against them, time," says Jeffrey Kraws, an Everen Securities analyst.

So big pharma is looking to make friends in a hurry. In the past 18 months, drug and biotech companies have struck 330 alliances. Drug companies have committed up to $6 billion in exchange for future royalties. One of the biggest collaborations, says Mark Edwards, managing director of biotech industry consultant Recombinant Capital, was last year's $200 million deal between Eli Lilly and Ligand Pharmaceuticals to develop retinoids (now used to fight acne and wrinkles) for treating diabetes.

In a typical deal, the pharmaceutical company makes a small, up-front investment for a biotech company to pursue promising research. It makes additional payments as a drug reaches various stages of development. If a drug makes it to market, the bigger partner handles marketing and/or distribution.

Eli Lilly got one of its best-selling drugs, ReoPro, through such an arrangement. In 1992, when the anticlotting agent used in angioplasty was nearing approval, Lilly paid $100 million to Centocor for the rights to ReoPro and another drug that ultimately failed. ReoPro now has annual sales of more than $250 million. Lilly's margins, after it pays royalties to Centocor, are an estimated 35% to 45%. So far, about 40 biotech drugs have come to market as a result of pharmaceutical-biotech firm collaborations. That number is expected to increase fivefold within five years.

Drug companies are also beefing up their own biotech research. They buy access to the databases owned by genomics companies and use that information to develop drugs. Pharmacuetical companies are famously tight-lipped about their internal R&D, but the U.K.'s SmithKline Beecham is known as an aggressive genomics player owing to its long-running alliance with Human Genome Sciences.

Though no drug has come from that partnership, SmithKline says genomics research allowed its scientists to work on 200 new targets last year. "SmithKline will be a leader in the next decade as products go into the clinic through genomics," contends Linda Miller, manager of the John Hancock Global Rx fund. She has 2.5% of her fund's assets invested in SmithKline.

Should you buy a drug company solely, or even partly, because of its biotech investing? Not yet. Biotech will play an increasingly important role in the fortunes of nearly all big drug companies. But with the possible exception of Lilly, big pharma won't see significant profits from biotech for several years. And it's impossible today to tell which companies will end up as the biggest biotech winners.

What we can tell you is that biotech is a reason to be bullish on drug stocks for the long term, and that drug stocks are a relatively safe way to play the coming biotech boom. (The failure of one drug won't sink Pfizer; it might doom its biotech partner.) Right now, pharmaceuti-cals are among the more expensive stocks in a frothy market. Two good companies have been roughed up of late, however, so they're cheaper than their peers.

Though no other drugmaker comes close to Merck's 18% annual growth rate since 1993, these days "St. Merck" carries a PEG of 1.7--which is 20% below the group's average. The company forecasts a tough second half this year, and investors are worried that its pipeline is drying up. But John Schroer, manager of the Invesco Strategic Health Sciences fund, thinks any problems are temporary. "The same people selling at $125," he predicts, "will be the same ones buying at $150 a few months from now." CIBC Oppenheimer analyst Steven Gerber adds that concerns over Merck's pipeline are unfounded. "We think Merck is extremely undervalued."

Our second pick is Eli Lilly. It's already had biotech success, and over the next five years, analysts expect the company to increase earnings by 17% a year. But Lilly's stock has been stuck in a narrow trading range since the end of 1997 after a one-time write-down of its PCS Health management business. Lilly has a PEG ratio of 1.8, a 16% discount to its peers. (And should a stock market crash depress millions of investors, at least Lilly sells Prozac.)

AG-BIO Looking for the perfect food

Remember the Flavr Savr? Introduced by Calgene in 1994, the tomato was the first genetically engineered food to win FDA approval. By reversing the gene that softens a tomato as it ripens, Calgene produced what was supposed to be a better-tasting fruit that developed fully on the vine without rotting on the way to the A&P. Unfortunately, the scientists who ran Calgene weren't marketers. They gave the tomato a ridiculous name, priced it too high and failed to develop a reliable distribution system. The Flavr Savr soon disappeared from U.S. produce aisles.

Four years later, things have changed. The agricultural biotech industry is now driven by chemical and pharmaceutical giants with considerable marketing savvy. (Calgene, in fact, is now owned by Monsanto.) "This time around it's about sales rather than research," says Christopher Bonavico, a portfolio manager at Transamerica Premier Funds, which owns Monsanto and seed company Pioneer Hi-Bred.

And while health-care biotech stocks lag, investors are paying attention to ag-biotech. Despite qualms among some consumers and regulators, especially in Europe, genetic manipulation of crops and vegetables is a fact of modern agriculture; 30 genetically manipulated seeds, including soybeans, squash and potatoes, have the U.S. Department of Agriculture's blessing. Fully a third of the nation's 155 million acres of corn, soy and cotton are planted with genetically altered seeds.

To understand ag-bio's impact, meet Tim Aughenbaugh, whose family owns a large farm in South Dakota. Last year, Aughenbaugh began planting Bt corn, a genetically altered seed that resists insects. Yields improved 15%. Now he's hooked. "We are at the mercy of the weather, government policies and commodity markets," he says, "so growers are interested" in anything that gives them an edge.

Farmers aren't the only fans. Mark Wiltamuth, an analyst with ING Baring Furman Selz, figures that the gross margin on Bt corn, which is sold by several seed companies, is 71% vs. 59% on normal corn seed.

Making "smarter," higher-yielding seeds is only the beginning for ag-biotech. Next companies will alter "output traits." Corn, for example, may be modified to contain more oil or protein. That would cut the amount that livestock producers, who buy 80% of the U.S. corn crop, must spend on feed supplements. Ultimately, pharmaceutical and chemical concerns have greater ambitions. Altered seeds will also begin to take over manufacturing processes, says Robert Giaquinta, chief of biotechnology for Du Pont. Engineered seeds could, for example, extract unhealthy oils in soybeans. Companies will "do in the green plant," Giaquinta says, "what is normally done in the steel plant."

Investors who want to plow into ag-biotech have several big-cap stocks to pick from. Besides Du Pont, companies getting into life sciences include Dow Chemical, Swiss food and drug giant Novartis, German chemical maker Hoechst and the United Kingdom's Zeneca. But the industry leader is Monsanto. It has spent $6.5 billion buying seed markers and distributors and setting up research alliances. Now its planned $34 billion merger with American Home Products gives Monsanto the cash to tap synergies between drug and agricultural biotech. Unfortunately, the combined entity, as yet unnamed, may not show earnings growth until 2002. That's why Monsanto's stock is down 8% from its high of $60 in June, when the merger was announced.

Still, over the long term, Monsanto is an ag-biotech player you want to bet on. As for whether you should buy it or AHP now, go for Monsanto. The two companies aren't rushing to complete their merger. And if the deal doesn't happen (which is unlikely) AHP isn't the ag-biotech play.

A second ag-bio stock to consider, especially if the uncertainty of mergers makes you queasy, is Pioneer Hi-Bred, the last publicly traded stand-alone seed company. At a recent price of $33, down considerably from its high, Pioneer still trades at 26 times next year's projected earnings. That is not cheap, but earnings may not be the best way to value seed companies. Monsanto has been paying five to 11 times revenues for acquisitions. Pioneer trades at just four times its revenues.

Pioneer's ace is a recent fifty-fifty venture with Du Pont, a leader in developing the next generation of seeds. The combination could bring $3.5 billion in revenues and 20%-plus margins within 10 years. Why buy Pioneer, not Du Pont? Earnings leverage. Splitting profits of, say, $700 million would more than double Pioneer's current per-share earnings. Du Pont's cut would add a mere 9%.

Of course, a decade is a long time to wait for a payoff. But Pioneer is an interesting investment now. Its shares have dropped 25% since late June on fears of a price war with Monsanto. But Jeffrey Poppenhagen, portfolio manager for Pioneer Growth Shares, which owns both stocks (the two Pioneers aren't related), thinks such fears are overblown. He argues that since Monsanto has paid top dollar for its seed companies, it can't afford to cut prices.