Is Biotech Flaming Out? After months of scorching returns, biotechnology investors have been badly burned. Here's a smart way to play the most volatile sector of all.
By Eric Moskowitz

(MONEY Magazine) – Biotech stocks have been as hot--and volatile--in recent months as Internet stocks. From last July to February 2000, the American Stock Exchange biotech index soared 220%. Protein Design Labs leaped 700% in the three months following Thanksgiving. Cell Therapeutics, trading at $2.75 last September, rocketed to $47 in March of this year--a 1,600% rise.

Investors gleefully piled in. But in March the sector swooned, with stocks like Protein Design Labs, Human Genome Sciences and Millennium Pharmaceuticals losing more than half of their value. The biotech index plunged 35% in just two weeks. The sector had become so speculative that one trigger for this carnage was a relatively innocuous announcement by President Clinton and British Prime Minister Tony Blair that data about human genes "should be made freely available to scientists everywhere."

The question for investors now: Is the biotech boom over or is there still serious money to be made here? Some seasoned biotech watchers are clearly skeptical, having previously witnessed the sector's tendency to boom, then bust. In '91 and '92 the biotech index soared 320%, but most biotech stocks went nowhere in the years that followed. By March '99 the index had returned a grand total of just 10% in 6.5 years. Mort Cohen, CEO of Clarion Partners and a longtime biotech follower, warns: "Old biotech investors like myself know it won't be good forever."

Still, the sector's long-term prospects are undeniably sweet. In September, the Human Genome Project--a federally funded initiative to map the entire sequence of genes in human DNA--announced that it was way ahead of schedule. With the sequencing race nearing an end, we're closer than ever to an era when medicine may be revolutionized by our knowledge of the role genes play in disease. Biotech bulls are now betting on the arrival of a new generation of gene-based and protein-based drugs. Matthew Murray, co-manager of Alliance Health Care fund, says this genomic revolution "should do to health care what the Internet did to technology." Adds Sharon Seiler, a vice president at Punk Ziegel, a biotech-focused investment firm: "There are more products in late stages of development among biotech stocks than ever before. The only question now is who the successful survivors will be."

Trouble is, that's a painfully tricky question to answer. The process of bringing health-care products to market is notoriously tough, and many biotech firms won't make it. That means it's all the more important to diversify, spreading your bets among a number of the most likely winners. It's also smart not to invest too heavily in such a speculative sector. We'd recommend staking no more than 5% or so of your portfolio on biotech stocks.

For conservative investors who want to dip into the sector, the best option is to buy a mutual fund. But as the story on page 48 explains, you're probably better off picking a diversified health-care fund than a pure biotech portfolio, since few biotech funds have experienced managers with long-term records. For more aggressive investors who like to pick their own stocks, we recommend investing in a handful of individual biotech firms that you should plan to hold for years, accepting from the start that they'll be intensely volatile.

Even after the recent pullback, though, you need to realize that this sector is hardly cheap. The risk-to-reward level for investors jumping in now is about as high as it's ever been. So it's prudent to steer clear of the frothiest high fliers, which will be especially vulnerable if biotech gets hit again. Lots of biotech stocks have simply flown too far, too fast. Take Immunex, a maker of drugs for infectious and immunological diseases. Profits soared 123% in '99, but it's trading at 223 times this year's earnings. "I just can't justify recommending it at these levels," says PaineWebber analyst Elise Wang.

Also be wary of hot companies like Cell Therapeutics that are staking their futures primarily on a single product. If it doesn't work out, the company is doomed. Even aggressive investors should avoid Cell Therapeutics, which is expected to lose $2.31 a share in 2000.

We would recommend that you focus instead on companies that have several major drugs in their pipelines, and these drugs should ideally be in a late stage of development. In general, you should favor companies with the strength to survive adversity--those with plenty of cash in the bank or that might be attractive takeover candidates for pharmaceutical giants like Pfizer and SmithKline Beecham. Profitability also counts, even in biotech: Stocks that actually have P/E ratios will prove to be less risky over the long term.

OUR STOCK PICKS

Amgen is no Cell Therapeutics. The biotech behemoth has an impressive pipeline of drugs that should come to market in the next three years, including Leptin, an antiobesity drug in Phase 2 trials. Although Amgen rose in tandem with the sector, its stock has been held back by a patent lawsuit involving its most lucrative drug, Epogen, a genetically engineered version of human hormones used to stimulate red blood cell production. "We believe a victory in the case could result in as much as a double for Amgen's stock," says Salomon Smith Barney analyst Meirav Chovav, who expects Amgen to prevail in court this year.

Amgen is also preparing to release a new version of another major drug, Neupogen, which increases the production of white blood cells. This version should be approved by the end of 2000 and has "$1.5 billion sales potential," says Deutsche Banc Alex. Brown's biotech analyst Dennis Harp.

Compared with its rivals, Amgen has great financial strength. Revenues rose 23% to $3.34 billion in '99, and analysts are expecting 25% annual growth for the next five years. Amgen, which has a P/E of 56, has beaten earnings expectations in each of the past six quarters.

Genentech is another bellwether with a slew of drugs in development. It already has seven drugs on the market, including Rituxan, an antibody for non-Hodgkin's lymphoma, and Herceptin, used to treat breast cancer. Genentech's most promising drug, though, is TNKase4, a heart attack therapy drug in Phase 3 trials. It's expected to receive FDA marketing approval in the second half of 2000. Heart attacks strike more than a million Americans a year, so the market for TNKase4 could be huge.

Analysts expect Genentech's earnings to jump 22% in 2000. The stock has already surged 219% since last July, and it sports a rich P/E of 136. Still, Matt Blackman, an analyst at Northern Trust, notes that "it's the kind of biotech stock you can put money in and still sleep relatively easy."

It's often said that it takes $300 million and 10 years to bring a drug from the lab to the pharmacy--an excruciating process that's destroyed many biotech firms. So you don't want to invest solely in companies that develop drugs. Another way to play the sector's growth is to bet on PE Biosystems, which supplies instruments and equipment used by R&D labs for gene splicing and DNA sequencing. Most prospectors did not find gold in the gold rush, but they all needed picks and shovels. Likewise, companies now racing to find gene therapies will need to keep buying gene-splicing equipment from suppliers like PE Biosystems.

The stock isn't exactly cheap. At $97 a share, it has a P/E of 105. But it is in a sweet spot of the biotech business, and it's growing fast. Analysts expect earnings per share to rise by more than 50% this year. "I really think that even though it's expensive, it's a good long-term bet," says Steven Delco, a biotech analyst at Miller Tabak.

For a cheaper play, consider Genzyme General, which develops drugs for medical disorders considered too small for big pharma companies. Cerezyme, its drug for Gaucher's disease, is expected to generate $550 million in revenues this year, up 16% from 1999, says PaineWebber's Wang. James Fiore, president of the Life Science Group, a biotech investment firm, says Genzyme General is cheap enough to stand up well even if the sector gets hurt. At $50, it's trading at 24 times 2000 earnings. Fiore also says investors have failed to recognize the value of the company's 30% stake in Genzyme Transgenics, which is investing heavily in protein-based drugs that could ultimately generate an additional revenue stream.

Another affordable stock: Pharmaceutical Product Development, a provider of drug-development services to big pharma outfits. With drug pipelines drying up, titans like Merck and Eli Lilly are throwing money at clinical research outfits like PPD, which help generate drug data used in clinical trials. PPD also sells software that allows companies to track drug developments more easily. PPD's software division just signed a deal with Oracle to develop Web-based industry applications.

At $16.5, PPD has a P/E of just 14, despite the fact that earnings per share have risen 26% annually over four years. One reason: It recently missed earnings projections by an embarrassing margin. But Martin Whitman, manager of the Third Avenue Value fund, expects earnings to grow 20% this year and argues that pharma companies will keep outsourcing heavily to firms like PPD to lower costs. In a sector where many stocks have hit Internet stock valuations, it's a compelling bargain.