(MONEY Magazine) – The first wave in biotechnology investing arrived back in the late 1980s, when revolutionary new medicines created by pioneers like Amgen alerted investors to the fledgling sector's potential. The second wave hit a decade later, as companies like Genentech and IDEC Pharmaceuticals marketed antibodies to fight cancer and other diseases. Now, as 2002 rolls in, biotech boosters are telling investors: Time to haul out those swimsuits. "This year is going to be the third wave," predicts Fidelity Select Biotechnology manager Brian Younger, citing a dozen new products that could soon be approved to combat such common ailments as the flu, psoriasis and erectile dysfunction. Here's a look at some other factors that may mean the sector is poised for a rebound.

Improving fundamentals. Total biotech revenues rose from $12.7 billion in 1996 to $25 billion last year, according to the accounting firm Ernst & Young. And Peter Ginsberg, a biotech analyst at US Bancorp Piper Jaffray, estimates that 15 biotech companies are now profitable. That number could double by 2004. An additional indicator of biotech's growing strength: The bigger biotechs are snapping up smaller ones. Recent deals include Amgen's $16 billion acquisition of Immunex and MedImmune's $1.3 billion purchase of Aviron.

More investors. For years, money managers avoided the sector unless they were specialists with science backgrounds. But as more biotechs become profitable, that's changing. Take a peek at the top three mutual fund owners of Genentech: Janus, Fidelity Magellan and Vanguard Health Care. The arrival of diversified fund managers into the biotech sector is "the tide that is raising all boats," says Kris Jenner, manager of T. Rowe Price Health Sciences. Further broadening the investor base for biotech is the recently reshuffled Nasdaq 100. Last December, the popular growth index dropped 13 technology stocks (including former hotties like Palm, Ariba, Novell, CMGI and 3Com) and added six biotechs. In fact, biotech stocks now make up 12.9% of the Nasdaq 100's total market value.

Slowing pharmas. The average earnings growth rate for the S&P 500's pharmaceutical sector is 15%. In contrast, the top biotechs may hit mid-20% numbers this year. Many major pharmaceutical companies have patent expirations looming, yet most biotechs still have years to go on their patents.

Such trends have helped boost biotech lately. While the American Stock Exchange's biotech index is down 34% from its March 2000 peak (vs. a 19% decline for the S&P 500), it has surged 27% since late September. Jenner of T. Rowe Price predicts confidently, "We're in a multiyear bull market for biotechnology."

Maybe, but that's hardly to say the sector is becoming less volatile. Many biotech companies are entirely dependent on a single product, leaving them vulnerable to dramatic price swings. Consider the fate of one of the new biotechs in the Nasdaq 100, ImClone Systems. After the Food and Drug Administration delayed approving the company's marketing application for a colon cancer treatment late last year, some investors began alleging that management had withheld key information from them. The stock plunged 72% in a month. Steep valuations throughout the sector magnify such risks. The average price/earnings ratio of the S&P 500's biotech stocks is 51 vs. 27 for the S&P's pharmas. A top company like IDEC has superb products, yet the stock's 71 P/E makes it vulnerable to any hint of bad news.

Those are the risks. Here are the rewards: The Amex biotech index has gained 217% over the past five years, walloping both the S&P (up 44%) and Nasdaq (43%). Here are three stocks and two funds that offer the best value for your biotech buck. Just remember: This risky sector should make up no more than 5% of your portfolio.

Genentech. Think all biotechs are small? With a market cap of $26 billion, Genentech is now about the size of General Motors and twice as large as Southwest Airlines. Since we recommended the stock last September, it's risen 27%, driven by strong sales from two drugs: Herceptin, a treatment for breast cancer, and Rituxan, for non-Hodgkin's lymphoma. Near term, says CEO Arthur Levinson, Genentech's two star products should continue to drive growth. Levinson also points to a pipeline of 20 products, including 10 in late-stage clinical development. (Xanelim, a treatment for psoriasis, and Xolair for asthma, could be approved as early as next year, he says.) Trading at 54 times this year's projected earnings, Genentech is no bargain, but its long-term earnings growth rate of 26% gives it a price-to-earnings growth (PEG) ratio of roughly 2, which is not bad for a high-growth stock. "If you had to own one biotech, this would be the stock," says James Fiore, president of Life Science Group, an investment firm.

Invitrogen. Think of Invitrogen as the Staples or Office Depot of biotech laboratory supplies, says T. Rowe Price's Jenner. This $3 billion market cap company occupies an essential niche in the sector by selling a kit used in DNA cloning, which provides the building blocks in any search for new medicines. Invitrogen's strengths include its diverse client base (ranging from academic labs to large pharmaceuticals), its worldwide range of operations and its relatively inexpensive core product (the DNA-cloning kit costs $300, making it unlikely that clients will cut back even in bad economic times). Invitrogen's stock trades at 29 times this year's estimated earnings; Jenner thinks the company's long-term earnings growth could hit 25%. That's a PEG ratio of around 1--low for a growth stock.

Biogen. This $7.9 billion company is one of the oldest and most profitable biotechs, with net income of $273 million last year. Its shares have slid 27% since February 2001, mainly on concerns that its blockbuster multiple sclerosis treatment, Avonex, could be threatened by a rival's product. However, US Bancorp Piper Jaffray's Ginsberg says that Biogen's late-stage pipeline, which includes another promising treatment for multiple sclerosis, is "one of the best among all the large-cap biotechs." Plus, Biogen's Amevive, a psoriasis treatment, could be one of the drugs approved this year. Biogen has significant excess manufacturing capacity, putting it in a sweet spot if the sector expands and new companies that lack manufacturing infrastructure strike licensing deals with older players. At 28 times this year's estimated earnings, and with long-term growth rates of 15%, Biogen could be the sector's surprise winner.

Fidelity Select Biotechnology. The oldest biotech fund is also the biggest. Manager Younger spreads his $3.1 billion among the top names, like Amgen, MedImmune and Invitrogen, as well as the up-and-comers. Investors must pay a 3% load, but the expense ratio is a relatively low 1%. The fund's five-year average annualized return is 18.2%.

T. Rowe Price Health Sciences. Here is a smart way to insert biotech into your portfolio while protecting yourself from some of the sector's volatility. Manager Jenner puts 43% of the fund's assets in biotech stocks like MedImmune, Invitrogen and Genentech, but he also holds on to large-cap pharmaceuticals like Pfizer and Eli Lilly. Over the past five years, this fund has returned an average annualized 15.4%. --ARAVIND ADIGA