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Invest Smarter in the New Biotech Landscape

Growing markets and solid fundamentals lead the industry

Biotech Stocks to BuyThe crowd follows trends. A trend they are missing is the growing importance of biotech and genomic companies in mainstream drug development and treatments. The sector, to my mind, now includes a much wider range of opportunities than companies that make drugs manufactured through the use of biological processes and encompasses everything from those outfits to makers of genomic research equipment.

The best words to describe these opportunities in the past have been “speculative growth.” Some of the best biotech companies are still very speculative, with promising but proven science; but there are now may others that are not speculative, with proven science and not yet generating revenues or misunderstood on Wall Street.

Ten years ago, virtually all but a handful of biotechs were “speculative.” This is no longer the case for investors. In the past, investors looked for “cheap” biotechs with unproven science and they were speculative up until a final FDA approval for their first treatment. That is no longer the case.

Biotech and Big Pharma

Many biotech and genomic firms have “proven” their science in some form enough for potential partners or companies wanting to buy them outright. Big Pharma’s research efforts are broken and the industry is turning to biotechs for core technology and half-finished product development that has proven itself enough for the purpose of an investment or acquisition.

The bottom is simple: biotech no longer needs to be categorized as “speculative” to investors.

Big Pharma outfits are in a world of hurt. More than $100 billion worth of patent expirations are in place or coming in the next two years, their R&D machines are broken and their product pipelines are relatively empty as they face this enormous revenue hole.

How did this happen?

  • The big outfits need billion-dollar drugs and focused on big opportunities in two ways: copies of existing drugs, such as statins for cholesterol reduction, or high-risk and high-reward initiatives aimed at untreated maladies such as Alzheimer’s. These have been universally unsuccessful.
  • Big Pharma consists of mammoth companies with mammoth bureaucracies even in the lab and are ill-equipped for 21st century scientific discovery. Think about market leaders in other industries. Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), and Facebook  all started as bootstrapped start ups. That is where creativity is found, not corporate compounds with guards and gates and Fridays off in the summer.

A changed approach

Big Pharma knows this about itself and is doing two things to fix the problem:

  1. Buying, investing or otherwise partnering with smaller outfits with promising science, typically firms out of the lab and somewhere in the clinical trial and approval process.
  2. Automating the R&D process using cutting-edge equipment, especially in genomic and proteomic research, and using third parties to accelerate the molecule and drug discovery process.

The central problem facing all drug developers is the approval process. Forget headlines, complaints and the comments of politicians running for office or legally on the take through campaign contributions. The FDA is actually a well-run, understaffed agency compared to those in other nations and is the gold standard for drug approvals.

At the same time, drug companies must follow ethical treatment guidelines for patients in clinical trials. This means a patient with a disease for which there is already an approved treatment – adequate or inadequate – typically has to be offered that treatment first and get enrolled in clinical trials for a new treatment after the first treatment has proven to be unsuccessful in some fashion or has reached the limits of its effectiveness. Translation: More and more drugs, especially for cancer, are being tested on very ill patients already proven to be resistant to other treatments. This has pushed many companies into drug discovery and development in two areas:

  1. Diseases without approved treatments or ones that are approved but only marginally effective using wholly new technology.
  2. Adjunct or modified therapies for diseases with established treatments, such as boosters for chemotherapy or a new diabetes drug that is administered only once a week rather than several times a day.

Where investors should look

Where does this leave investors looking at traditional drug development companies?

  • They need to look for new technologies and treatments that are not yet on the market but are to many “proven.”
  • Investors also need to look at leaders in technology that extend or improve the efficacy of existing treatments.

The other area investors should look at very carefully is infrastructure – the companies that provide the products and services used in the R&D process.

This is a booming sector characterized by hardware companies that have developed adjunct databases of genomic and proteomic data and companies that actually go you and find novel molecules and proteins that in turn are licensed by drug companies. Instead of picking the winner of a horse race, you are investing in companies that sell the hay or service the betting machines, knowing the race will always be run.

This is a technology-driven sector . Researchers pay for “better, cheaper, faster” in a manner similar to the earlier days of the computer industry.

Do your research, avoid the losers

More than any other sector, investors in biotech and genomics need to understand the companies they are buying and where their products fit in the marketplace or stand in the approval process or both.

Let me give you an example: Spectrum Pharmaceuticals (NASDAQ:SPPI) I found this outfit when it had no revenue and a unique business model – it obtained drugs from larger companies that were somewhere along the clinical trial and approval process and whose parent did not want them any more for business, not scientific reasons. If memory serves, I found the company below $3 a share six or seven years ago. It is now above $15, and Spectrum has done this by executing its business plan, not making any scientific discoveries.

The development process is opaque, unpredictable and maddening even for those most successful in developing new drugs. Most believe the same is true for the FDA approval process – and they are wrong. While it can still be quite difficult to pick winners, it is easy to find losers. Back in 2002, when Imclone blew up, I was asked by clients (I was doing institutional research at the time) to see if I could find the next Imclone.

I graduated Georgetown with a degree in philosophy and minors in beer and basketball. The closest I came to biology were the two medical students I shared a house with for my last three years at school. But a client is a client. Using the great survey work done by ChangeWave Research (now part of the 451 Group) I asked people inside the industry how to find losers. Easy, they said —  look for poorly constructed clinical trials.

I did. In three months I picked and wrote about six potential losers. All blew up.

This is what investors need to do. When you manage a portfolio, capital preservation comes first. When you are picking biotech and genomic stocks, capital preservation also comes first and you do this by avoiding losers.

Traditional, speculative biotech is a small part of my portfolio – but the icing on the cake so to speak, a part of my investments that could produce great returns over time. The key is time. You have to be aware of how long these investments take to play out, you have to very sensitive to critical events such as FDA hearings, you need to know who is partnering with whom and and why as the nature of the partnership could presage a buyout or takeover.

This article was originally written by Michael Shulman

Article printed from InvestorPlace Media,

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