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Biotechs are Back Under the Microscope

Their potential is significant now that the genome hype has passed and cash-rich firms plunge ahead with development.

Along with speculative net stocks, biotechs collapsed with a resounding thud over the last two years. Now that investors seem fixated on cash flow, it's easy to conclude that the sector, a giant cash-consuming machine, will remain unloved. But with increased M&A activity and a full pipeline of new products expected to be released over the next couple of years, biotech stocks are poised for a rally.

You can't assume that biotech stocks are due to rally simply because they are cheaper. After all, the sector endured a five-year slump in the early 1990s that took valuations to extremely low levels. But one key factor separates today's biotechs from those of a decade ago: Much stronger balance sheets.

The white-hot IPO market of recent years allowed many players to raise more than $100 million each. And established players snapped on their feedbags and sucked in cash through widely-subscribed secondary offerings. SG Cowen analysts estimate that biotechs raised $35 billion in 2000 and an additional $16 billion in 2001.

For the moment, investors are digesting some bad news, most of it company specific. The FDA rejected ImClone Systems data for its cancer drug and also rejected Sepracor's new drug application for an allergy medicine. The SEC is investigating the accounting practices of Ireland's Elan Pharmaceuticals. No surprise that the Nasdaq biotech index fell by almost 16 percent in the first quarter, despite analyst predictions back in January that the sector was ready to rally.

That rally may finally be poised to take off. Robertson Stephens' Michael King, for one, is unfazed by the first-quarter downturn, noting that biotechs tend to trade weakly during the first three months of any year. As the conference season heats up later in the year, so will share prices, says King.

Merger-and-acquisition activity will likely fuel the sector's rebound. Major drug firms such as Pfizer, Bristol-Myers and Merck are under pressure to maintain double-digit growth, even as their own drugs face patent expirations. That should make biotechs — especially those that have drugs in the later stages of the FDA approval process — more desirable in the coming quarters. This includes Genzyme, MedImmune and Serono, a Swiss company with a recently approved multiple sclerosis drug.

More than 100 biotech firms were purchased by drug companies in the past five years — double the number purchased in the previous five years. That should continue. SG Cowen analysts estimate that drug companies will need to add $70 billion in acquired drugs to their portfolios over the next four years, just to meet Wall Street growth expectations.

Much of the M&A action may center on oncology. Forget ImClone's missteps: The anti-angiogenesis drugs (which shrink blood vessels that feed tumors) that it and others make are for real.

Deutsche Bank's Dennis Harp suggests a dramatic reason to buy biotech stocks: demographics. He says the number of Americans over the age of 65 will double. “And the health care expenditures on that age group are four times the level for those under 65,” he says.

To be sure, genomics stocks are no longer the flavor of the month. It's now apparent that there will be a decade-long gap between the mapping of the human DNA genome and the development of DNA-focused drugs. Merrill Lynch's Eric Hecht estimates that the typical genomics stock lost 70 percent of its value in the last two years. That's why companies such as Celera Genomics are replacing their management teams with executives more focused on developing drugs in the near-term.

Analysts may not agree on particular stocks, but they share a view of key characteristics for biotech buys. Salomon Smith Barney's Elise Wang, for example, looks for companies that have drugs near the end of the FDA approval process. She figures that approval to market the drug is an excellent near-term catalyst for the stock.

But other analysts suggest taking a stab at lesser-known, comparatively undervalued upstarts. That would be a smart move if the market returns to its frothy ways, since smaller, more speculative biotech outfits tend to flourish in bull markets. But those stocks are extremely volatile and can jump — or fall — in double-digit percentages in one day.

Rather than taking sides in that debate, you may just want to try to gain broad-based exposure to the sector for your clients. The iShares Nasdaq Biotechnology Index Fund, for example, is a basket of all 76 companies that comprise that index.

You can also put your clients into more traditional funds. Dresdner RCM Biotechnology is the most venturesome, holding a host of small and medium-size biotech stocks. The Rydex Biotechnology is worth a look. It's an index fund that weights its portfolio according to the stock's market value. About one-third of its assets are in five giants: Amgen, Genzyme, Immunex, MedImmune and Chiron. But it has a hefty $25,000 minimum investment.

Regardless of which investment vehicle is most appropriate for your clients, the biotech sector looks like the place to be for the coming years.

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