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Fool On The Hill

Tuesday, April 27, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Biotech or Internet?

Two technological innovations likely to have the most profound impact on our lives over the next twenty years will be the Internet and biotechnology. Investment opportunities in both areas are now plentiful. While many biotech companies have done well over the past year, Internet companies have stolen the show. The strength of Internet shares reflects the fact that everyone is aware of this revolution and can see how it will affect their lives. Daily press releases and news blurbs discuss product enhancements, new entrants in the field, and innovative moves by key Internet players. Upon hearing such news, investors pile into the impacted stocks, thinking of the limitless growth opportunities offered by these moves.

Biotechnology stocks, however, are a little more obscure. The major companies tend to have only one or two drugs currently on the market and the general population doesn't even know about them. The new product cycle is extraordinarily long, lasting several years and culminating with a review by unpredictable governmental agencies. Even before this review, many once-promising drugs are kicked out of testing due to adverse side effects or lack of efficacy. For these reasons, the current prices of major biotech stocks don't incorporate boundless optimism about the prospects for products in the pipeline.

An investment portfolio expected to last more than a decade should probably have some exposure to these emerging sectors in the economy. The advances likely to occur in both these fields are unimaginable to most of us. When they occur, stock prices of the successful companies will soar to reflect this value. The allure of investing now in what appears to be the hottest sector is immense. Before taking the plunge, however, be sure to put the future opportunities of a company in context with its current market valuation and the uncertainty associated with the realization of its objectives.

Most of the value in these companies is derived from future growth. If that growth doesn't materialize, the value of your investment will deflate like a helium balloon popped with a nail by a disappointed investor. For a picture of what this looks like, check out this three year stock chart of Iomega (NYSE: IOM).

While both groups of companies appear to have boundless growth in the years ahead, the major biotechnology companies are much less expensive than their Internet peers. Biotechs like Amgen (Nasdaq: AMGN), Biogen (Nasdaq: BGEN), and Genentech (NYSE: GNE), and Chiron (Nasdaq: CHIR) have price/earnings (P/E) multiples of less than 50 times this year's earnings estimates, whereas multiples for Internet companies (if they have profits) are in the hundreds or thousands.

What do these valuations mean? Let's assume that a P/E multiple of 25 is "normal" for a stabilized growth company (this figure is actually high by historical standards). To get their multiple down to 25, Internet companies will need to grow their revenues and earnings streams many fold in the next few years -- and that assumes their stock price remains flat. To justify an increase in price, the companies will need to increase earnings even more than that. On the other hand, the biotech stocks mentioned above will have P/Es less than 25 if they double their earnings over the next few years. That's substantial growth, but not unreasonable given the breakthroughs likely to occur over the next decade. If earnings rise faster than that, these stocks will be poised to move even higher.

Beyond attractive relative valuations, biotech companies are threatened less because of their substantial barriers to entry. Developing a new drug costs millions of dollars. But having money isn't enough. You need the scientific expertise to develop compounds that will be useful. Once found, these compounds need to be taken through a series of tests to ensure that they work and do not cause serious complications. After passing these hurdles, the drug must then be approved by a governmental agency. In the U.S., the Food and Drug Administration (FDA) is responsible for determining whether drugs are safe for citizens. Although the approval process is arduous, most drugs enjoy monopoly status for several years, which helps owners recoup development costs and earn a profit on their investment.

In the Internet world, competition can be fast and fierce. We have already seen that with the introduction of numerous Web portals and e-commerce companies. The pace of new competitors in the market should accelerate now that so much capital is flowing into the business. The impact of this competition is already being felt. Having noticed the success enjoyed by eBay (Nasdaq: EBAY) in the auction market, Amazon.com (Nasdaq: AMZN) has entered the fray with its own auction site. Seeing upstart eToys as a competitive threat, Toys 'R Us (NYSE: TOY) today announced plans to create a website with the help of Benchmark Capital, which helped fund eBay and other Internet companies.

What is stopping people from entering the market? Not too much. All you need is some seed capital and a savvy entrepreneur, motivated by the prospect of making millions in an initial public offering. Some companies have patented technology, but competitors seem to be adept at circumventing that hurdle. In the online brokerage industry, we've already seen competition cause a significant drop in fees -- you can now trade online for $5-$15 a trade. Now a couple of firms have raised the ante by attempting to lure new customers with $50 or $75 in cash for opening an account. As these types of promotions proliferate, profitability will suffer. (Didn't we see the long distance industry get into this kind of war a few years ago? Why do you think they decided to stop?)

Biotechnology is also a competitive business. Numerous companies are searching for drugs to address diseases like cancer, arthritis, and HIV. Others are working on developing methods to clone human organs for surgery and transplants. Knowledge learned by one company will be used by others to further efforts in developing similar techniques. While competition exists, the barriers to entry are much more substantial. You won't see someone come out of nowhere and be a viable competitor the next day. It will take months or years to jump through the regulatory hurdles required to bring a competing product to market. During that time, the inventor of the original product can develop strategies and contingency plans to facilitate continued success.

Advances in biotechnology and the Internet over the next few years will be mind-boggling, altering everyone's life. Fortunes will be created by companies developing the right products and services. As individual investors, we have the ability to participate in these developments. The most successful among us will be those who are patient, use common sense, and consider the underlying fundamentals and prospects of investment opportunities. Anyone investing in the right company in either industry will be extremely successful. My guess is that the odds for the greatest success will lie on the road less traveled.

The Fool is hiring. Answer the call.

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