J&J and Cougar: Meow or Roar?

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Who says Johnson & Johnson's (NYSE: JNJ) an old fogy? The health-care giant is doing something that many of its investors -- Buffett included -- wouldn't do; it's buying a development-stage drugmaker that has no proven drugs.

The $970 million that Johnson & Johnson is paying for Cougar Biotechnology (Nasdaq: CGRB) looks a little high for the potential risk of failure -- I have picked Cougar to underperform the S&P 500 in the Motley Fool CAPS -- but, being a large company, Johnson & Johnson can afford to take on the risk. And the health-care conglomerate only paid a 16% premium on yesterday's closing price, so it's not paying much more than what other investors thought it was worth.

Most of the value of Cougar is tied up in abiraterone, its phase 3 prostate cancer drug; the rest of Cougar's pipeline is in early-stage testing. The data from two trials testing abiraterone against metastatic prostate cancer isn't expected until early 2011, so Johnson & Johnson's investors will have to wait a while before they'll know whether the bet will pay off. The rewards will be huge if the trials are positive; a sub-$1 billion price tag will look cheap if abiraterone hits sales of $1 billion annually.

By the time the results are out, we should know whether Dendreon's (Nasdaq: DNDN) prostate treatment, Provenge, was approved or not and even have some hints as to how much demand there is for the treatment. Pfizer (NYSE: PFE) is scheduled to finish up a trial testing its already-approved cancer treatment, Sutent, in prostate cancer patients about the same time arbiraterone's trials are scheduled to conclude. If the trial is successful, Johnson & Johnson will have a head start on Bristol-Myers Squibb's (NYSE: BMY) Sprycel, which isn't scheduled to wrap up its phase 3 trial until 2012.

Johnson & Johnson may be making a huge mistake here and abiraterone could flop, but investors can learn a lesson from its purchase. As long as you keep each development-stage drugmaker as a reasonable percentage of your portfolio -- and Cougar will make up less than 1% of Johnson & Johnson market cap -- it's reasonable to take on those risks for the potential reward.

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