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Biotech's Next Phase

Year to date, the Merrill LynchBiotechnology Holdrs (AMEX: BBH  ) exchange-traded fund (ETF) is up over 50%. At an astounding 73%, the median gain for the universe of biotech stocks was even better. It's been a great year.

Put another way, given a list of biotech stocks, the Wall Street Journal's famed blindfolded, dart-throwing monkey would have had a pretty darn good year. But the truly Foolish investor never confuses a bull market for investing genius.

Whether you call yourself a serious investor or a dart-throwing monkey, it's a good bet next year isn't going to be nearly as good. For one thing, solid companies aren't trading at or near cash as Millennium (Nasdaq: MLNM  ) did at $6 and change back in February. Indeed, that biotech returns have already flattened this past quarter is likely a harbinger of things to come.

So, for the Homo sapiens among us, what's the best way to invest in biotech in the year ahead? Here's how I'd go about it.

A pipeline dream
A good first step when investing in biotechnology and pharmaceutical stocks is to evaluate the clinical pipeline, the markets the company or specific drug addresses, and the expected or likely revenues from drugs in development. From there, one can begin to make a valuation judgment based on expected future revenues. A sophisticated investor can then adjust these revenue projections to reflect the risk of FDA rejection. A 90% chance of rejection in early-stage phase I trials; a 50% chance in phase II; 20% in phase III; and 10% post-phase III are rough guidelines.

When I see a company like Pain Therapeutics (Nasdaq: PTIE  ) , with a pair of phase III trials for drugs targeting billion dollar markets underway and trading at a market cap of $150 million, I take a second look. Introgen (Nasdaq: INGN  ) is another with advanced products, but a market cap just shy of $200 million.

As a rule, I don't like to pay much more than $400 million in enterprise value (total market capitalization less cash plus debt) for each phase III trial of a "billion-dollar drug," and no more than $150 million for each phase II trial of a "billion-dollar" candidate. I make exceptions for trials in which I am particularly confident, as I was earlier this year with Millennium's cancer drug Velcade.

Of course, such evaluations are complex and subjective. It helps to have a scientific or medical background or at very least some knowledge of the disease a drug candidate aims to treat. As Peter Lynch intoned, "Buy what you know." A good place to start is the Fool's own Biotechnology discussion board.

Playing the field
Of course, making a value judgment ultimately entails some estimate of what a drug is worth. Is that "billion-dollar" drug the real deal? And as importantly, what about competition?

Amylin's (Nasdaq: AMLN  ) Exenatide would be competing in a huge market against several large competitors including GlaxoSmithKline (NYSE: GSK  ) . Might these competing drugs be better? If a drug candidate is injected, are competitors making easier-to-administer pills, or experimenting with less frequent injections?

And clearly, when considering a drug that will be marketed some time down the road, one can't overlook the other companies' pipelines, either. A Fool might have heard good things about Neurocrine Bioscience's (Nasdaq: NBIX  ) sleeping pill indiplon, but an analysis would be incomplete without a breakdown of Sepracor's (Nasdaq: SEPR  ) Estorra that is sleepwalking through the FDA.

Sharing the load, selling the stock
Finally, there are the devilish details that get overlooked. One is sharing -- most biotechnology companies must partner up with a big pharmaceutical company to share the costs (and profits!) of a promising new drug. Most biotechs simply don't have the resources to sink $100 million or more into a series of clinical trials. Slice some revenues from your projections if rights to certain markets have been given up or shared, or if a pharmaceutical company has been granted a percentage of sales off the top.

What happens if an early-stage biotech company hasn't partnered up with big pharma? It has to get the cash from somewhere to fund the trials. If it's not a well-funded partner, it could be a bank -- but getting a loan on favorable terms is not likely for most profitless biotechs. If it's not a bank or Big Pharma then it's ... you, the investor, or that dart-throwing monkey!

It's quite common for biotech companies to raise cash by selling more stock. Naturally, this dilutes future earnings, so a Fool should review the SEC filings and company news to check for announcements that a company plans to sell stock. If there are none, you might expect one in the future, particularly if it looks like the company can't afford to fully fund its trials on its own.

Risky business
You don't need a medical or science degree to invest successfully in biotech, but it probably helps. I myself have been blindsided by the unexpected trial failure or stock sale that dilutes the current shareholders 20% or more. Biotech is no more immune to these particular nasty surprises as is high-tech to product flops or excessive option grants.

Again, as with other sectors, biotech has its own ETFs for investors who believe the sector will continue to outperform, but who don't want either to invest the time to research individual stocks or pay the high-fees associated with sector mutual funds.

If you do think you have what it takes, move slowly. Don't overpay for pipeline drugs, monitor the competition, and keep a watchful eye on cash hoards. Do so, and you can hope to reap another good year in biotech. Maybe you'll even beat that pesky chimp.

David Nierengarten, Ph.D., works with a biotechnology venture capital fund. He lets the chimp beat him at darts but not investing ... usually. He often contributes to and is an active member of the TMF community as DavidMN. He owns shares of GlaxoSmithKline. He appreciates your comments at and on the Biotechnology discussion board.

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