Finding Biotech's 50-Baggers

Like all biotech investors, I'd love to find the next Amgen (NASDAQ:AMGN) -- to be the whiz who picks the next biotech Rule Breaker. Back in January 1990, Amgen was available at a split-adjusted $1.07 per share. Right now, Amgen shares are going for about $61, which is more than a 50-bagger for long-term investors who held onto a great company. Anyone who invested $2,000 in Amgen 15 years ago, and held on, has a stake worth more than $110,000 today.

Of course you'd like to buy the next Amgen. Who wouldn't?

This is my goal as well. I search for small biotech companies that are poised to be tomorrow's industry leaders, as Amgen and Genentech (NYSE:DNA) are today. I want the biotech companies that are going to deliver the groundbreaking drugs for Alzheimer's disease, cancer, multiple sclerosis, and all other diseases where current treatments are lousy. These patients need good drugs now! And this presents a great opportunity for the companies that are first movers developing these products. I want to invest in these companies and I want to do so at a reasonable price.

Destined to be the best
Finding these superb biotechs isn't a search for a once-in-a-lifetime opportunity. These great investments pop up much more frequently than you may think. The market features plenty of promising small caps with solid management teams and exciting drugs in development. Check out these four great investments over the past 10 years.

These four companies are among the bigger, better-known names in the sector. But at one time, they were obscure small caps that had yet to attract a following on Wall Street. Their stock prices reflected that, and this created a great opportunity for shrewd investors who moved ahead of the pack. Consider that a $2,000 investment in MedImmune would have grown to a whopping $88,000 in just 10 years.

The next big thing
The next five-, 10-, or 50-baggers are out there right now making tomorrow's great drugs. As Rule Breaker investors, we want tomorrow's Amgen because today's Amgen won't give us the kind of return we're looking for. Don't get me wrong, Amgen is still a great long-term investment for a conservative growth style. But to make the kind of investment that will rise more than 20 times in value over 10 years, we have to look to the small caps.

We have a broad universe of companies in which to conduct our search. Did you know that there are more than 250 publicly traded small-cap biotech companies to explore right now? The vast majority of them are unknowns. To me, that spells opportunity.

These companies, which are currently toiling away in obscurity, are developing new technologies and creating new drugs that are safer and more effective than anything available today. I strongly believe that these research labs will generate many breakthrough drugs. As an investor, I want to participate in this success.

Increasing our odds of success
Conventional wisdom says that small biotechs are speculative crapshoots that are very likely to blow up sooner or later. That they just must be riskier than big pharmas with actual products and earnings. Hogwash, I say! Merck's blowup this year demonstrates that companies of all shapes and sizes can be hazardous to your portfolio's health.

I will be the first to admit that not every small-cap biotech company is going to become a lasting success. Many are fated to permanently toil in obscurity, or even disappear. Only a select few will move on to become one of the great Rule Breakers. The risks of owning these companies are mitigated because they:

• Have strong balance sheets that allow the company to fully fund R&D;
• Own proprietary technologies that give a unique edge over the competition;
• Are designing drugs to fill unmet medical needs;
• Are first movers with a superior product; and
• Have superb management teams with proven track records.

Using the list above, we can identify quality companies with sound drug development strategies. These companies spend money on R&D with the intent of getting the best return possible on that investment for shareholders. I will gladly tag along with management teams that have a clear goal of increasing shareholder value.

It was this approach that led me to recommend Vertex Pharmaceuticals (NASDAQ:VRTX) to subscribers of our Motley Fool Rule Breakers newsletter advisory service earlier this year. Vertex is up more than 25% since recommendation (vs. a 2% rise for the S&P 500), largely buoyed by the progress it has made in its innovative hepatitis C drug program.

Not every company is going to be a resounding winner. In fact, the vast majority of them are deficient in some manner. Some of the major faults I come across are technologies that are unlikely to work, shaky balance sheets, incompetent management, or the fact that the company is just plain overvalued for what it is positioned to deliver.

After screening these pretenders out, I am left with a select few that I believe are true Rule Breakers. These are companies that will not only beat the market over the next five years, they'll give it a sound spanking.

The quest to find tomorrow's industry leaders is the focus on my monthly Biotech Beat in Rule Breakers. In the latest issue, I offer up some small-cap biotechs that are on the move. If you'd like to join the discussion and preview a few companies that could be the next Amgen, take a free 30-day trial. There is no obligation to subscribe. Together, we can uncover biotech's 50-baggers.

For additional articles on the biotech industry, see:

• Flamel Inflames Passions
• Is Eyetech Better Than It Looks?
• BioMarin Bounces Back

This article was originally published on Nov. 16, 2004. It has been updated.

Motley Fool Rule Breakers biotech analyst Charly Travers owns shares of Vertex but not of any other company mentioned in this article. The Motley Fool has a disclosure policy.