Genetics of a Rule Breaker

As 2004 draws to a close, I am drawn to reminisce about some of the big names from biotech's past. Five years ago, we were smack-dab in the midst of Biotech Mania: roughly speaking, the 24 months covering 1999 and 2000. It was a time we at Motley Fool Rule Breakers remember well.

Two dates of particular note were March 6, 2000, and June 26, 2000. The former was the day the Nasdaq Biotechnology Index (NBI) hit its all-time peak of 1596.53. For much of the past two years, the NBI has hovered at half that value. The stock prices of many small-cap biotech companies are a fraction of their price from that time. However, I also look at it as how far the market had to come to stop the insanity.

The second date was the day Celera Genomics (NYSE: CRA  ) and the Human Genome Project at the National Institutes of Health jointly announced that the sequencing of the human genome had been completed. The sequencing of the human genome was, in large part, the driving force behind all the interest in biotech companies because of the belief that knowing our genetic code would lead to a flood of new drugs and cures.

As a result of this buzz, the money spigot turned wide open. The inflow to biotech came not just from the IPOs of any company with -omics in its business plan, but from major pharmaceutical companies looking to stock drug pipelines with future blockbusters. CuraGen (Nasdaq: CRGN  ) , Human Genome Sciences (Nasdaq: HGSI  ) , and Millennium Pharmaceuticals (Nasdaq: MLNM  ) all landed incredibly lucrative drug discovery deals with big pharma. And if big pharma was going to throw hundreds of millions of dollars into small biotechs, why shouldn't institutional and retail investors follow? Follow, they did.

Whether it is a tulip craze or a genomics-driven bioboom, a momentum run propelled by greed will always come to an end -- often a very painful one. The decline in the NBI from 1500 to the current level near 750 did not happen smoothly and gradually. It was more like an avalanche that began with a tremor at the end of 2001, when ImClone Systems (Nasdaq: IMCL  ) ran into trouble with the Food and Drug Administration. The NBI fell below 400 before snapping back a bit.

With the wisdom of experience and the benefit of hindsight, what lessons can be learned from biotech's boom and bust to help us be smarter biotech investors in the future?

Investing on hope
A main problem during the mania was that the market was investing -- make that speculating -- on hope. There was the hope that patents on DNA sequences had value. That new genetic information would quickly lead to new drugs. That it would make drug development faster and more efficient.

The problem was that a lot of those assumptions turned out to be wrong. Many of the -omics companies may have had a lot of knowledge of human biology from all the genetic research, but there were no products. And in cases where there were products to be sold, such as database subscriptions, it quickly became clear that this was not going to be a high-margin business model that would deliver sustainable and growing profit for the long term. I think this became obvious when Celera acquired Axys Pharmaceuticals in mid-2001 to accelerate its transition into drug discovery.

Another of my favorite lessons from the period is that a sexy story does not make a business plan. Some CEOs are master storytellers, and we heard a lot of stories during the boom. Investors love to hear CEOs talk about how their company is going to revolutionize drug development. How many times did we hear Millennium CEO Mark Levin say he was helping to build "the biopharmaceutical company of the future?" Catchphrases and stories work in the short term to prop up the share price and raise capital. It sure worked for Millennium. But, inevitably, unless solid clinical data back up the claims, the stock is going to pop like a balloon until the fundamentals catch up.

Valuation matters
This brings us to another critically important lesson: Valuation matters. Always. And not just for big, dividend-paying Fortune 500 companies that are relatively easy to value. Small, unprofitable biotech companies that are not going to have products on the market for years are not worth several billion dollars! You should never say never, but I will. Never, ever should we see that again.

Now that the buzz is long gone, we can, and should, rationally evaluate companies based on reality, not pie-in-the-sky pipe dreams. Hopefully, that lesson has been learned. If not, before too long the market will hold that session again for the remedial students.

When I write about biotech companies in Motley Fool Rule Breakers, I strictly apply the following list of criteria, which comes from the experience of participating in the biomania and subsequent bust:

(1) A company must have a tangible product that has a clear value. No phantom products of dubious value are allowed. A good story does not equal a viable business plan for the company's future.

(2) Drugs are a source of long-term profit growth. Services can be fine if you want a commodity-type business, but I'm simply not interested.

(3) Valuation is critical. Yes, it is hard. But that makes the market for biotech companies very inefficient and allows everyone who crunches the numbers to do quite well. Biotech investors take quite a bit of risk when evaluating a drug and taking a chance that it will work. Because of that, we have to make sure that when we're right, we can participate in the company's increase in value.

Investing is a lifelong learning process. We never know everything, but it is important we strive to learn from the lumps we take along the way. That is the path to becoming a successful investor.

For additional articles on the drug industry, see:

Fool contributor Charly Travers owns no shares of any company mentioned in this article.

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