Fool.com: Investing in Biotech (Fool on the Hill) December 21, 1999

FOOL ON THE HILL
An Investment Opinion

Investing in Biotech

By Warren Gump (TMF Gump)
December 21, 1999

Although the price-to-earnings ratios of most biotechs are quite high, I believe the sector's opportunity-to-price ratio is greater than that of any other sector. This perspective is formed by the tremendous prospects brought on by advances in genomics, particularly the pending unraveling of the human genome. The better understanding of the human body brought on by this endeavor should result in extraordinary developments over the next three to twenty years. Investors with the patience to put their money in these stocks should be well rewarded for their duration. (For a little more on why I didn't pick Internet-focused companies, check out my April Internet or Biotech article.)

Any investor serious about participating in the biotech sector needs to at least consider owning shares of Amgen (Nasdaq: AMGN) or Genentech (NYSE: DNA), the industry's two largest companies. Both have at least two major products on the market and several promising compounds in development that could lead to an even more prosperous future. Their people, product breadth, and financial strength leave them best-positioned to reap the benefits from the developments that are likely to occur over the next few years. Most people could pick either of these two companies, even at today's seemingly high valuations, and be well positioned to reap the financial rewards this industry should bring.

In pursuit of more industry exposure, you could start looking a little lower in the food chain and evaluate Immunex (Nasdaq: IMNX), Biogen (Nasdaq: BGEN), MedImmune (Nasdaq: MEDI), or any of the other companies widely considered at the forefront. The truth of the matter, though, is that I don't have the medical background to really analyze and understand what is happening.

Reading press reports, reviewing financial statements, and learning from other Fools provides a lot of information, but it's hard for me to really grasp the implications of industry developments with my limited knowledge of chemistry, biology, and medicine. This leaves me with a significant handicap. I don't worry about this too much with Amgen and Genentech due to their product diversity and history of bringing new products to market, but I become more apprehensive when dealing with less-dominant players.

This issue is even more acute with smaller biotech companies. Often, these firms have no products on the market -- their entire value hinges on the ability of their research efforts to develop successful new products. Some of them will undoubtedly be extraordinary winners; at the same time, many will bomb completely. Without insight into what these companies are doing, investing in them would be little more than gambling. And it's better to invest than gamble.

One way to broadly participate in the exciting world of biotech companies is to invest in a biotechnology-oriented mutual fund. Two such funds are the Fidelity Select Biotech Portfolio (FBIOX) and Rydex Biotechnology (RYOIX). Such a move provides expert guidance and industry exposure, but it also incorporates the drawbacks of mutual funds known by most well-versed Fools. (Check out our mutual fund area for more information on why the Fool discourages the use of non-index funds.)

The most significant hindrance to fund performance is high fees. The Fidelity fund has a 3% front-end load and a 0.75% redemption fee on top of an annual expense of 1.3%. Rydex doesn't have any loads, but its annual fees are a hefty 1.55%, and it has a minimum initial investment of $25,000. If the biotech sector performs as well as I expect, the resultant strong fund performance should more than recoup these stiff fees and still achieve market-beating returns. Nonetheless, I'd be a lot happier if there were a way to mitigate this fee disadvantage.

One way to achieve this objective is to invest in the H&Q Life Sciences Fund (NYSE: HQL), a closed-end mutual fund that has heavy exposure to the biotechnology industry. While this fund has an expense ratio (1.60%) higher than those of the two previously discussed funds, it also has an enormous advantage: The stock trades at a substantial discount to the actual fund value. Although the stock closed at $14.44 yesterday, the underlying portfolio was worth $19.39 -- a 26% discount that would cover the current expense ratio for 16 years.

H&Q Life Sciences is quite different from either the Fidelity or Rydex fund. The biggest difference is that H&Q Life Sciences primarily invests in small companies (including private ones), whereas the other two funds have a substantial allocation to larger companies. Over the past several years, this focus has hindered H&Q's performance, and its NAV returns have significantly lagged those of biotech fund competitors. The fund should be well-positioned, though, if some of the fund's smaller companies come closer to commercializing breakthrough developments. The 33% NAV rise over the past six months may be an indication that this strategy is starting to pay off.

Investors have numerous ways to participate in the revolutionary changes occurring through biotechnology. While no single strategy will be best for everyone, any serious growth investor should evaluate whether they have enough exposure to this industry. Being invested in biotech is not always a peaceful experience -- you have to be willing to endure the wide price swings inherent in the stock prices of an emerging industry -- but the long-term investor should be well rewarded.

Related articles:

  • Rule Breaker to Buy PE Celera Genomics Corp.
  • Genentech's Heart Beating Again
  • Amgen Shouts S-U-C-C-E-S-S
  • Biotech Big Boy Biogen
  • The Motley Fool's Industry Focus 2000 (biotechnology is a featured industry)

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