Summary: Biotechnology companies may offer tremendous potential, but the risk and complex nature involved makes many investors shy away. Several different ways to invest in biotechnology do exist, however, and some of them are very low risk. This column provides a framework for how to think about and invest in biotechnology, whatever your tolerance for risk happens to be.

Biotechnology is an important, Rule Breaking industry that will likely change human life more than any other. Despite its potential, however, many investors shy away from investing in biotech because it is difficult to understand and it entails high risk. Different ways to invest in biotechnology do exist, though -- ways that lessen your risk and still offer you the potential reward.

Starting with our next paragraph, this column offers a framework for how you can think about the biotech industry by dividing it into various sectors in your mind. Doing this, you'll likely find ways to invest some long-term dollars in one or more parts of this promising, large field. We'll start with the risky guys.

  • Biotech Companies With Few or No Drugs. Investing in these biotechs is a high-risk, potentially high-reward situation. If you purchase stock in a company without drugs on the market, or with only a few small drugs on the market, your chance for great reward rests almost solely on the company's ability to get large, important drugs to the market.

    To invest in these young companies, you need to know the companies very well and you need to focus on, among other things, the:
    1. Drug pipeline. Know what drugs the company is developing, the market size that they may serve, the competition, and what stage of development the drugs are in.

    2. Cash balances. Without cash to live on, these typically small revenue companies are in trouble.

    3. Research & Development. The companies must have substantial R&D budgets.

    4. Partnerships. Young biotech companies almost must have strong marketing and drug development partnerships in order to one day thrive.
    Two companies in this stage of development that I have been drawn to and interested in are Human Genome Sciences (Nasdaq: HGSI) and Millennium Pharmaceuticals (Nasdaq: MLNM). Of course, many dozens of other promising, emerging biotech companies are working to get drugs to the market. Greg Carlin (ElricSeven on the boards) wrote an excellent research report, called Harvesting the Human Genome, that teaches you how to analyze drug pipelines at such companies and potentially value them. Among other information, the report also analyzes the drug pipelines at 12 leading, younger biotech companies. All in all, "there be dragons" investing here, but also the potential for a pot of gold.

  • Biotech Companies With Established Leadership. More mature, successful biotech companies begin to establish sales leadership in the health needs that they serve, such as Amgen's (Nasdaq: AMGN) leadership in blood cell boosters. These companies usually have annual sales in the billions, or close to it, and have substantial cash balances and partnerships. Being established, they typically offer lower potential reward than an unestablished company, but they still can offer market-crushing returns and they can do so with much less risk. When evaluating these companies, look at their drug pipelines, because their long-term future depends on it.

    Companies that emerged from the masses of biotech startups in the 1980s to become leaders include Amgen (which is analyzed regularly, including its pipeline, by Motley Fool Research), Biogen (Nasdaq: BGEN), Genentech (NYSE: DNA) and Medimmune (Nasdaq: MEDI). Medimmune is smaller than Amgen or Genentech, but it has six drugs on the market and it should top $1 billion in annual sales by 2001. Investing in established biotech leaders, like these and others, is a safer way to put your money to work in biotech. These companies, perhaps as much as any, stand to gain from new genomic discovery and reward shareholders as a result.

  • Monster Pharmaceutical Companies. Do your palms sweat at the thought of taking any risk at all? And yet, your heart is telling you: "Buy biotech for 20 years. Buy it!" One of the safest ways to do so is to buy giant pharmaceutical leaders such as Pfizer (NYSE: PFE), Eli Lilly (NYSE: LLY), Johnson & Johnson (NYSE: JNJ), American Home Products (NYSE: AHP), Merck (NYSE: MRK), Schering-Plough (NYSE: SGP) or Abbott Laboratories (NYSE: ABT).

    Four of these companies are worth more than $100 billion each, and the others are worth at least $70 billion each. These companies have the budgets and expertise to benefit from gene-based drug development either via acquisition or through their own research -- and most likely both. Pfizer is a monster of a way to invest long-term in biotechnology and the benefits that it will bring, and Pfizer presents very low long-term (decade or longer) risk. Arguably, so do Johnson & Johnson, Eli Lilly, and Merck (which are the ones I know best).

  • Biotech Mutual Funds. If you're still nervous about buying just a few biotech or pharmaceutical companies, then consider a biotechnology mutual fund. That's right! A biotech fund. The Fool usually frowns on mutual funds because they underperform the S&P 500 and they charge you fees for doing so. However, if you find a well-managed biotech mutual fund that does not have high turnover (or high trading frequency) and does not spread its assets too thinly (it would be nice to see a biotech fund holding only 20 leading stocks) and charges you a low annual fee, then this may be your way to invest!

    If you're betting on biotechnology to be a big winner overall at the end of the next two decades, but you don't know where to invest, consider spreading your money in a smart, low fee biotech fund. If you would like to suggest a biotech mutual fund by name, please post it on our biotech board, along with its annual fees and turnover ratio, if you know them.

    A strong biotech mutual fund would likely get you invested in the following opportunities as well.

    Related Investment Opportunities

  • Bioinformatics Companies. Alongside new drug-producing biotech companies, new businesses are emerging. These are information businesses that support drug development. Celera Genomics (NYSE: CRA), Incyte (Nasdaq: INCY), DoubleTwist Inc. and other companies provide genomic information and expertise. These companies are as risky as young biotechs without any drugs, because their businesses are new and the unknowns are large. We believe in the long-term potential at the best companies, however, so we purchased Celera.

    Understanding these companies is a different matter than understanding a young drug-producing biotech. In bioinformatics, great technology and management is key, along with a lot of cash and R&D spending, as well as large partnerships and, of course, a growing client list.

  • Biotech/Bioinformatics Equipment Providers. Supplying the machines and tools that are necessary to develop new drugs and/or harvest bioinformatics, equipment providers sell the "picks and shovels" that biotech, pharmaceutical, and bioinformatics companies are buying. This high-margin, big-ticket machinery and technology empowers drug discovery. Leaders include chipmaker Affymetrix (Nasdaq: AFFX) and Celera's parent, PE Biosystems (NYSE: PEB). I'm still learning about these businesses, but Greg Carlin (ElricSeven) just wrote a new research report on Genomics Picks and Shovels. It's a great place to start.

  • Proteomics. That word, proteomics, may be one of the most important words in relation to drug discovery over the next 50 years. In our recent Rule Breaker biotech chat, David Gardner said he believed proteomics would create more value than many other biotech fields. Proteomics is the study of proteins for drug development. That grossly simplifies it, however.

    Many companies are involved in proteomics. A new report -- Proteomics: The Coming Revolution? -- details the science and lists the companies involved. It is still early, but some investors suggest that proteomics will become a more important word than genomics. I haven't read the report yet, but a handful of Fools have, and one (Greg Carlin) reviewed it for you.

    However you invest in biotechnology or bioinformatics, take your time and understand why you're buying whatever you buy. Also, realize that you should commit your money to a long-term period -- at least 10 years, and ideally longer. Enjoy your learning process in this fascinating field, and enjoy discussing it with others on biotech company boards. If you don't enjoy doing this work, it probably isn't worth it!

    Fool on!

    Suggested Links:
  • Motley Fool Research Report on Amgen
  • Harvesting the Human Genome (Pipeline Evaluation) Report
  • Genomics Picks and Shovels Report
  • Proteomics: The Coming Revolution Report
  • 6/26/00: Rule Breaker Biotech Chat Transcript
  • Motley Fool Biotech Discussion Board