There's no doubt about it: Investment in biotechnology companies is humming. In recent days, Corcept Therapeutics filed with the Securities and Exchange Commission for an initial public offering, Eyetech Pharmaceuticals (NASDAQ:EYET) completed its IPO, Vion Pharmaceuticals (NASDAQ:VION) sealed a private equity placement, and Onyx Pharmaceuticals (NASDAQ:ONXX) priced a follow-on offering.
Scores of other biotech and specialty pharmaceutical companies are in the process of raising cash in both private and public markets. As I've written here previously, the resurgence is a reasonable return to normal levels of funding following an extended drought. Nevertheless, it might not be a bad idea to take a step back and reflect on the last time the biotech segment was awash in cash, and see if there are any lessons to be gleaned from that period.
Riding the biotech cycle
Since the industry's beginning, biotech financing has come in fairly regular boom and bust cycles. The last one, which culminated in 2000, was the largest boom by far. Biotech companies cumulatively raised $39 billion in 2000 alone. About 30 new biotech drug developers went public. According to Burrill and Company, the cumulative market capitalization for the sector peaked in February 2000 at $490 billion.
Then came the bust. Biotech firms' take from investors dwindled to just $13 billion in 2001. As cash resources vanished, an inevitable contraction followed. The total equity valuation for the publicly held companies nose-dived to $197 billion by August 2002. Firms without approved drugs were particularly hard-hit. They had no cash flow, making them unattractive acquisition candidates. And they had little hope of generating revenue without access to investment cash to advance their pipelines.
Market capitalizations for this unlucky group plunged below cash on hand. Dozens of firms restructured and many filed for bankruptcy. A lot of shareholders lost their shirts.
The early money gets the worm
I don't mean to suggest that a bust is on the horizon. Investors, however, can learn from the past to pick biotech stocks wisely today. Investing in newly public companies is always risky, but for those intent on taking that risk, there are some points to keep in mind.
First, it's better to buy companies that are going public sooner rather than later. That's because newly public biotechs rarely raise sufficient funds for extended operations from their IPOs. Before they commercialize products, they often have to return to the market with follow-on offerings to fill their coffers. So a biotech company that goes public earlier in a boom rather than later has more time to stage a follow-on while market conditions are favorable.
Investors also should take a close look at a company's pipeline and understand the odds of eventual regulatory approval. Firms concentrate on killing ineffective programs as early as possible since costs increase as a drug moves through development. Still, according to the Tufts Center for the Study of Drug Development, historic attrition rates for drugs in phase 2 trials exceed 50%. While drugs that reach phase 3 testing have a better chance of FDA approval, more than one in five of these therapies still fail.
Who's looking good?
So when nosing around for solid stocks, focus on companies with late-stage programs. For example, Eyetech is attractive because it is already poised to file a New Drug Application, the final regulatory hurdle before market approval, for Macugen, its lead drug. This means that Eyetech could start generating sustainable revenue in a fairly short time. Eyetech's alliance with Pfizer (NYSE:PFE) for Macugen is also a huge plus. Sales and marketing heft -- something most biotech companies lack -- is critical to a new drug's long-term success. Pfizer clearly has the global infrastructure to fill this need.
For an early stage company, Corcept Therapeutics also appears to be in a relatively solid position. The company received "fast track" designation from the FDA for its lead drug, and Corcept projects it will complete pivotal phase 3 trials in a year and a half. On the downside, Corcept looks like a one-trick pony, because the rest of its pipeline is at a very early stage. Still, a strong one-trick pony may be better than companies with multiple earlier-stage drugs in development.
When looking at more established companies, do not get caught up in the euphoria. The market capitalization for the biotech industry climbed back up to $330 million in Dec. 2003, three companies already have gone public this year, and 14 more are on tap to do so. In this positive investment climate, some companies that have been public for years have closed private placements. While the investors in these deals might know something that average investors don't, it's best to avoid these stocks. If these firms can't sell stock to the public, they are probably still on somewhat shaky ground.
Even for companies that are able to sell shares in follow-on offerings, it still pays to be careful. With a company like Onyx, for example, investors should probably tread lightly. The buzz surrounding Onyx's BAY-439006, in co-development with Bayer (NYSE:BAY), has set the stock on fire. The drug is exciting since it operates by a novel method of action and appears to have the potential to treat a variety of cancers.
However, BAY-439006 only recently began phase 3 trials, so it is still a long way from approval. Onyx has no other drugs in clinical trials, and its stock is already up more than 100% in the past six months. Given the risks inherent in the stock and its already healthy valuation, it's best to take a wait-and-see position with this one.
For now, the rise in biotech appears to be sustainable. While there has been a surge of IPO filings and follow-on offerings, investors appear to be making careful decisions, since several less-solid companies have been forced to withdraw deals. As long as the focus remains on revenue potential and not hype, the sector should be in for a long run.
Now What?
From biotech to retail to furniture, Tom Gardner is always in search of successful small-cap stocks that are poised to grow. Take a free trial to his Motley Fool Hidden Gems newsletter. Since its inception, Tom's picks have whomped the S&P 500 by 20%. Also, join us on our Biotechnology discussion board. Only on Fool.com.
Fool contributor Brian Gorman lives in Chicago and welcomes your comments via email. He does not own any of the stocks mentioned in this article. The Motley Fool is investors writing for investors.
