In the realm of biotech investing, some days you eat the bear and some days the bear eats you. Last year was a great one for the sector, with the Nasdaq Biotechnology Index (INDEX: NBI) up 42%. Even more stellar results came to those invested in the small caps, with gains in excess of 100% quite common. As it turns out, 2003 was the best time to be a biotech investor since the mania surrounding the Human Genome Project in 1999 and 2000.

Of course, these runs will have to come to an end sooner or later, and this year has us pining for the good old days. As Fool Zeke Ashton has said, investing in small biotechs can be a tough way to make money. This year has been generally miserable for biotech investors. The NBI is down 12% year to date, though that's not really devastating performance. What hurts is that the NBI is now down about 23% from the peak in April. While that has been an excruciating experience, that is life investing in a highly volatile sector such as biotech.

As expected, some of the biggest losers this year have been companies that had difficulties in getting their drug programs on the market. In May, I wrote about two of these companies, Genta (NASDAQ:GNTA) and Allos Therapeutics (NASDAQ:ALTH). Over the course of 2004, Genta and Allos have seen their stocks decline 87% and 47%, respectively.

Still, it's not really surprising to see stocks tumble on bad news. That's what should happen when major events change the outlook for a company. However, the stock slides have not been limited to companies that have had rough times. Even companies that have made progress in their drug programs with no major setbacks have been hit hard with the shifting sentiment.

For example, Abgenix, Cell Genesys, and Medarex have all had stock declines in excess of 20% without having any major stumbles. Of these, Cell Genesys has been hit the hardest, with a nearly 50% decline despite moving its prostate cancer vaccine drug program into phase 3 trials.

While this year has been generally rough so far, not all biotech companies have been lousy performers. Some drug stocks have actually done quite well. A few of the notable standouts have been Biogen IDEC (NASDAQ:BIIB), Connetics (NASDAQ:CNCT), ImClone Systems (NASDAQ:IMCL), and Sepracor (NASDAQ:SEPR). All of these companies have seen gains in stock price in excess of 35%, with Sepracor coming in a big winner at a gain of 87% so far this year.

What has happened?
The way I look at small drug companies (those without meaningful revenues or profits), there are two significant assets of value. The first is the net cash on the balance sheet, and the second is the net present value (NPV) of drugs in development.

In general, cash balances for these companies decline slowly over the course of the year. Gradual changes in the balance sheet do not explain the wild swings in the prices of these stocks. Instead, the volatility comes from changes in sentiment toward the pipeline drugs. In periods of optimism, the market looks far into the future, and even early stage pipeline drugs are valued richly. On the other hand, during periods of negative sentiment, early stage drugs have minimal value, and often even drugs that are fairly close to launch may not have much value.

I think the wild swing we have experienced this year has been a transition from generously valuing companies on future prospects to a conservative valuation on what they are worth right now. When this happens, small biotechs are valued primarily on the cash on the balance sheet, with less emphasis on the NPV of the drug pipelines. When this happens, the companies that do not have near-term products are going to suffer the most, while the ones with drugs very near to the market, or already launched, will hold up a bit better.

This phenomena can be rationally explained. The NPV of a drug pipeline can be increased or decreased by how far out in the future you look and by adjusting the discount rate. For example, during periods of negative sentiment, earnings are not projected very far out in the future, and they may be discounted at a higher rate. Thus the NPV will be lower than in more optimistic times.

Where do we go from here?
Though it's tempting to hold an envelope to my forehead and make a guess on the general direction of biotech stocks, I will refrain from impersonating Johnny Carson's Great Karnak.

Making a prediction on what will happen with biotech stocks in the coming months would be a futile endeavor. I have no ability to predict what will happen in the short run with the sector, and I doubt anyone else can do it either. While many of these stocks have fallen hard, the situation could get much, much worse. Many biotech investors can recall the dark days of 2002, and this year hasn't been nearly that bad. Alternatively, the sector could improve. We can speculate which way the market will go, but there's no way to know for sure.

In general, I don't like to make investment decisions based solely on the overall sector valuation, though it is something that I do keep an eye on. I think that the best approach is to look for undervalued companies in all market environments. What I want to do is find quality drug programs that are not yet priced into the stock. Of course, it will be much easier to find good buys at fire sale prices when the sector is depressed than when it is flying high. It is during the downturns that the knowledgeable and rational biotech investors make their money. This is when we can buy shares on the cheap in good companies that no one likes at the time.

The wild ups and downs are just something that biotech investors have to deal with. If you own a good company and paid a good price for the stock, then I'd suggest not watching it every day. Assuming the reason for owning the stock is still sound, sit tight with it, and wait for the story to play out.

To read more of Charly's coverage on the biotech industry, check out his recent articles:

Fool contributor Charly Travers' Magic 8-Ball says that he owns shares of Cell Genesys and Medarex. The Motley Fool has a disclosure policy.