Last year proved a tough pill to swallow for biotech stocks. According to SmartMoney's Sector Tracker, they've collectively dropped nearly 7% over the past 52 weeks. Among those hit the hardest, Amgen (NASDAQ:AMGN) and Nektar Therapeutics (NASDAQ:NKTR) each endured a bloodshed of more than 20%.

With the S&P up 11% over the same period, biotech investors must be wondering when their shares will spring back to life.

The current biotech drought comes on the heels of a very good 2005. The Biotech HOLDRs ETF (BBH) surged 31%, and the sector was anchored by big winners like Momenta Pharmaceuticals (NASDAQ:MNTA) and Celgene (NASDAQ:CELG), which returned 212% and 144%, respectively.

Get 'em while they're cold
According to our Fool biotech guru, Charly Travers, "2006 was a Dr. Jekyll and Mr. Hyde year for biotech. The first half of the year was terrible, but the sector came on strong at the end. Frankly, every year is like that with these companies. If you look back over the last five years at the performance of the Nasdaq Biotech Index, you will see every single year had a major pullback at some time or another."

During last year's pullback, some of the major biotech companies took advantage and snapped up some smaller players. For instance, Eli Lilly (NYSE:LLY) nabbed Icos, and Gilead Sciences (NASDAQ:GILD) added Myogen after each stock traded downward.

Does this consolidation mean 2007 will produce a bumper crop of pharmaceuticals? Standard & Poor's biotech analyst Paul Starsia isn't so sure. In a January 2007 interview with BusinessWeek, Starsia predicted that 2007 will be a "building year," and didn't see any transformational products or technologies in the pipeline.

He's been right so far. The biotech sector has sunken 3% this year.

No news is good news
Since the biotech sector has cooled since 2005, now is a good time to start researching investment ideas in the industry. After all, health-care spending is rising at record rates. Moreover, many small biotech companies have enormous potential in their research programs and should be considered for at least a slice of a larger portfolio simply because of their total return prospects. Among the best 50 stocks of the past 10 years are Gilead and Celgene.

That said, this is an inherently volatile sector and should be treated as such. A few failed FDA screenings could send a small biotech stock straight to the compost heap.

So how do you separate the winners from the losers when it comes to small biotech companies? Charly recommends looking for firms that:

  • Use proven technologies (like molecule or monoclonal antibody drugs).
  • Have qualified management with a track record of solid decision-making.
  • Are solidifying partnerships with more established industry players.

If you'd like to learn more about a few promising biotechs, our Motley Fool Rule Breakers growth investing service can help. Led by Motley Fool co-founder David Gardner, Rule Breakers has selected a handful of biotech stocks they think are poised for growth. In fact, one of Charly's best picks, Vertex Pharmaceuticals, is up 165% since its recommendation in February 2005.

You can take a look at all of our past recommendations and research for 30 days, free of charge. Simply click here to take advantage of a free trial -- there's no obligation to subscribe.

Todd Wenning's random 90's movie of the day is "Dazed and Confused" starring Matthew McConaughey. He does not own shares of any company mentioned. Momenta Pharmaceuticals is a Rule Breakers pick. Eli Lilly is an Income Investor choice. The Fool's disclosure policy knows there's always a party at the Moon Tower.