Is it turnaround time for biotech stocks?

That's the question I posed in March, in a previous version of this article. Since then, biotech stocks have experienced a bit of volatility. According to SmartMoney's Sector Tracker, biotechs were up a collective 10% for the year ended May. But they've given back some of those gains in the past six weeks, and they're now up just 3.6% for past year. The past year's winners include InterMune (NASDAQ:ITMN), Myriad Genetics (NASDAQ:MYGN), and Medarex (NASDAQ:MEDX), each up more than 50% since last July.

But despite these winners, biotech stocks as a group still trail the S&P 500 by more than 18 percentage points over the past year. Biotech investors must be wondering when their shares will spring back to life.

The current biotech funk follows a very good 2005. The Biotech HOLDRs ETF (BBH) surged 31%, and the sector was anchored by big winners like Adventrx Pharmaceuticals (AMEX:ANX), LifeCell (NASDAQ:LIFC), and Genentech (NYSE:DNA) which returned 193%, 86%, and 70%, respectively.

Get 'em while they're cold
According to 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 nabbed Icos, and Gilead Sciences added Myogen after each stock traded downward.

Does this consolidation mean that 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 dropped 0.7% year to date.

No news is good news
Since the biotech sector has largely underperformed the market in recent years, 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. They should be considered for at least a slice of a larger portfolio, simply because of their total return prospects. The best 50 stocks of the past 10 years include Gilead and Celgene.

That said, this is an inherently volatile sector, and it 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 173% 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.

This article was originally published on March 26, 2007. It has been updated.

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