Now Is Not the Time to Wimp Out on Biotech

Developmental-stage drugmakers have been hit hard during the first three months of this year. I mean really hard.

While their revenue-generating brethren like Genentech (NYSE: DNA) and Gilead Sciences (Nasdaq: GILD) have weathered the downturn fairly unscathed, developers without drugs have largely gotten hammered.

Ow! I stubbed my toe
The problem basically boils down to risk. It's not that the developmental-stage companies have become more risky; instead, the reason for the downturn is that investors' risk tolerance has changed.

It's probably not even individual investors who are wimping out, so much as institutional investors needing to shift their risk around. Motley Fool Rule Breakers analyst Karl Thiel summed it up best in a recent post on the newsletter's discussion board for Omrix Biopharmaceuticals (Nasdaq: OMRI):

A big part of the reason biotechs are getting hammered is that funds are holding a lot of relatively illiquid credit debt. The debt is being downgraded, raising the risk profile of portfolios. And so what do they do to get the risk levels back in line with their standards, since they can't necessarily lose the debt? Lose the biotechs!

Nevertheless, these companies really aren't more risky than they were six or 12 months ago. Heck, a lot of them are actually less risky, since they've moved drugs further through the development marathon and are closer to being able to drop the "developmental stage" label from their moniker.

An excellent example
Even with the uptick over the past couple of weeks, Exelixis (Nasdaq: EXEL) is down more than 20% since the beginning of the year -- and was down more than 40% year to date earlier this month. What's caused the steep decline? Pretty much nothing.

Since the beginning of the year, the company has issued 13 press releases. Seven of those were announcing presentations for analysts -- not share-moving meetings by any means. There was also an announcement of management promotions, a notice of a trial beginning, and its earnings announcement, which, without any revenue, was fairly immaterial.

The remaining three were more positive than negative. Bristol-Myers Squibb (NYSE: BMY) and Genentech both agreed to pick up their options for compounds that Exelixis was developing. GlaxoSmithKline (NYSE: GSK) declined its option to take over development on XL784, but given that the drug had failed its phase 2 trial last October, it seemed unlikely that Glaxo would use one of its picks on the drug. Others in Exelixis' pipeline look more promising, and Glaxo has only two picks remaining in their deal.

All told, Exelixis' partners rewarded the company with $23 million in milestone payments. Investors, however, rewarded Exelixis with essentially bubkes.

A history lesson
I hate to say it, but things could get worse.

In 2002 -- the last biotech bear market -- companies were trading at levels close to the cash on their balance sheets. Investors were essentially valuing the pipelines of companies like Transkaryotic Therapies at close to zero and occasionally even giving the pipelines negative value, claiming that the pipelines were a drain on resources.

That's not true today. There are plenty of small debt-free cash-rich drugmakers with enterprise values greater than zero. That's good news, but it also means that the industry could fall further.

Given that, I'm not willing to call a bottom just yet. Then again, you've gotten your short history lesson in for the day, so maybe we aren't doomed to repeat it.

Either way, if you've got money that you don't need for many years, I just don't see bailing out of drug stocks now as being a good move. Sure, you might avoid further damage on the downside, but you could easily miss the inevitable upswing on the other side. Don't forget, Transkaryotic more than tripled in just more than a year as it was gobbled up by Shire Pharmaceuticals (Nasdaq: SHPGY). Taking on risk certainly has its potential for rewards.