Take The Biotech Ride
But wear your blindfold.


“Biotech is Red Hot! . . .

“You can’t stop science, and the need for miracle cures and innovative treatments has only grown with the aging of our population.”

That’s the pitch that just landed in my e-mail inbox. And it’s not the only one. Biotech is indeed red hot, and the need for miracle cures indeed persists. But when a sector runs a fever, it’s a warning: The sector could be about to take a dive, like a star athlete on the cover of Sports Illustrated.

Over the past 12 months the stock market has bounced around a great deal, but as a whole it’s returned roughly zero. By contrast, stocks of companies that use new genetic techniques to develop powerful medicines — that is, biotech stocks — have risen by about one-third.

Since early March, Biotech HOLDRS (BBH), an exchange-traded fund (ETF) that includes the largest biotechs, has risen 43 percent. By contrast, Pharmaceutical HOLDRS (PPH), an EFT that owns the big traditional drug companies such as Pfizer (PFE) and Merck (MRK), is up only 19 percent.

What you need to know about biotech is that it is very, very volatile. Shares will suddenly spike, then plummet, then go to sleep for a while and wake up again. There is no telling how long the current enthusiasm for biotechs will last. But don’t take the biotech bull market as a reason for selling the biotech stocks you already hold. The steep rise can’t go on forever, but overall this is a wonderful sector. Just expect craziness. Here’s a story, part of which will be familiar to you:

A biotech company called ImClone (IMCLE) spends years developing a drug called Erbitux, an antibody that’s supposed to inhibit the ability of colon-cancer tumors to grow. The drug shows promise and enters the last stage of trials required before approval by the Food and Drug Administration. Bristol-Myers Squibb (BMY) invests $2 billion for a 20 percent share of ImClone and the right to market Erbitux. But the key trials are a shambles, and in December 2001 the FDA withholds its blessing.

Just before that decision, the company’s chief executive, Samuel D. Waksal, tries to dump 80,000 of his shares and tells his daughter to sell her own holdings. At the same time, Martha Stewart, a friend of Waksal’s, sells the 4,000 ImClone shares she owns. ImClone plummets. From a high of $75.45 at the end of 2001, it hits $6.11 by fall of 2002.

Fast-forward 18 months. On June 4, 2003, Stewart, the woman who brought good taste to the masses through magazines, cooking shows, and pillowcases, is indicted on nine counts of fraud and obstruction of justice in the sale of her stock, charges that she denies. On June 10, Waksal, who pleaded guilty in the insider-trading case, is sentenced to seven years and three months in prison.

Meanwhile, guess what’s happened to the cancer drug.

It works! A new study, sponsored by a German firm, finds that tumors shrank by at least half in about one-third of patients taking Erbitux. European approval may be imminent — and an okay in the United States should follow. “For those who were skeptical about Erbitux, perhaps influenced by all the financial shenanigans, this clearly shows that the drug is active,” says Robert J. Mayer, who heads the gastrointestinal cancer unit at Boston’s Dana-Farber Cancer Institute.

The news breaks three days before Stewart’s indictment and nine days before Waksal’s sentencing. The stock doubles in three weeks. It’s up more than 400 percent from its low last year.

The reason for such craziness is that biotech stocks aren’t like retailers or utilities or even semiconductor makers — for the simple reason that most of them, like ImClone, are built around only a few products, all of which may still be in the early stages of development.

If a drug works and hits the market, the firm could reap huge profits — first, because the drug’s value to people who are sick and dying can be priceless and, second, because the drug will have, at least for a time, patent protection. But bringing a drug to market is a hugely expensive proposition. It takes an average of nearly seven years and $800 million to win FDA approval, according to the Tufts University Center for the Study of Drug Development.

Again, ImClone: Last year, revenue rose 20 percent, but it was still only $60 million, while expenses were $218 million, for a loss of $158 million; the year before, ImClone lost $128 million. Obviously, this sort of thing can’t go on for a long time, and most biotechs are in a race against the clock. Can they get a blockbuster drug to market before the money runs out?

Even if the drug succeeds, the company faces enormous risks. Consider Biogen (BGEN), a well-run company that developed a successful genetically engineered drug called Avonex for multiple sclerosis. Biogen has a few other medicines in the pipeline, but Avonex last year represented 93 percent of the company’s revenue. Sales of Avonex suddenly slowed when another firm, Serono (SRA), came up with a competitive drug called Rebif (where do they get these names?). Biogen’s stock has fallen from a high of $129 in 2000 to $39.53.

To raise capital and spread the risks, most biotech firms license their drugs or otherwise enter partnerships with big conventional pharmaceutical companies. Biogen, for instance, has licensed Intron A, for non-Hodgkin’s lymphoma, a type of cancer, to Schering-Plough (SGP). And Isis Pharmaceuticals (ISIS) has formed a partnership with Eli Lilly (LLY) to try to win approval for Affintak, which targets lung cancer.

The smaller, more entrepreneurial biotechs provide the innovative research. The big pharmaceutical companies have the money and the experience to get a drug through trials and then to sell it to doctors and hospitals. The big companies also have enough drugs already in the market to generate strong cash flow, but they are always worried about their pipeline, the new medicines that will replace the ones whose patent protection runs out.

But the big firms are tough negotiators, and they often wait until a drug is on the brink of success before committing their cash. In short, making biotech drugs is a tough business. But it is clearly one of the great businesses of the 21st century. The human genome has been mapped, and, with cancer for example, new genetically engineered medicines are more effective and less toxic than the blunt instrument of chemotherapy.

My own view is that biotech stocks are essential to any sensible portfolio. But here’s the warning: The ride will be wild because biotechs depend on bet-the-company products. You can’t try to pick winners and losers. Diversification is a necessity.

I have owned biotech for the past 31/2 years through Biotech HOLDRS. I bought the ETF, which trades like an individual-company stock on the American Stock Exchange, when it made its debut. Since then, I have paid almost no attention to its price as it soared and dipped. I was actually surprised when my editor asked me to consider writing a piece about the recent rise of biotechs. I didn’t know!

My strategy is simply to own this ETF for the next 20 years or so, keeping a blindfold on, like a kid with his eyes closed on a roller coaster. As it turns out, the fund opened at about $100 a share in late 1999, went straight to about $250 in 2000, then down to $65 last summer and back to $124.20 on Friday.

Another ETF, iShares Nasdaq Biotechnology Fund (IBB), has traced a similar path: from about $70 in February 2001 (when it was launched) to over $100 to below $40 and back around $70 again.

The iShares ETF (like the HOLDRS fund) is heavily weighted toward the largest of the biotechs. Amgen (AMGN), which has a market capitalization (or value according to shareholders) of $83 billion, represents nearly one-fourth of the assets of the iShares security.

Amgen’s best sellers — Epogen and Aransep for anemia — will generate more than $3 billion in revenue this year. Neupogen and Neulasta, which fight the side effects of chemotherapy, should contribute $2.3 billion, according to a report by Nancy Chow of Value Line. Amgen has been profitable since 1989, with earnings rising in a Beautiful Line from 2 cents per share to $1.39 last year and $1.75 estimated for 2003. Since the stock trades at $65.18, its price-to-earnings ratio, based on this year’s expected profit, is 37.

Profitable biotechs don’t come cheap, but Value Line estimates that Amgen’s earnings, which grew at an average rate of 22 percent over the past 10 years, will grow at 20 percent for the next five. Like other biotechs, Amgen pays no dividend. At the end of last year, the company had a cash hoard of $4.6 billion, a highly unusual position for a biotech. Maybe some of the firm’s intense cash flow will start going to shareholders every quarter now that the dividend tax rate has been cut. Stranger things have happened.

Except for Amgen, no biotech has a market cap greater than $10 billion — and few are anywhere near that size. Among the top 10 holdings of the iShares fund, which tracks the Nasdaq biotech index, are Gilead Sciences (GILD), which has risen from less than $5 (accounting for splits) in 1998 to $56.31, and Chiron (CHIR), which supports its biopharmaceutical division with a subsidiary that tests for HIV and hepatitis C.

Gilead became profitable only last year, and its current P/E exceeds 100. Chiron has had positive cash flow for the past 10 years and trades at a P/E of 32. It’s up by about one-third since March, and its relatively steady rise over the past decade shows the value of balancing chancy biotech with a more reliable stream of income.

Contrast Chiron with Vertex Pharmaceuticals (VRTX), which has only a single drug on the market — a protease inhibitor, used to treat HIV infection, called Agenerase. In the pipeline are about a dozen drugs. The aptly named Vertex peaked in 2000 at $99 a share and was trading at $9.53 last month. It’s now at $15.31, boosted by a restructuring, news that three drugs are advancing toward approval, and the general lift in the sector.

But don’t bother learning the names of these stocks unless you plan to devote a lot of time to study. It’s much better to buy a fund — either one of the ETFs (one is as good as the other), which try to mimic the sector, or a portfolio managed by an actual human being. Most managed funds, unfortunately, are small, new and untested. Their results this year are impressive, but track records are spotty.

Pimco RCM Biotechnology (RABTX), for example, launched in 2002, is up 32 percent in 2003. Fidelity Select Biotechnology (FBIOX), one of the largest such funds, rose 78 percent its first year (1999) and 33 percent its second, then it fell 25 percent in 2001 and 40 percent in 2002. So far in 2003, it’s up 24 percent.

Best of the bunch is probably Rydex Biotechnology (RYOIX), which has returned 13 percent on average for the past five years. It’s up 34 percent in 2003 and carries expenses of 1.3 percent with no load.

And, yes, the Rydex management team has the courage to own ImClone, which (this year anyway) has nicely rewarded the fund’s shareholders. If Erbitux gains approval soon enough for a launch by mid-2004, analyst Chow reminds her readers, “this milestone would trigger a $250 million . . . payment . . . from Bristol-Myers.”

Unfortunately, ImClone has been delisted from Nasdaq. Its former chief executive goes to prison on Tuesday, and its most famous shareholder faces trial early next year. The biotech game is risky, even crazy. But, despite the recent run-up, I remain a true believer. Biopharmaceuticals are saving lives, and I expect that, over the long run, they will be making handsome profits and offering ample gains to investors who keep the faith.

James K. Glassman is a fellow at the American Enterprise Institute and host of Of the securities mentioned in this article, Glassman owns Biotech HOLDRS. This column originally appeared in the Washington Post.


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