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Posted 7/5/2001
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The Speculator
Biotech: An investing frontier for risk-takers
Biotechnology sprang from nothing barely two decades ago yet promises to become one of the largest industries on the planet. Here's a strategy for maximizing profits by following FDA approvals.
By Victor Niederhoffer and Laurel Kenner
The ability to manipulate the genetic codes of living things will set off an unprecedented industrial convergence: farms, doctors, drugmakers, chemical processors, computer and communications companies, energy companies and many other commercial enterprises will be drawn into...what promises to be the largest industry in the world.
-- Juan Enriques and Ray A. Goldberg, March 1999 Harvard Business Review
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If there's one industry today that typifies America's success in encouraging people to make money and pursue happiness by improving the lives of others, it's biotechnology.
The exuberance of American innovation and entrepreneurship can be seen in the amazing speed of the industry's development. The first commercial biotech company was created in 1978; the latest figures show 1,300 U.S. biotech businesses, 300 of them public, with a combined market value of $353 billion as of early 2000, according to Ernst & Young.
For investors, the thrills and disappointments of biotech also recall the phase in U.S. history when it took a J.P. Morgan to convince 19th-century European investors that America wasn't a deadbeat country that would repeatedly default on bonds.
We'll say at the outset that we aren't experts on biotech. We therefore consulted Roger Longman, the discerning publisher of Windhover Information's medical journals, for investing insights. And we worked hard to find one small area in which our expertise might help reduce uncertainty about investing in this important field -- the relation of market moves to U.S. Food and Drug Administration approvals.
How biotech began
Broadly defined as the technology of using cells and molecules, biotech has its George Washington in the person of James Watson, co-discoverer of the structure of DNA. Its Benjamin Franklin is Craig Venter of Celera Genomics (CRA, news, msgs), who succeeded in doing in 17 months what the government-sponsored Human Genome Project sought to do in 15 years. Recall how Franklin astonished the Europeans, accustomed as they were to the solemn deliberations of royal academic societies, by venturing into a rainstorm with a kite to prove lightning was electrical.
In the pharmaceutical field alone, biotech companies are experimenting with therapeutic proteins, immune system modulators, gene therapies, stem cell technology, drug delivery, vaccines, signal transduction, telomerase and monoclonal antibodies.
One of those monoclonal antibodies, an ImClone (IMCL, news, msgs) tumor-stopper known as IMC-C225, before the FDA as we write, typifies biotech's revolutionary potential.
Cancer, the C-word, so terrifying and ubiquitous it takes just one letter to identify, is actually dozens and dozens of diseases. That's why the cancer drug field has consisted of niche markets rather than big payoffs -- and why big companies, with a couple of exceptions, have stayed away, according to Longman of Windhover Information.
Biotechnology is changing that. Genentech (DNA, news, msgs), the first biotech company, reported in April that first-quarter profit rose 20% on higher sales of its cancer drugs Rituxan and Herceptin. The company reports second-quarter earnings next Wednesday.
ImClone's drug is the first of a hot new class of drugs called "epidermal growth factor receptor antagonists" -- meaning they interfere with tumor growth. The success of ImClone's drugs in clinical trials has encouraged other companies to follow the same paths. AstraZeneca (AZN, news, msgs) and OSI Pharmaceuticals (OSIP, news, msgs) are both testing synthetic molecules that attack the same receptors.
"People are starting to realize that cancer, which used to be the focus of a series of very small businesses, can actually be quite a valuable business to be in," said Longman.
In the jargon of the FDA bureaucracy, companies must complete three stages of clinical tests involving larger and larger numbers of human volunteers -- Phase I, Phase II and Phase III -- before applying for FDA marketing approval. ImClone has received an "approvable" letter for the antibody's use in treating colorectal cancer. The company expects the drug will have many other applications in cancer treatment.
Should you buy in?
Too late to invest? Probably not.
We looked at what happened to stocks of companies from the date the FDA approved new drugs. We used a list of all biotech drugs approved in 1998, 1999 and 2000, a total of 60, provided by the Biotechnology Industry Organization trade group in Wash., D.C.
Thirty days after approval, the average gain was 7%, and 55% of the stocks were up.
The average gain after 60 days was 13.4%, with 58% of the stocks up -- slightly more than the investor can expect from the market in an average year.
After 90 days, the effect began to dwindle; the average gain was 12.6%, with 60% up.
Buying on the day of approval and holding for 60 days is probably one of the easiest, least risky ways to invest in biotech. Of every 100 drugs (not just biotech) that the industry tests, only 25 or 30 go through all three phases of the mandatory clinical trials; of those, 20 receive government approval, according to the FDA.
If you don't mind taking on more risk (and the possibility of a superior return), one approach would be to buy a basket of stocks with drugs in the last stage of clinical trials. Longman advises waiting until the last patient is enrolled in the third and final ("Phase III") clinical trial -- or, better yet, at "data lockup," when the last bit of data is in. Right now, 169 biotech companies have drugs in Phase III testing, according to Sectorbase, a powerful, $425-a-month database that we had the pleasure of testing (check out the Sectorbase site with the link above left).
For the best returns, find companies valued at less than $1.5 billion that have managed to retain significant licensing rights to their drugs, Longman advises. Small companies often must sell rights to bigger companies to raise money during the years of testing and approval. (About a dozen biotech companies have market values above $10 billion; 20 are in the $1 billion-$10 billion category and 30 are $600 million to $1 billion, while smaller companies number in the hundreds.)
Two interesting names
Longman is intrigued by two small companies: Neurocrine Biosciences (NBIX, news, msgs), which owns all the rights to an insomnia drug now in Phase II testing, and Icos (ICOS, news, msgs), which is close to receiving approval for a potency drug that would compete with Pfizer's (PFE, news, msgs) Viagra. While Icos is in a 50-50 partnership with Eli Lilly (LLY, news, msgs), its drug doesn't make people see blue-green, nor does it interact badly with heart drugs, as Viagra does, according to Longman.
Acquiring information on patient enrollment, data lockup and licensing agreements takes work. And regrettably, investing in companies that are testing drugs takes a good deal of patience, as the FDA takes a long time to approve or reject a drug after human trials are completed. The average waiting time is one year, according to the FDA; two years isn't uncommon, and even "fast-track" approvals take six months.
The total time from invention to approval can be as long as 15 years, according to both the industry and the FDA, depending mainly on the length of clinical trials. The average is eight and a half years, according to the FDA.
During the wait, interest bills and other operating costs pile up. ImClone has spent $100 million on its as-yet-unapproved tumor drug. The Pharmaceutical Research and Manufacturers of America trade group, citing a Boston Consulting Group study of drugs approved in 1990, says the average cost of developing a drug is $500 million. That figure includes research failures, and has probably come down in recent years, thanks to pressure from patient advocacy groups and the industry to speed up reviews.
Accepting the risks
We suspect that the length of FDA reviews reflects a desire to reduce risk, an aim occasionally in conflict with the American spirit we wrote about earlier in this column. The current process unfairly favors the big companies that can afford to shoulder the expense of waiting out the FDA. And the FDA's bureaucrats have a stronger incentive to reject drugs than to approve them, since they would be blamed for any new thalidomides.
But for every life saved by the delays, it is possible that thousands are sacrificed because efficacious drugs are stuck in the pipeline or in the inventor's mind. As Paul Heyne says in "The Economic Way of Thinking": "The common contention that even the smallest risk of death is too great to accept simply makes no sense. It might make sense if risk could always be avoided without incurring new risks. That isn't the case, however."
One could argue that most people would prefer to know that any drug they must take has been through rigorous scientific tests, so as to avoid frauds and treatments that have nothing more going for them than wishful thinking and anecdotes. One also could argue that desperately ill people should be able to take whatever risk they wish. The question is whether a government agency should have the power to say yea or nay. Tyler Cowen, head of the Mercatus Center think tank at George Mason University, suggests that the FDA's role might properly be limited to issuing advisories on drugs. Physicians and patients would be free to disregard the advice.
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Rather than offering a list of picks ourselves, we have turned to the new StockScouter rating system, developed at MSN MoneyCentral with a research firm whose chief, Carr Bettis, we have admired. (You can take a closer look at the rating system on the beta version of CNBC on MSN Money.)
We hope to extend our studies to the performance of companies in various stages of the FDA pipeline before the announcement. Until then, we thought it might be interesting to include a list of picks generated from MSN MoneyCentral's new StockScouter rating system.
We don't know whether they meet Longman's subjective criteria, and we have not evaluated the efficacy of the rating system, but since the system was developed by our editor and an expert on insider trading, both of whom we respect, we believe the picks are worthy of consideration. We'll track these as a group for the next 6 to 12 months. Please share your thoughts and studies at this message-board thread, where we have already placed a chart summarizing our FDA-related findings.
StockScouter's highest rated small-cap biotechs
| Company Name | Market Cap | 7/2/01 Price | % Chg YTD * | Rating |
| Charles River Laboratories (CRL, news, msgs) | $1,384,416,000 | $34.22 | 25 | 9 |
| Embrex (EMBX, news, msgs) | $126,266,278 | $15.75 | 2.4 | 8 |
| Integra LifeSciences (IART, news, msgs) | $372,458,687 | $21.05 | 54.4 | 7 |
| BioReliance (BREL, news, msgs) | $106,574,000 | $13.00 | -1.9 | 7 |
| Organogenesis (ORG, news, msgs) | $254,403,364 | $7.30 | -18.8 | 7 |
| Techne (TECH, news, msgs) | $1,284,299,000 | $30.05 | -16.7 | 7 |
| Aviron (AVIR, news, msgs) | $1,667,863,500 | $55.30 | -17.2 | 7 |
| Lifecore Biomedical (LCBM, news, msgs) | $63,280,000 | $4.50 | -2.8 | 7 |
| Hemispherx Biopharma (HEB, news, msgs) | $188,943,306 | $6.40 | 34.7 | 7 |
At the time of publication, neither Vic Niederhoffer nor Laurel Kenner owned any stocks mentioned in this column.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.