BioTechnology

Shares of biotechnology companies have declined, after the much anticipated American Society of Clinical Oncologists meeting in early June in New Orleans. This sector has been on a roll ever since Genentech (NYSE: DNA) vaulted 45% on May 19, 2003 following positive news from Phase III trials of Avastin in colorectal cancer patients. Is the recent correction a good time to fish or cut-bait?

Before you decide to dump or load up on biotech stocks, it is worthwhile to look at the 3C's driving this sector: Cancer, Cycle-time, and Consolidation.

Cancer

A hot-bed of activity, cancer research has attracted lot of attention. The buzzword is 'targeted drugs'. Unlike traditional forms of cancer treatment which do not discriminate between healthy and malignant cells, targeted drugs act more like smart weapons. They take on the molecular mechanisms involved in the growth of cancer without hurting the surrounding healthy tissue, and offer the possibility of making the disease a manageable, chronic condition.

Tarceva, an experimental drug developed by OSI Pharmaceuticals (Nasdaq: OSIP) and licensed to Genentech and Roche (ROG.VX) is one of the more highly profiled targeted drugs. The drug shows promise in extending the lives of lung cancer patients when used in combination with Avastin. Tarceva’s efficacy against pancreatic cancer is being investigated in a Phase III trial and results are due in the second half of 2004.

ImClone's (Nasdaq: IMCL) Erbitux, that is already approved for treating colon cancer, is another targeted drug that is in the limelight. According to data presented at the ASCO meeting, head and neck cancer patients treated with Erbitux and radiation had a median survival rate nearly twice as much as those who received radiation alone.

Cycle-time

Thanks to an efficient Food and Drug Administration, the time required for FDA review has shortened. With priority review having been granted by the FDA to Gilead Sciences' (Nasdaq: GILD) Viread/Emtriva combination anti-HIV pill, a decision is expected in September, four months earlier than the originally expected January 2005.

Companies for their part are also aggressive in reducing cycle-time. Genentech, for example, was ready to launch Avastin literally within hours of getting FDA approval. Helped by favorable test results, Elan (NYSE: ELN) and Biogen Idec (Nasdaq: BIIB) filed for their multiple sclerosis drug, Antegren, in May 2004, a year earlier than expected.

Consolidation

The organic growth of biotechnology companies has proven to be a long and uncertain process. While biotechnology firms seek to merge between themselves, pharmaceutical companies are also targeting biotechnology companies.

Last year Biogen and Idec, merged to form Biogen Idec. The Biogen Idec merger was driven by the need to reduce risks, derive scale advantages, and enhance domain expertise. This year, Amgen (Nadsaq: AMGN) has announced its intent to buy 79% of Tularik (Nasdaq: TLRK) it does not already own. Tularik shores up Amgen’s pipeline by bringing in five products in various stages of clinical testing with T67, the liver cancer drug, in Phase III trials. Recently, QLT (Nasdaq: QLTI) and Atrix (Nasdaq: ATRX) have agreed to merge to move closer to becoming a fully integrated biopharmaceutical company.

Major pharmaceutical firms faced with the double whammy of weak drug development pipelines and upcoming patent expirations are looking to purchase biotech firms to rev up their growth engines. Recently, Belgium based UCB (UCBBt.BR) has offered to buy U.K.’s largest biotech firm, Celltech (NYSE: CLL).

The potential of targeted drugs, shortening of cycle-times, and possibilities of buyout provide a powerful case for investing in the biotechnology sector. So how does one play the biotech cycle?

Investing in biotech stocks has never been for the faint-hearted. News from clinical trials can make or break a company’s share price. One needs to only look at the 'Slim-Jim' type one-day moves in OSI Pharmaceuticals to the upside and Genta (Nasdaq: GNTA) to the downside, to get the picture.

Many biotech companies have high cash burn rates. Even the profitable ones have relatively few marketed products. For companies in this universe, the value is predicated on cash flows that are forecasted to come through several years out. As such, it makes sense to invest in a basket of biotech companies rather than one single entity.

Today's marketplace offers several opportunities for investing in the biotechnology sector. First, there is Fidelity Select Biotechnology (Nasdaq: FBIOX), an actively managed, no load sector fund. With over $2 billion in assets, this is by far the largest open ended mutual fund that focuses on biotechnology. From April 30, 2003 through May 31, 2004, FBIOX has advanced 36.6%. As of March 31, 2004, FBIOX held 60 stocks with the top 10 holdings accounting for about 64% of the portfolio. Top holdings in this fund included names like Genentech, Biogen Idec, Gilead Sciences, Cephalon (Nasdaq: CEPH), and Millennium Pharmaceuticals (Nasdaq: MLNM). A noticeable absentee among the fund’s top 10 holdings was industry heavy weight, Amgen.

There are two exchange-traded funds (ETFs) that focus on the biotechnology industry as well: iShares Nasdaq Biotechnology (AMEX: IBB) and Biotech HOLDRs (AMEX: BBH). There are some subtle, yet important differences to consider between the two exchange-traded funds. From April 30, 2003 through May 31, 2004, the IBB has advanced only 31.9% compared to the 45.3% gain for the BBH.

The iShares are designed to track the Nasdaq Biotechnology Index and include over 100 biotech companies that trade on the Nasdaq. As of March 31, 2004, the top 10 holdings in the iShares had a combined weighting of about 36% with Amgen by itself having a 17% weighting. A notable absentee in the iShares is Genentech whose shares trade on the NYSE.

The Biotech HOLDRS, on the other hand, are Depositary Receipts that represent an undivided beneficial ownership in the common stock of 18 biotech companies. This ETF is concentrated; as of June 10, 2004, the top 5 industry heavyweights, Amgen, Genentech, Biogen Idec, Gilead Sciences, and Chiron (Nasdaq: CHIR) had a combined weighting of about 79%. One twist of the HOLDRs is that they have to be traded in round lots of 100 shares; one lot of the BBH at about $140 per share takes a cool $14,000.

In sum, while bottoms are hard to pick, there is a case to be made for being long this sector. Among the options available, Fidelity Select Biotechnology and iShares appear more attractive. For one, they offer better diversification. Further, exposure to development stage companies is higher. Some of the development stage companies have appeal as takeover candidates whereas the industry leaders in the HOLDRS are more likely to be buyers than sellers.