Why Biotech Stocks Are Cheap
By Daniel Kadlec
When all is said and done, there may have been more losers than winners in last week's bizarre "rally" in the shares of the cancer-drug firm EntreMed. The stock began the week at $12 and ended at $33 1/4, a tidy 177% runup. But in the process, the company's 12 million shares outstanding changed hands an average of four times each--at prices up to $85. Sure, anyone who bought the stock more than a week ago received a windfall. But, in theory, there are three times as many people who got creamed. Cancer could well be eradicated before some of those latecomers get even with this stock.
The episode is typical of how individuals can get burned when they rush into a stock on a hunch, rumor, hope or partial information. With EntreMed, many placed buy orders for last Monday morning "at the market," with no inkling that the market price had swelled sevenfold without a posted trade. The pros knew. They saw the backlog of buy orders that had built up over the weekend.
Another information edge the pros enjoy is "real-time" stock quotes. You may not know it, but the NASDAQ quotes you get from CNBC, and quotes on most free Websites, are delayed 15 min. That delay can kill you when a stock is falling a point every 60 sec. And, let's be frank, a story in the New York Times or TIME can't take the place of in-depth analysis, although journalists can add valuable information.
The risks are especially acute in the complex world of biotechnology, where each of some 300 public companies, including EntreMed, claims to have one or more wonder drugs in research. Those claims make terrific investment pitches, and on the heels of a successful new drug launch--Pfizer's impotence pill, Viagra, in this case--investors can get, uh, excited. The reality, though, is that maybe 10% of today's biotech companies will ever bring a blockbuster drug to the market. Those that do will enrich shareholders. But casual investors face long odds trying to be in the right stocks.
That said, there are reasons to invest in the wonder-drug business. A potential huge payoff certainly is one. Last July, MedImmune's infant-pneumonia drug, Synagis, passed a significant clinical hurdle, and the stock shot from $15 to $55. More fundamentally, though, biotech stocks as a group have been woeful laggards for three years, and may represent the broadest base of value in today's sky-high stock market.
In the past, I've written about biotech investing with far more pessimism, mainly because of the risks, which haven't changed much. But some other things have changed, a lot. The overall market has roared ahead while biotech stocks barely budged, creating a vastly wider gap in value, and the biotech industry has had more time to mature. It will probably turn net profitable next year, and, notes money manager Stephen Flaks in Scottsdale, Ariz., "there are now hundreds of drugs that will be on the market within two years." Companies with such drugs are among Flaks' favorites: Matrix Pharmaceuticals (cancer), Neurocrine Biosciences (Alzheimer's) and Imclone Systems (cancer).
This new-product cycle has a number of pros bullish on the sector. Sensing opportunity, New York investor Stuart Wiesbrod founded Merlin Biomed, a private health-care fund, just three months ago. He estimates that the entire biotech industry has a stock-market value of about $110 billion. That's less than the market value of one big drug company like Merck or Pfizer, each with market values around $140 billion. Yet the biotech industry has 600 drugs in advanced development, vs. maybe 20 for each big drug company.
Biotech companies are notorious for moving ahead with tests too quickly. But, Weisbrod notes, "that still doesn't account for this huge discrepancy." His top picks, too, expect to have drugs approved within two years: Biochem Pharma (hepatitis) and Centocor (blood clots). Another fan of companies with late-stage drugs is Evan Sturza, editor of Sturza's Medical Investment Letter, whose top picks are Aviron (flu), Gilead Sciences (HIV, hepatitis) and Sepracor (side effects from Prozac, Claritin and others).
The safest approach to biotech is via mutual funds. Vanguard Health, Fidelity Select Health and Putnam Health Sciences have the best three-year returns, according to Lipper Analytical Services. But if you're playing with the speculative part of your portfolio, which is appropriate here, individual stocks pack the big thrill. Naturally, there's no telling if biotech stocks will break out of their slump anytime soon. But if you want to be there when they do, start nibbling now.
Daniel Kadlec can be reached at kadlec@time.com