StreetTalk: BioPharm Stocks: What the Pros Look For

Coming from Wall Street. I'm often asked what "professional" investors think about the life sciences industry.

Brian O'Connell

I talk to traders, analysts, and financial advisors all the time and the consensus seems to be, "We're not sure."

Big-time investors have a sense of uneasiness, almost frustration, with the biopharm market. Sure, there is money to be made in the industry, but the risk of failed ventures, slow research pipelines, lawsuits, and uncertainty about the federal government's new prescription drug program hold many investors back.

I've said it before and I'll say it again. Wall Street hates uncertainty. It drives investors away. From my point of view, there remains a great deal of uncertainty about biopharm stocks all over the financial markets today.

Look, I understand that staking a big bet on the biopharm markets has never been for the weak-kneed. Clinical trials are no sure thing — they are the life sciences equivalent of betting on the Chicago Cubs to win the World Series. But such trials can spell the difference between a biopharm firm writing its quarterly earnings statements in black ink or red. Relative to other industries, like telecom or manufacturing, biopharm firms also have high cash-burn rates.

Fair or unfair, these are the issues that professional investors examine when deciding whether to dip their toes into the biopharm market. The trend in recent years has been to stash money into a bevy of life sciences companies by investing in a biotech or pharmaceutical stock mutual fund.

Favorites of Wall Street professionals are funds like the $2 billion Fidelity Select Biotechnology (NASDAQ: FBIOX, which holds about 60 biopharm industry stocks). It relies on large-cap life sciences companies (more on that in a moment); a lousy clinical trial for one firm in the fund is easily balanced by good news from another. Exchange Traded Funds (ETFs) are catching fire, too. Barron's reports that, through the end of February, 2006, ETF assets have surpassed $300 billion. That's three times more than the total amount of ETF assets at the end of 2002.

Proponents call ETFs America's "next generation" of financial products. They offer daily liquidity, low expense ratios, and tax efficiency.

Right now, there are two primary ETFs that focus on the biotechnology industry: iShares NASDAQ Biotechnology (AMEX: IBB) and Biotech HOLDRS (AMEX: BBH). Both are getting a lot of business from investors, who prefer the bundled approach rather than one that requires them to pick individual stocks.

NUMBERS LOOK GOOD

To be fair, the numbers for biopharm companies in the financial markets aren't bad. According to the Burrill Biotech Select Index, the biotech sector, at a gain of 5.6% for the year, outperformed both the benchmark Dow Jones Industrial Average and the NASDAQ Index (at 2.25% and 2.5%, respectively).

G. Steven Burrill, CEO of San Francisco-based Burrill & Company, says it's the bigger companies that continue to attract the most investment dollars these days. "Biotech's success in the capital markets has been led by the large cap companies with robust product pipelines and diversity," he asserts.

Burrill is on to something. As we head into spring, it's the big companies with the largest market caps that are drawing the most interest from Wall Street types. Genentech's market cap going into 2006 was $97.5 billion. Another biotech giant, Amgen, was at $97.3 billion. Simply defined, market cap is the most commonly used measure of a public company's size on Wall Street. Market capitalization equals the total dollar value of all outstanding shares. It is calculated by multiplying the number of shares times the current market price. Large-cap stocks usually check in between $10 and $200 billion. Anything above $100 million usually catches the big hitter's attention in the financial markets.

That's an interesting point in the biopharm sector. Companies with sizeable market caps indicate to investors that, while not a sure thing, they represent less risk. In other words, large-cap life-sciences firms know how to research, develop, and market drugs and other products.

On Wall Street, the gurus like to say that risk management is all about sleeping. Specifically, how much sleep will you lose with the risk you've accepted with your investment portfolio? In those terms, the biopharm sector is hardly a sleep inducer—it is more likely to make heavy investors toss and turn all night wondering if they did the right thing.

BIG MERGERS CARRY THE LOAD

The good news is that there is a ripple effect from big life sciences companies with good large market capitalization.

Genentech and Amgen, $100 million companies, bring a lot of investors into the biopharm circle. "Because of these two companies' individual success, the industry's market cap hit an all-time high of $487 billion at the end of 2005, surpassing the previous record of $475 billion recorded in the summer of 2000, and up 22 percent for the year, up from the $400 billion mark at the end of 2004," says Burrill.

Another way that Wall Street professionals leverage large life sciences companies—and bring smaller, more growth-opportunity companies into the mix—is through company partnerships. In 2005, biotech partnerships raised $17 billion in new venture capital money, a record for the biotech industry.

"We have witnessed a very clear indication that mergers and acquisitions, along with partnering, have become a more attractive option for biotech companies to help drive their product development programs and ultimately increase shareholder value," explains Burrill.

He cites the recent merger between Amgen and Abgenix as a good example of the profits-through-partnership trend. "The deal saw Amgen pay $2.2 billion to acquire Abgenix and was motivated, in part, by the deal structure Amgen had in place with its partner," he continues. "Following positive phase 3 clinical trials on Abgenix's panitumumab for late-stage colorectal cancer therapies, Amgen's deal called for 50 percent of worldwide profits going to Abgenix once the drug is marketed. Since panitumumab has the potential to capture 50 percent market share, estimated to be over $1 billion, Amgen decided it was better to buy the company."

Mergers are proving to be a great way to attract investors who, as pointed out earlier, may shy away from investing in life sciences firms. Instead of paying royalties to corporate partners, bigger biopharm firms simply buy them instead and keep all the royalty revenues under one roof. That beefs up the bottom line and paints a better picture on traders' spreadsheets. Smaller, up-and-coming biopharm companies offer larger companies fresh research and products that they may not ordinarily have.

Maybe that's why partnering deals rose by 125 percent in the fourth quarter of 2005, compared with the fourth quarter of 2003, and 102 percent compared with the fourth quarter of 2004.

In 2006, partnerships between life-sciences companies are expected to generate $10 billion in new capital (out of $35 billion raised in the biopharm industry overall). Burrill says that $25 billion of that $35 billion will come straight from the pockets of Wall Street investors. Evidently, investors agree with Burrill's premise that biotech stocks will once again outperform the Dow and the NASDAQ indexes.

The view from Wall Street on biopharm stocks isn't as gloomy as it was in early 2005, when biotech executives were talking about "nuclear winter" for life-sciences stocks. But it isn't a bed of roses, either.

Investors are taking a ride with big dogs like Genentech and Amgen, and keeping an arm's length from unproven, if potentially profitable, smaller companies in the biotech and pharmaceutical fields. That's not likely to change anytime soon.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, 79 Radcliffe Drive, Doylestown, PA 18901,267.880.3144, fax 267.880.1939, brian.oco@verizon.net