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[February 22, 2006]

Stock Strategist: Biotech Investing for the Long Haul

(Morningstar Column (KRT) Via Thomson Dialog NewsEdge) Feb. 22--Many believe it takes guts to invest in biotechnology. Like any cutting-edge industry, huge potential upside mingles with potential disaster. Shares of Irish biotech Elan dropped 70 percent in one day last year after the company and its partner Biogen-Idec removed their new drug Tysabri from the market due to possible lethal side effects. However, a quick glance at the 2005 performance of the Amex Biotechnology Index (BTK) shows that this basket of biotechs had an annual return north of 25 percent. How can individual investors tap into biotech's potential without being obligated to pounce on any bit of clinical data that dribbles out of a company?

Investor myopia makes the performance of many biotech stocks highly volatile. With a focus on short-term performance, investors regularly overreact to both positive and negative news, trading in and out of stocks in an attempt to get a big return when clinical trial results are announced. Here we suggest three key qualities to look for when selecting biotechs as long-term investments.

A diversified toolbox is the first clue to a biotech's competitive advantage. If a company only has the tools to create one type of drug, the range of applications for these drugs will be limited. Too much reliance on a given technology or therapeutic area also reduces a company's ability to adapt to future changes in the market. As competitive forces shift, technologies can become obsolete and markets that were previously highly profitable can become fiercely competitive. Many larger biotechnology companies such as Amgen have the tools to create the right type of drug, from recombinant proteins and antibodies to small molecules, for any therapeutic area they would like to tackle.

That said, there are a few established biotechs that have chosen to specialize in one therapeutic area and have managed to stay on top despite heaps of competition. Gilead's competitive advantage stems from its ability to develop and market HIV drugs that dominate the field, despite the existence of 27 FDA-approved HIV antivirals. Even after Viread and Truvada were approved, the company continued test these drugs against those of key competitors, gathering the strongest case possible for prescribing them over alternative therapies.

For younger biotechs that have yet to establish a competitive advantage, one of the most important factors to assess is the future of the market they have chosen to pursue. Many companies focus on areas that are already highly competitive. By the time their products reach the market, competitors are likely to be so strongly established that gaining a significant share of the market is difficult at best. For example, several small biotechs such as Telik and Onyx have drugs in trials for lung cancer that would compete with Genentech's Avastin, a drug that leads to an improvement in survival that could be tough to beat. To compound these competitive pressures in the cancer market, the prices of several newer, advanced cancer therapies (including Avastin) have been called into question. With six-figure annual treatment costs that typically only increase survival by months, future reimbursement in this area, particularly through government-sponsored programs such as Medicare, could be especially vulnerable to cuts.

Several companies are trying to capitalize on the recent popularity of certain areas of research. For example, concerns over a possible avian flu epidemic have many companies scrambling to create vaccines. Success in this field is not only related to the efficacy of any vaccine created, but also to the actual occurrence of an avian flu pandemic. A true market for these drugs may never exist, and government stockpiling would only provide a short-term boost to companies that manage to develop possible vaccines. Dutch biotech Crucell is riding the avian flu roller coaster, with shares up 70 percent in the past year on avian flu speculation and a renewed interest in the barely profitable vaccine industry. Gilead's share have also seen a bump from the flu buzz, even though the efficacy of its antiviral Tamiflu is questionable against avian flu.

However, there is at least one area of research that is both competitive and trendy, but the sheer size and certainty of the market involved makes it attractive. The American Diabetes Association recently upped its estimate of the number of Americans with diabetes to 21 million, and many diabetics aren't controlling their blood sugar with current therapies. New types of diabetes drugs, such as Pfizer's and Nektar's inhaled insulin Exubera and Amylin's non-insulin injectable drugs Symlin and Byetta, give patients much needed alternatives to traditional insulin therapy.

Even with the right drugs in their hands, management teams still have to navigate competitive waters and stay focused on the long-term health of their companies. Some appear to have a better grasp on this concept than others. We applaud Amgen's plan to bump up research and development expenses by 30 percent-40 percent in 2006, as the company is aggressively pursuing new types of drugs and designing head-to-head studies against Avastin, a prospect that would have most other companies shaking in their boots.

In biotech, higher up-front research expenses are often necessary to maximize the long-run potential of a company's pipeline. Emphasizing cost-cutting bysetting overly ambitiousshort-term earnings goals can be damaging to a company's long-term prospects. Millennium still clings to its goal of non-GAAP profitability in 2006, even though meeting this goal would be a somewhat dubious success. Since the company is trying to expand its business outside of key drug Velcade and should be investing appropriately, the desire to turn profitable appears to have trumped long-term growth. On the flip side, MedImmune failed to meet 2005 sales guidance for its inhaled influenza vaccine FluMist, and management does not pretend that 2006 will be a strong year for the drug, either. Instead, the company has been busy showing that a new version of FluMist is actually more effective than the standard injectable vaccine in children. The company's steady focus on finding a complement to its blockbuster respiratory disease fighter Synagis is impressive, and MedImmune has good prospects in pediatric infectious disease for the long term.

Negative earnings and a dearth of revenue make traditional screens useless in measuring the potential of young biotechs. We think that these three key factors make an excellent qualitative screen for potential biotech investments. That said, biotech investing is not appropriate for all investors, but it can be an important part of a well-diversified portfolio.

Karen Andersen may be reached at karen_andersen@morningstar.com.

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