In recent weeks, there have been signs that the drug discovery industry has begun to slide, dragged ...
In recent weeks, there have been signs that the drug discovery industry has begun to slide, dragged down by investors looking to escape the roller-coaster ride of the equities markets.
The Nasdaq biotech index has dropped by a quarter in March 2001 and is now resting at 60% below last year's peak. But are biotechs going the way of the dot.coms, or do they actually represent a miracle cure for the ailing technology sector?
Amongst widespread doom and gloom for technology stocks, Nasdaq's golden child has, up until now, been the biotechnology sector, which has so far managed to keep its head while some around are losing theirs.
The exuberance that surrounded the completion of the sequencing of the human genome last year led to a rapid run-up in biotechnology stocks. Between November 1999 and March 2000, the Nasdaq biotechnology index tripled, with biotechnology companies initially seeming immune from the sell-off in technology stocks.
In 2000 the Nasdaq Composite Index posted its worst performance ever, but the biotechnology component of the index rose 15%.
However, there have been signs of a downward trend in recent weeks, that may have surprised analysts. After all, biotechnology stocks should technically remain immune from wider economic factors since demand for their products is inelastic.
Similarly, profits warnings from technology giants such as Microsoft, Ericsson and Dell have certainly not been echoed by disappointment in the biotech sector because biotechs have no profits to announce.
To the uninitiated, this may smack of dot.com fever, where profits were marginalised in favour of market share and advertising spend, but the sophisticated investor should be aware that the biotech business model has been validated by prior art, and that biotechs can, and frequently do, turn in a profit.
So, if biotechs aren't going the way of the ill-fated internet start-ups, and do have a valid business plan, what is going wrong with the share prices? In a limited sense, biotechnology stocks do echo the dot.coms in that they represent a risky stock option even at the third stage of clinical trials, things can always go wrong.
The obvious example here is Scotia, where approval of Foscan following phase III trials has been initially denied by regulators, with the result that administrators have been called in. The profitability of approved drugs also depends on a strong patent portfolio and marketing spend. Still, this has always been the case with biotechs, and should not, in itself, be enough to deter investors.
But what has become clear is that, once investors' appetite for risk declines (as it has done in recent months), demand and profits metrics become irrelevant and valuations of growth stocks decline, regardless of what metric they are measured by.
There may also be an underlying fear, again stimulated by painful memories of dot.coms such as Boo.com burning their way through millions of pounds every month, that biotechnology companies will find it difficult in the current climate to obtain financial backing from investors.
This combination of factors lowered investor confidence and the stampede to exit the market, in addition to less capital to sustain the cash burn of biotechnology companies may be enough to blind potential investors to the benefits of biotechs. Analysts and investors alike seem to be caught up in a general trend of running for the tech exit when they would be better advised to keep their seats.
Patience is a virtue
The presently fashionable anti-technology tide hides real opportunities for those who are prepared to watch and wait. Biotechs are not, and have never been, a chance to make quick profits. No matter how promising they seem, potential drugs still must be tested in laboratories, and human clinical trials and regulatory procedures continue to be time-consuming. But, with these considerations in mind, biotechs are at the forefront of those stocks that can, and will, reap rewards.
The reasons for this are fairly easy to understand. Revenue streams in the tech sector have failed to materialise, and those remaining in the game are now rapidly re-evaluating their business models. For ISPs, for instance, the revenues generated from click-through advertising have not kept pace with the rate of cash burn.
Business-to-consumer internet business models have suffered from the same malaise original expectations have far exceeded reality.
By contrast, biotechs do have a proven track record of product delivery, and several biotechs now possess the virtue of being on the cusp of product rollouts.
Furthermore, given the centrality of intellectual property to this sector, when a biotechnology company does bring a product to market, it can be sure that the potential earnings streams predicted for a blockbuster drug will, over time, be possible to realise.
The development of entirely new treatments and equipment, protected by patents with 20-year lives in most jurisdictions, is a significant advantage that biotechs have over many other technology stocks. It cannot be coincidence that intellectual property is now booming in the internet sector, with dot.coms and tech giants alike trying to patent their software and methods of doing business. They have recognised the value of the patent, a near monopoly on sales which biotech can and does, continue to enjoy.
The general sense of doom and gloom surrounding the technology sector has led to market caps for biotechnology companies that fall way short of their actual value.
When the market does turn, solid biotechnology stocks, companies like BioCompatible and Powderject, are likely to undergo a sharp appreciation in value. For the investor with foresight and patience, now is an excellent time to buy into the prospects of high future earnings streams.
Acambis, the UK biotechnology company, is a good example of an organisation with long-term potential for the investor. This company has achieved a breakthrough in the search for a vaccine against several potentially lethal diseases caused by mosquito bites.
The group, formerly called Peptide Therapeutics, recently announced that it has successfully completed a clinical trial of a vaccine against Japanese Encephalitis. The result will enable Acambis to carry out further trials. If those trials are successful, the vaccine could be on the market within four years. The market for JE vaccine, which should have fewer side effects than existing drugs, is estimated at $300m a year.
When looking at development-stage biotech companies, the smart investor needs to examine the cashflows that will float the company through development, the accompanying cash burn rate, and the number and quality of drug candidates in trials and finally, look for partnerships with deep pockets.
Such partnerships can provide much needed revenue streams to nurture the company through the various stages of drug development.
CeNeS Pharmaceuticals expects a significant increase in sales this year from strategic linkages with large pharmaceuticals.
The company, which develops drugs for central nervous system disorders as well as drug-delivery products, last year bolstered its portfolio with the £10m purchase of the UK and Ireland rights to three drugs from Glaxo Wellcome.
Biotech to pharma
A substantive contract win for a biotechnology company is also something to watch out for. PowderJect Pharmaceuticals is another UK biotech with solid earnings prospects for its lead product, an anaesthetic delivered by needle-free injection that uses a burst of helium to push the drug through the skin.
It has also acquired a profitable vaccine manufacturer and has recently won a two-year contract to supply TB vaccines and diagnostic tests to the Department of Health, which could create up to £17m in net revenue.
The market reacted promptly to the news, with Powderject shares rising 6.3%. Successes such as this are clear indicators of a company that is starting down the long and arduous road from loss-making biotech to profitable pharmaceutical. Even Glaxo Wellcome had to start somewhere.
Biotechnology companies should not be heaped in the same basket as other technology stocks.
Investors who want to avoid getting their fingers burnt in another tech wreck scenario must look for those companies that are on the verge of launching drugs into either phase three trials, or are about to secure regulatory approval for their patented products.
Effective distribution and marketing strategies are also keys to profitability.
The valuation of companies becomes clearer the closer a company gets to market, and the risk factor of these stocks depreciates proportionately over time. Investors should be wary in making their selections for the coming year in order to avoid the widespread technology woes, but should take care not to be over cautious.
Paul Mumford is senior fund manager at Cavendish Asset Management
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