Time to Buy Biotech?

Popular biotech indices like the AMEX Biotechnology Index (BTK) and the Nasdaq Biotechnology Index (NBI) don't really tell the story here. They are, respectively, highly selected toward large companies and market capitalization-weighted. So the $20 billion-and-up companies like Amgen, Biogen Idec, Genentech, Gilead Sciences, Genzyme, and Celgene pretty much drown out what's going on at the sub-$1 billion companies that make up the bulk of the industry.

So, yeah, the biotech indices are hurting, but anyone who follows the industry can tell you it feels much worse than even the numbers reflect. Many companies are at or below the nadir's set in 2002-2003, when the biotech sector bottomed out in a pique of pessimism--just look at Human Genome Sciences, deCODE Genetics, Exelixis, CV Therapeutics, Protein Design Labs, or Affymetrix…to pick just a few examples. Even Vertex Pharmaceuticals, an investment darling just a year ago, is starting to flirt with its 2003 lows despite any corporate development of real significance.

What's going on here? Well, I'm not here to defend these individual companies or the many others in the same boat. Some have been their own worst enemies, or have simply been unlucky in the clinic. But some have arguably taken a much worse thrashing than they deserve. Investors might want to note that anyone brave enough to wade into the beaten down biotech sector five years ago could have found rich rewards with any number of companies that offered triple-digit returns over the subsequent few years.

Yet they should also be aware of some of the factors leading to the currently low stock prices.

• Hedge funds own a lot of biotech stock--or at least, they used to. They also own a lot of debt instruments, many of which are backed by increasingly risky obligations. As the risk rating of these instruments rise, so does the overall risk ratio of a given fund. To balance this out, the funds could sell the debt instruments--but they're often illiquid and tough to dump these days. Or they could sell their biotech investments. Voila! Problem solved. You can see it in action with some of the more visible hedge funds. Witness Dan Loeb's Third Point, which recently dumped most of a 10% stake in CV Therapeutics, as just one example.

• The companies hardest hit tend to be those without products--which is not by itself too surprising, since speculative investments contingent on favorable clinical studies are hardly favored in already uncertain times. But even companies that do have current or near-term products are also being sent near five-year lows. One factor at play is that many of these are likely to need access to additional capital to reach their goals. That means either taking on debt--not an easy task in the current credit crunch--or issuing more equity--scarcely any better. The biotechs that are holding up OK are the ones with bulletproof balance sheets--that is, the large cap ones that weight the indices toward relative stability. If you think access to capital is going to remain a long-term problem, you'll probably want to steer clear of any company that isn't cash-flow positive or doesn't have enough cash to outlast the crisis.

• You can't sell a drug without first getting approval from FDA. From this understaffed, overburdened, risk-averse FDA. 'Nuff said.

That's why many folks are steering clear. But does it pay to be greedy while others are fearful, and invest in some of biotech's smaller and more unfortunate companies? A typical analyst would say no. They would say there are few catalysts on the horizon to turn sour sentiment around, too much uncertainty about the depth or length of our credit woes, and that it's more prudent to wait for a turn and miss a little upside before taking on a risky investment in a volatile sector.

There's certainly some wisdom to that. But let's not forget that many companies with valuations at multi-year lows are also sporting maturing pipelines of desperately needed products, and that Big Pharma--you know, those companies that do have bulletproof balance sheets--have proven themselves increasingly will to acquire biotech. More importantly, the value of future product sales, even heavily discounted for risk, definitely point to some bargains lurking out there. When this ship finally turns, you'll see some beaten down companies double in value before you know what's happening.

Maybe that's worth a nibble.