How advances in biotech could revolutionise your portfolio

An exciting new age of medical discoveries is dawning, says Jim Mellon. Here, he looks at the future of biotechnology, and picks the best 12 pharmaceutical stocks to buy now.

About two years ago, I upped sticks from Britain and bought a flat in San Francisco, the pre-eminent centre for biopharmaceuticals research and companies. I did so because I had just read a book by Ray Kurzweil called The Singularity is Near: When Humans Transcend Biology (see below) and its message had led me to open a whole new chapter in my investment career.

Kurzweil's basic idea is that technology is advancing so quickly that within most of our lifetimes "machine" or artificial intelligence will surpass human ability and intelligence. When that point (the so-called singularity) is reached, almost anything will be both imaginable and possible. This "intelligence explosion" is already happening, but most of us are unaware of it the pace of change is too rapid for individuals to grasp.

Some find this all a bit spooky; others note that there is a touch of cultism about some of Kurzweil's pronouncements. But his basic message about technological trends is a powerful one. It is a message that every investor should take note of because it is changing the world.

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In our daily lives, we see technology in the form of laptops, smartphones, iPads and other gadgets of the digital age. The rapid adoption of these products has helped to make Apple the world's most valuable company, as it spews out cash and churns out new varieties of products.

But these gizmos are nothing but the fripperies of our new age of discovery. Far more important are the less tangible ramifications of the change we are living through. These are about the much more fundamental issues of extending human life and maintaining general wellbeing. They also all but guarantee us concurrent industrial and demographic revolutions.

The end of old age

In our new book, Cracking the Code, Al Chalabi and I posit the following: within ten years, almost all cancers will be curable (if not cured), death from heart attacks and strokes will continue to fall rapidly, life expectancy at birth will rise to well over 100, and old age will not necessarily be characterised by a state of "illderliness", but rather one of "wellderliness". Robot aides will be on the way to becoming ubiquitous, fertility rates will fall everywhere, including in Africa, and nano-based technologies will be conquering industrial markets.

As a result of these advances, new drug and other medical therapies based on what is sometimes known as "Network Biology" will stem the tide of age-related disease. These include Alzheimer's and other neuro-degenerative conditions, as well as arthritis, osteoporosis, and macular degeneration. Diseases such as chronic kidney disease, type 2 diabetes, and hepatitis in its various forms will be curable or controllable.

Obesity, the scourge of the Western world, and now also of many developing nations, will be on its way to being containable. New drugs to reduce appetite or lessen fat accumulation will be approved, without the risks associated with previous regimes. Food content will be mandatorily altered to exclude trans-fats and possibly high-fructose corn syrup, and at long last, a reversal in the increase in calorific intake of Westerners will take place.

Since 1958, the average American has been consuming more than 800 unneeded calories per day, with the inevitable result that one-third of the population is now obese which is the number-one cause of lifestyle diseases leading to death, surpassing even smoking.

As a direct result of this developing armoury of disease prevention and cure, much of our conventional wisdom will be debunked. The growth of human populations will abate; the sad decline that most people experience in their later years will no longer be the norm; and retirement at 65 will be an odd luxury for only the very few.

Computers and biology

Medicine is being revolutionised by the fusion of computing power and biology. Two key events since World War II have made this possible. One was the discovery of the shape and function of DNA by James Watson and Francis Crick in 1953.

The second, 50 years later, was the sequencing of the human genome. As a result of these, the blueprint of cellular existence has now been unveiled. As computers become more powerful, and as the cost of that power falls in line with Moore's Law (which roughly states that computer processing power doubles every two years), the manipulation of genes, proteins, cells and stem cells for the advancement of human health is transforming the outlook for all of us.

The cost of genome sequencing is falling to a level (around $1,000) that is affordable in the developed world. So it will soon be possible to use it in a clinical setting to identify genetic mutations and create personalised treatment regimes particularly in oncology.

Stem cells are on the way to proving clinical efficacy in areas such as cardiovascular disease, and can now be induced from blood or tissue and made to be specific to individuals. Diagnostic companion kits are increasingly used to see which patient is suitable for which treatment. And in the past few years, previously fatal diseases, such as AIDS or Hepatitis C, have become controllable to the point where patients can lead normal lives.

All these breakthroughs are at the vanguard of a host of life-extending and changing therapies. Robotic surgery, organ regeneration, and the use of so-called short-interfering RNA (siRNA) to switch genes on and off at will are all existing treatments and will become clinical norms.

Big pharma and the patent cliff

Until relatively recently, new drug development was generally undertaken by big pharma': the likes of Pfizer, Eli Lilly, AstraZeneca, GlaxoSmithKline and Novartis. These companies, mostly US-based, but also British, Swiss and French, emerged from the huge consolidation of conventional drug companies that has taken place since World War II.

Big pharma has long relied (and to an extent still does) on large sales forces promoting the latest in small-molecule or synthetic chemistry drugs. Since the War, a profusion of these drugs has hit the market, with huge benefits for humanity. Apart from antibiotics (developed just before the War) there have been, among others, anti-depressants, beta blockers, statins, ACE inhibitors, anti-histamines and ulcer drugs.

However, the research productivity of big pharma has declined in recent years. It takes more and more money to develop new drugs (upwards of $800m per successful compound), and much more time. On average, it takes eight years for an invention to make it to the market.

That leaves just 12 years of patent protection. Worse, as productivity has declined, and fewer products have met the requirements of the US Food and Drug Administration, many big pharma companies have begun to confront a patent cliff.

This is where high-selling drugs (such as the statin Lipitor, which came off-patent for Pfizer late last year, and had peak sales of $12bn a year) lose their exclusivity via patent protection. Generic drug producers (such as Teva, Watson, and Mylan) then step in and make these compounds for a fraction of the "branded" cost.

Generics now make up 70% of the volume of drug sales in America, the largest global market for pharmaceuticals. More than four billion prescriptions were issued in the States last year. Yet in terms of sales by value, generics only accounted for 13% of the $333bn spent. This is a reflection of the high price for branded products, prices that are necessary to recoup the investment needed to get just one compound to market.

A new industry creeps in

However, while big pharma has been facing the problem of declining research productivity and expiring patents, a whole new industry has been sneaking up on the inside: the biopharma industry. Starting in the late 1970s, when Genentech developed its first products, firms making biologics' drugs produced in living systems (eg, by fermentation, or in living cells of animals) have become major players. Biologics, which will account for over half of the top ten drugs worldwide by 2015, are the direct result of the acceleration of technological and biological capability noted earlier.

Although there are many different types of biologic compounds, the majority have been for inflammatory diseases (such as rheumatoid arthritis) and for cancer. Drugs such as Avastin, Herceptin, and Humira continue to be huge sellers, and have been very profitable for a number of biopharma companies.

Names such as Celgene, Biogen, Amgen, Genentech (now part of Roche), Gilead, Vertex and Shire have made fortunes for their founder investors. Not all make exclusively what are known as largemolecule' biologic drugs, but all come from an environment of entrepreneurship that has not been much evident in big pharma companies.

The 1970s Genentech model still more or less applies today. Cutting-edge science (in Genentech's case it was the development of recombinant DNA) meets capital, typically in the form of venture capital or angel investment'. Further funding comes from the public markets and/or alliances with big pharma companies, which provide money in exchange for partial and variable rights to specific drugs.

Big pharma and biopharma

As time has gone on, the boundaries between big pharma and biopharma have blurred. Some biopharma companies have grown to become vertically integrated behemoths in their own right (Biogen and Shire are good examples). Big pharma has acquired biopharma businesses (eg, Roche bought Genentech). And new drug companies have competed directly with big pharma in small-molecule drugs.

The big pharma firms, some of which we like very much as investments, have become marketing organisations with extensive international reach. In most cases, as their research pipelines have been replenished, the patent cliff has been significantly exaggerated by analysts, and earnings are growing. Despite cost pressures in developed markets, resulting from government austerity, sales for most are still growing.

In emerging markets, such as China and India, these companies have a significant reputational advantage. So the likes of Pfizer or Glaxo should enjoy strong growth in emerging markets for years to come. After all, in China, Russia and India, drug expenditure per head is somewhere between $10 and $20 a year, compared to $800 in the States.

Pharmaceuticals themselves are attractive on a cost-benefit basis. By far the biggest element of healthcare costs is hospitalisation. If drugs can cure or control disease without the need for hospitalisation, then they can be an effective way of controlling what have become unsupportable cost burdens.

For example, such is the growth of Alzheimer's in societies where the average age is rising (one in two people over 85 has some form of dementia), that the need to reduce the burden is encouraging a great deal of research into compounds that could reverse the disease. Also, many elderly patients in hospital are there due to falls, which have led to the breakage of brittle bones again, great effort is being put into addressing this area.

Building a pharma portfolio

I have been actively involved in mining in the past ten years, and there are some similarities between the pharma industry and mining: long lead times, low-ish chances of success, high capital expenditure and government intervention.

It makes sense then that the key to success as in mining is twofold: diversification and thorough research (to separate the potential winners from the many losers). The latter is the main reason why I have been spending so much time in America. I've listed some of my tips on how to build a portfolio in the sector below.

Cracking the Code: Understand and Profit from the Biotech Revolution, by Jim Mellon and Al Chalabi is out on 30 April (John Wiley and Sons, £16.99).

Profit from the end of the human era

In 2005, scientist and businessman Ray Kurzweil released The Singularity Is Near: When Humans Transcend Biology. In the book, he advanced the notion of "the singularity". This refers to a point beyond which machines become more intelligent than humans and drive technology forward so rapidly that we are "cut out of the loop" amid an "intelligence explosion". The human era will be over we'll have merged with machines and evolved into superhumans, in effect.

Kurzweil who reckons this could happen before 2050 also argues that many of the baby boomer generation will survive to see the singularity, and thus take part in this evolutionary leap. This view rests on the Law of Accelerating Returns: the idea that technological progress occurs exponentially, so that one advance enables us to discover new advances more quickly, and so on.

Applied to the field of health, this idea means that scientists will make breakthroughs rapidly enough to mean that many of those alive today will benefit from ever-expanding lifespans. Clearly these ideas are controversial. At the time, The New York Times praised Kurzweil for arguing "his case in fascinating detail" and called his work "startling in scope and bravado".

However, it also stated that "much of his thinking tends to be pie in the sky" and that he was "disinclined to contemplate the dangers of what he imagines".

The twelve best pharma stocks to tuck away

I think that about 50% of a pharma-focused portfolio should be in the largest, dividend-producing and internationally diversified companies around. My favourites include Pfizer (NYSE: PFE), the world's largest drug company, which has an interesting pipeline in osteoarthritis and rheumatoid arthritis.

I also like GlaxoSmithKline (LSE: GSK), which has a particular strength in infectious disease, and in respiratory disease. Roche (Switzerland: ROG) is also excellently positioned for the long term, as is Shire (LSE: SHP), the UK-based specialist in orphan disease and attention-deficit disorders.

In Japan, I strongly recommend Astellas (JP: 4503), which has a handsome dividend yield (currently 3.8%) and has entered into several successful partnerships, notably with Medivation, which up until recently was my largest investment in the sector. As partners, the two are preparing to launch a prostate cancer product, MDV 3100, which is likely to be a blockbuster.

Another 30% of the portfolio should be invested in biopharma companies of some substance, such as Biogen (Nasdaq: BIIB), Amgen (Nasdaq: AMGN), and Gilead (Nasdaq: GILD). These are all US-based and are strong cash-flow generators with good drug pipelines. Gilead is the world leader in Aids treatments and has acquired an exciting HCV (Hepatitis C) programme. Biogen is the world leader in multiple sclerosis treatments (a huge and growing market). Then there is Amgen, a leader in auto-immune disease therapies for the likes of psoriasis.

Lastly, I'd put about 20% in smaller stocks. I currently like these four: Arrowhead Research (Nasdaq: ARWR) is a leader in siRNA and has an interesting pipeline in obesity and Hepatitis B. MAP Pharmaceuticals (Nasdaq: MAPP) has Levadex, which ultimately should be approved for migraine treatment, a serious and as yet unmet need. Summit (LSE: SUMM), has an interesting pipeline in Alzheimer's and in Duchenne muscular dystrophy. Finally, I should note that I am a director of a company called Plethora (LSE: PLE), which has a strong product in sexual health.

Disclosure: Jim Mellon owns all of the stocks listed above.