Why the biotech sector is set to bounce back

The disastrous results of biotech group TeGenero's drug trials have battered the biotech sector. But investors are unlikely to stay away for long. Here are six stocks that look like they could be worth picking up...

Update: read Biotech sector: the drugs that could help us live with cancer for the more analysis and investment opportunities in the biotech sector.

Just as the biotechnology sector was again finding favour with investors, biotech firm TeGenero's drug trials ended in disaster. This has put the future of drug research into question. Will biotech itself survive?

Investors have experienced plenty of ups and downs in the biotechnology industry's short life, says HSBC. There have been many "binge and purge" cycles and the genomics bubble of 1999-2000 was one of the most extreme.

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But just as investors were beginning to warm to some of the racier biotechnology shares again, the problems of little-known German biotech firm TeGenero threaten to cool their enthusiasm. The horrible side-effects of the testing of the firm's biotechnology leukaemia drug on six human guinea pigs in London last week the volunteers ended up in intensive care have put clinical trials under the spotlight, says the FT.

At any one time, as many as 300 of these Phase I trials may be in progress, involving only about 2,500 people in total. They are an "indispensable" part of the process of drug testing, and are meant to test safe dosages of a drug before it enters Phase II and Phase III, when much larger numbers of volunteers participate. But while regulators and the police investigate what went wrong whether it was an intrinsic flaw in the drug (called TGN1412), or a problem with its manufacture, dosage or supervision the fact that such a failure is so rare should be testament to the "strong safeguards" established over many years.

Until last week, these safeguards had been sufficient to weed out any dangerous drugs before they reached the human stage, says Edward Fennell in The Times. So the implications of what has happened are potentially "enormous" not just for the patients themselves, but also for research, the pharmaceutical industry and the regulatory system itself.

The current regulatory framework for medical trials in the European Union is set by the recent Clinical Trials Directive, says Liz Cohen, senior associate at law firm Bristows. Before this directive was introduced, Phase I trials in the UK were not as strictly regulated as Phase II and later trials. Now they enjoy the same protection.

But well before Phase I testing, TeGenero and its trial contractor, Parexel, would have had to undertake a huge array of tests, both on tissues and then on animals. The results would then have been presented to both the Medical and Healthcare Products Regulatory Agency (MHRA) and to a local ethics committee before trials on human beings could begin. Strict guidelines like these, assuming they were followed, should have ensured that any inherent defects were identified. So one tentative conclusion is that human error was to blame.

Whatever the cause, the UK biotechnology industry is now worried that the very public disaster could lead to a "crackdown on regulations" that will make it difficult to discover new medicines, says Katherine Griffiths in The Daily Telegraph. According to some experts, the MHRA, which is controlled by the Department of Health, might have to "reconsider" the central process whereby drugs are allowed to progress from animal testing to Phase I human trials. Questions are being asked on whether animal testing might "no longer be appropriate" as a guide to safety in humans, given the increasingly complex nature of the drugs under development. If so, then it might be harder to find human volunteers at the early stage of testing because they would be at higher risk.

The problem is that while conventional drugs are just simple chemicals, modern biotech drugs, produced through genetic engineering, are large proteins, say Sarah Boseley and Ian Sample in The Guardian. This can make contamination during the manufacturing process by a virus, for instance "far easier" and have more potential to cause a harmful reaction in the body. And as these proteins are biological products, they are more complex and so can induce reactions in the body that could be of an "allergic or hypersensitive nature", according to Saad Shakir, head of the Drug Safety Research Unit at Southampton University. The result is that, although human testing of new drugs has been very safe in the past, now that a new generation of highly sophisticated biological products has arrived, we could be entering a "new paradigm".

Detailed research by US investment bank Goldman Sachs points to a similar conclusion. It contrasts the old and the new and finds significant differences. Traditional pharmaceuticals are relatively small and simple molecules made by chemical processes, usually taken orally. Cell-based biotechnology drugs, on the other hand, are usually large proteins digested in the stomach, so they tend to be given to late-stage patients by injection, inhalation, or other routes. While the manufacturing of traditional pharmaceuticals involves "well defined" chemical steps, the complexities involved in biotechnological manufacture the use of DNA, cells and enzymes mean the end product is far more difficult to control.

Until the inquiry into the TeGenero tests reaches its conclusions, investors are likely to be cautious about the biotechnology sector. However, safety records remain good overall and it should be remembered that the industry is still in its infancy. The "current era" of biotechnology began in the 1970s, with the development of technologies that could make recombinant DNA. And the first biotechnology company Cetus was founded in the United States as recently as 1971. With potential applications in agriculture, animal health, industrial processing and environmental protection, as well as human well-being, the sector's potential benefits are, arguably, too far-reaching and important for it to be sidelined for long.

Besides, the industry is showing rapid growth too. In just over 30 years, a nascent industry has spawned about 4,400 biotechnology companies worldwide, with about 640 (15% of the total) publicly traded. Of these, 70% are in some way involved in research into human health.

Companies and investors ploughed money into gene sequencing and screening technologies before the bubble burst in 2001. Since then, there has been an emphasis on the more old-fashioned virtues of pipeline growth and new-drug approvals. However, the very long, uncertain and expensive drug-development process means there will always be plenty of volatility along the way.

Many firms, for this reason, have diversified. Some of the bigger biotechnology companies, such as Genentech and Amgen in the US, have started to develop chemical drugs in addition to biological drugs, while many pharmaceutical firms, such as AstraZeneca, are now also concentrating more resources on biotechnology. So it's hard to believe that the momentum in the industry will stall for long.

The biotech firms the brokers are tipping

Investors in the biotech sector are faced with a bewildering choice. US firms Amgen (AMGN) and Genentech (US:DNA) are the largest in the world, but while Genentech trades on a hefty price/earnings ratio of 50 times, Amgen trades on a much more reasonable multiple of 21 times. Amgen is also seeing sales growth for its "blockbuster drugs", including the top-selling biotech drug of 2005, Epogen, an anaemia treatment, and it has a promising pipeline of new drugs, says Citigroup analyst Elise Wang. The company also has a healthy balance sheet and more than 20% annual growth in revenues over the last five years.

Bear Stearns recently warned that a full human pandemic of the H5N1 (bird flu) virus could set off the worst global stockmarket crash since the 1930s, says Ambrose Evans-Pritchard in The Daily Telegraph. The broker suggests buying US biotech giants Amgen and Medimmune (MDI), which would "hold up well, or even rise" in the first phase of a pandemic. Both stocks reacted well to Asia's Sars epidemic in 2003.

Merrill Lynch has published a positive report on biotech firm Alizyme (AZM) and has raised its target price from 170p to 215p, a 25% rise, says The Guardian. The firm has confirmed it was "in talks" with some global pharmaceutical groups about licensing its obesity drug, Cetilistat. In total, they have three drugs ready for Phase III trials, but no partners to fund the process. A Phase III programme for Cetilistat could cost $200m (£114m), according to Merrill Lynch more than the firm can afford. An outright takeover is possible, with a likely valuation of 270p a share.

Swiss biotech firm Actelion (US:ALIOF) is a leader in the field of pulmonary arterial hypertension. Its drug, Tracleer, is "undervalued" by investors and the research and development pipeline is not being valued at all, says Goldman Sachs. This has led to the shares trading on a "significant discount" to industry peers. Goldman Sachs estimates Tracleer alone is worth SFr175/share and the group as whole should be valued at SFr219/share. It is currently trading at around SFr115. With industry consolidation underway, Actelion could be "strategically attractive" to a larger predator. Goldman gives it an "outperform" rating.

Finally, Evolutec (EVC) is a novelty. It is developing drugs from tick saliva to treat auto-immune diseases, such as asthma and hay fever, says Investors Chronicle. It recently released positive data from Phase III trials of hayfever drug rEV1 31, for a market worth up to $6bn in annual sales. It is "well funded" following two share placings last year, which raised £20m. The shares dipped after the money raising, but potential licensing agreements for the drug means they are still a buy.