Get ready for a wave of buyouts in biotech

Here's something I've learned about investing over the years: while there is always a risk that a stock you invest in goes bust destroying your investment in the process it doesn't happen very often.

What's much more likely to damage your wealth is the insidious effect of fundraisings.

Fundraisings can cripple a share price. And whatever way the fundraising comes in either through debt or equity the effect is usually the same: pain for the original shareholders.

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Today I want to look at equity fundraisings. They're the ones that really hurt. I'm going to look at the biotechnology sector to show you why.

We'll look at two biotech investment trusts. As you'll see, the performance of these two funds is drastically different. And it all comes down to these crippling fundraisings.

Watch out for these cursed sectors

One way companies raise funds is via rights issues, where shareholders are invited to pump in more cash. Another favourite is the share placing, where new external investors stump up the money.

Either way the dilutive effect of investors buying in on the cheap devalues your stake. And some sectors are more prone to this curse than others. You need to look out for them.

Exploration companies are a classic example. They raise money to buy property rights and then go off exploring their domains. Even if they find something, they often need to return to the markets for cash to extract whatever they find.

If they don't find anything, well it's back to the shareholders for more cash to keep on looking. And a firm loses its lustre pretty quickly when it keeps bringing out the begging bowl.

And I'll tell you another type of company that has the same penchant for using up shareholders' money: start-up pharmaceuticals. These guys love burning cash!

Finding a drug is only the start. Clinical trials can take years. That's why they keep coming back for more cash. No matter how many millions these guys start off with, it never seems to be enough.

If you want to see what I'm talking about, check out these two biotech investment trusts...

A tale of two trusts

As long-time readers know, I like investment trusts. When I want to get exposure to a sector they are my first port of call.

And since I've made pharmaceuticals my number one sector for 2011, I've been looking into biotech.

As the name suggests, biotech uses living organisms (and their processes) for medicinal benefit. It's an incredibly exciting area.

And whenever you find an exciting opportunity, there'll be a fund manager signing up investors close by. They latch onto great ideas as they know they'll be able to market the concept.

But some of them are worse than others...

First we've got the International Biotechnology Trust PLC (LSE: IBT) run by Schroder's. This fund is aimed at early stage biotech businesses. In fact, the companies it invests in needn't even be quoted on an exchange. They're in at the pioneering stage of these businesses and they're looking for mega-growth opportunities.

Second up is the Biotech Growth Trust PLC (LSE: BIOG) which is managed by Orbimed. If that name sounds familiar, it may be because I tipped Orbimed's World Wide Healthcare Trust earlier this year (which, given market conditions, has been ticking over very nicely). While still looking for the rising biotech stars, Orbimed isn't quite as aggressive on all the early-stage stuff.

Now when it comes to marketing these two trusts, which sounds the most exciting? I would venture that it's the one where the fund manager is in at ground level. That sort of thing sells itself to investors... "Oh, all the profits that'll come from the new wonder-cures from modern science and we're in at the start!"

But of course there's a problem. As we've seen, biotech companies burn through cash. Especially during the early stages. Sexy as the story may sound, cash-calls and disappointing clinical results nearly always lie down the line. And that can really hurt the early investor.

Let me show you what I mean.

This table shows you what you would have ended up with if you'd have invested £100 in each of the funds I mentioned over various timeframes.

Source: Association of Investment Trusts

The figures are pretty conclusive. The Orbimed fund has grown 20% over the ten years. But Schroder's exciting and sexy early stage investment strategy has performed abysmally, losing nearly a quarter of the investment.

Now either the management team has been particularly poor, or (as I suspect) their strategy of investing in pioneering biotech firms is flawed.

Where's this all heading?

There are two reasons I've homed in on this story.

First, if you want to invest in exploration firms, pioneering pharma, or anything ground-breaking, do your homework. Either make sure you know exactly what you're doing, or find someone who does.

The best time to invest in these so-called opportunities is usually when they come back to the market looking for more cash. Wait until they're desperate and buy in just after a rescue rights issue, or placing. That's when the patient investor gets a bargain.

The second point is that the biotech sector is now maturing. Many of them have already had most of these debilitating cash calls.

Just look at the technology sector it's been through the same thing. And now the survivors are riding high. This week we saw Google pick up Motorola's mobile phones business. Why? Well it certainly wasn't the phones business it was after. No, it was the thousands of patents that Motorola has built up over the years. It's all about intellectual property (IP), and Google needs it to further its mobile phone ambitions.

And that's exactly what the biotech firms offer: loads of IP. And their shares look pretty good value. After years of undertaking research and drugs trials (and haemorrhaging cash), many have potentially exciting drugs in the pipeline that's the IP.

In fact, some of the biotech stocks I've been looking at have nearly as much cash on their balance sheet as the value of the company itself! Then there's all the IP, not to mention tax losses they're sitting on.

Here's the point: Big Pharma will be salivating at the prospect of taking over many of these biotech stocks.

Last week I was speaking to an industry insider. He's been in the pharma business around twenty years and he's now the finance director of a small pharma company. He reckons consolidation is coming to his industry. That means big pharma using some of their enormous cash-piles to buy up biotech firms.

That's going to be very good news for biotech shares and I sense a huge opportunity.

But I'm not rushing in yet. The market is going to remain tough for these biotech minnows.

Once the worst of the current financial storms have abated, I'll be looking to pick up a diversified biotech trust. And you know what? I think I might just have found the one I'm looking for!

More to come on this incredibly interesting story as it develops.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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