Biotech: Get in at the beginning of the next big bubble

John Mauldin, the US investment adviser and pundit,is hardly what you'd call bullish. Like us, Mauldin expects tough times aheadfor the global economy, involving a double-dip recession and huge problemsdealing with government debt.

But for all the potential bad news ahead, there is oneasset class he's very interested in. In fact, last month he announced that he'sstarted buying stocks in this sector and plans to keep adding to his holdings"at least every quarter for several years".

So what's he buying? Some defensive combination of goldmajors, tobacconists and tinned goods manufacturers? Far from it. Mauldin isinvesting in biotech, arguably one of the most speculative investment areasthis side of junior mining stocks. And he's buying now because he wants to bewell-invested in the sector by the time the bubble he expects to arrive one dayhas inflated there. "I have lived through a number of bubbles. I have nevergotten to invest in one. This time, dear God, just once please let me be at thebeginning of a bubble."

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What is biotechnology?

The word "biotechnology" encompasses several scientificfields, including agriculture and some forms of alternative energy. But oftenwhen people talk about biotech, they're referring to its medical uses. And themedical biotech sector certainly has everything you need to create a bubble.For one thing, few sectors have better fundamentals than the healthcareindustry. Everyone gets ill. Everybody wants to live for longer, and to behealthier. And the fact is that only wealthy populations live long enough todie in great numbers from the sorts of diseases and conditions, such as cancer,that only biotech-based medicine holds the promise of cures for.

It's exciting too. It holds the same golden combinationof the promise of life-changing potential with a sort of science-fictionwizardry, as the internet did. Who wouldn't want to invest in a firm with acure for lung cancer or a method of regrowing your heart walls? It's the chanceto do some good and to make a lot of money in the process.

Of course, a sexy story and sound long-term fundamentalsare one thing. Fulfilling that potential is another. Since the last big biotechboom ended in 2000, alongside the popping of the tech bubble, the sector hasn'trealised its potential either in terms of investor returns, or for those hopingfor the raft of miracle cures promised at the millennium. And for the really'blue-sky' treatments that Mauldin is interested in, such as stem-cell therapy,we could be waiting a while before we see widespread commercial applications.

But even if you exclude the potential for bubble-blowingin the sector, there are several good reasons to expect 2010 to be a good yearfor biotech.

Big pharma's pipeline squeeze

Big pharma companies are running out of drugs and outof time. The main players face a 'patent cliff' in 2011, says Andy Smith,manager of the Axa Framlington Biotech Fund. AstraZeneca, for example, couldsee drugs that account for around 38% of sales coming off patent by 2012. Whenthat happens, generic rivals swoop in with their cheap copycat products andsales fall hard. And the trouble is, most big pharma companies don't have thenew products to replace these old blockbusters. As Smith puts it, their researchpipelines are being "squeezed at both ends".

So where are they going to get their new drugs from?Well, they won't be filling the gaps internally. Again looking at AstraZeneca,at its latest results, the group plans to cut a further 8,000 jobs. About 3,500of them will be in research and design. Anders Ekblom, executive vice-presidentof drug development, said the group wants to create "healthy tension" betweenin-house and external researchers. As Jeanne Whalen and Sten Stovall put it inThe Wall Street Journal, "this fits a trend in the industry: growing pressureon internal research and development staff to justify their existence ascompanies increasingly look to outside biotechnology firms and academic groupsfor new experimental drugs to buy and develop."

The good news for big pharma is that it might be short ofideas, but it's not short of cash. As James Burns, head of investment trusts atSmith & Williams says, these firms "have very strong balance sheets andhuge cash positions with which to make acquisitions and solve the problemsthey are facing".

And the companies that are best placed to provide thesenew products are biotechs. These firms have in some cases been working for upto 30 years to create new treatments. Many are now at the stage where they canprovide the pharma sector with the new products it needs. The economic woes ofthe past 18 months have seen consolidation between the big players in thehealth sector rather than big spending on small biotechs. But with time againstthem, the impetus to look at buying in products is greater than ever before.

Obama's healthcare reforms

This isn't the only reason to expect more mergers andacquisitions activity in the sector. The healthcare sector in general wasovershadowed by one thing in 2009: the threat of serious reform to the US healthcaresystem. When first proposed, says Smith, it looked like the new rules couldcost around $1trn across the entire sector. A year later, and for better or forworse (we're not going to delve into that particular can of worms here), thosereforms have been seriously damaged by Obama's 'shock' loss of Massachusetts to theRepublicans. As Smith puts it, "reform is not dead, but it's on life support.Whatever's going to be taken out of the sector, it will be less than $1trn."

In any case, healthcare reform was always more of anissue for big pharma than for the biotech industry. But that hasn't stopped itfrom hanging over share prices. Uncertainty has a habit of paralysing activity.If big pharma is scared of higher costs or new regulations dictating the typesof drugs it can make, that's one reason not to go on an acquisition spree. Italso makes it harder to work out what value to put on a company, says Smith.With this uncertainty lifting, the path should be clearer for increasedactivity in the sector.

New life at the FDA

Another boost for the healthcare sector in general thisyear could be a recruitment drive at the US health regulator, the Food andDrug Administration (FDA). Of all the world's health regulators, the FDA is themost important it holds all the key hoops that any new drug or treatment hasto jump through. But as well as becoming more demanding In recent years (notnecessarily a bad thing), the FDA has also "historically been chronically understaffed",says Burns, which has slowed up the approval process.

But with the appointment of a new FDA commissioner,Margaret Hamburg, this could change. For one thing, she is expected to be morekeen to drive through new drugs. It will also be easier for her politically,because she's been picked by the Democrats. Moreover, the FDA is also likely toget a big budget increase for next year.

As the Los Angeles Times puts it, the agency is "ascreaming exception to the Obama administration's freeze on discretionaryspending in the 2011 budget. Overall, the FDA budget could grow by as much as23% to just over $4bn from the current $3.3bn". The budget has already grown by78% since 2008. "The increased spending would allow the FDA to add 1,200 jobs,expanding its workforce by 10%." Part of the reason for the big hike isprecisely so the FDA can keep up. "Today, the FDA is relying on 20th-centuryregulatory science to evaluate 21st-century medical products," warns theregulator.

Biotech is historically cheap

As Burns says, "the major, profitable biotech companiesare now trading at historically low valuations, and are as cheap as they havebeen since 1991". The p/e of the sector recently fell below that of the S&P500 as a whole for the first time ever, reports The Wall Street Journal.Moreover, most big investors are ignoring the sector. "Virtually all generalistinvestors are underweight the sector, so any change in sentiment could have adramatic impact."

Of course, just because a sector is cheap doesn't mean itcan't get cheaper. However, as noted above, valuations in the biotech sectorare underpinned by the potential for mergers and acquisitions. After all, ifstocks are cheap it's all the more reason for desperate big pharmas to try topick them up at inexpensive levels before investors get interested in thesector again. That in turn could be a catalyst for the stocks to be ratedhigher by investors.

So what should you be buying now? We take a look at thestocks and funds that are set to profit from both big pharmas' pipelineproblems and from growing interest in the biotech sector below.

The best bets in biotech

So what stocks should you buy to profit from big pharma'swoes? The problem with trying to predict which stocks are mergers andacquisitions targets is that you're as likely to get it wrong as you are to getit right. So you are better not to buy stocks simply on the basis that they maybe taken over at some point. In terms of getting broad exposure to risinginvestor interest in the biotech sector, you'd be better off buying aninvestment trust, or even an exchange-traded fund, in the sector. James Burnsof Smith & Williams likes the Biotech Growth Trust (LSE: BIOG). BiotechGrowth trades at a discount to its net asset value of 8%. Given the board has atarget of trying to ensure the discount doesn't widen beyond 6%, as Burns says,now "would seem an attractive entry level for new investors". The portfolio iscurrently split between 40% in major biotech stocks and 60% in smaller ones.

Another safer bet than individual biotech stocks is tolook for the 'picks-and-shovels' companies that will help biotechs and bigpharma firms to get products past the FDA (the US regulator)and thus replenish their pipelines more rapidly. Pharmaceutical ProductDevelopment (NASDAQ: PPDI) is a good example. The company is a clinicalresearch organisation. It specialises in helping drug companies from giantslike Pfizer to small biotechs to get over the various hurdles involved inbringing a product to market, including the various phases of clinical studiesundertaken and the regulatory approval process.

The stock trades on a forward p/e of 18, and has adividend yield of 2.6%. It's not a huge yield, but as Matt Koppenheffer pointsout on Motley Fool, it has room to grow. "To date, the company's payout ratiohas been kept relatively low, at 35%, which provides security and gives thecompany extra room to raise the dividend in the future. Meanwhile, thecompany's balance sheet is a thing of beauty, with nearly $600m in cash and nodebt."

Within the sector, Forest Labs (NYSE: FRX) is "a greatcore holding with lots of upside", reckons Jon Stephenson, research analyst forSummer Street Research. Forest is a big pharmagroup. But unlike most of its peers, Forest isalready focused on using external researchers to do the hard work of drugdiscovery for it, says Jay Palmer in Barron's. "Forest doesn't employ thousandsof in-house research scientists... instead [it] lets smaller biotech andmedical-research firms come up with the drug and do the initial testing; itthen swoops in with an offer to buy, or more often license, the promisingones."

Like most big drug groups, the group has problems withpatent expiry. Its best-selling drug, anti-depressant Lexapro, loses protectionin 2012. However, it also has a decent pipeline, says Palmer. Seven drugs arein Phase III (late-stage) clinical trials, including a powerful antibiotic andtreatments for schizophrenia and diabetes. And as Palmer puts it, "the stock isstrikingly cheap". It's on a p/e of 8.7, a big discount to the rest of thesector, and it also has an extensive cash war chest with which to buy orlicense more new drugs. Stephenson has a price target of $43 a share on thestock. Then there's the market for 'biosimilars'. These are basically theequivalent of 'generic' drugs for biopharmaceuticals in other words, they arecopycat treatments that can be made once existing ones fall out of patent. Butthere are some key differences. For one thing, biosimilars are harder and morecostly to manufacture, simply because biopharmaceuticals themselves are morecomplicated drugs. But more importantly, says Joseph Kreuger onSeekingAlpha.com, is that they "fall under new patent protection, effectively extendingthe exclusivity of the old drug it is replacing".

In other words, when companies are facing patent expirieson biopharmaceuticals, one good option would be to manufacture a biosimilardrug to allow them to maintain their hold on the market. One stock to buy totake advantage of this, suggests Kreuger, is PROLOR Biotech (OTC: PBTH). Thecompany uses its patented technology to create longer-lasting and moreeffective versions of existing biopharmaceuticals. Given that its technologycould potentially be used to extend the life of products with a current marketvalue of around $5bn, Kreuger reckons the stock is a very obvious takeovertarget. Be aware that the company is traded over-the-counter in America,so you'll need a broker who can trade these stocks TD Waterhouse is one thatdoes.

This article was originally published in MoneyWeek magazine issue number 472 on 05 February 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.