The best way to play this red-hot, high-risk investment

At least one sector of the market has enjoyed a genuine, full-blown bull market this year: biotech.

Companies working to produce exciting new drugs have seen their stocks rocket in many cases: the NASDAQ biotech index in the US is up 31.7% in 2012 so far.

But with over-indebted Western governments coming under increasing pressure to cut spending on health costs, is it time to take your profits, or is there still plenty of energy left in this bull market?

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We think the latter. Let me explain why and tell you some of the best ways to get on board if you haven't already.

Healthcare spending is falling but good drugs will always be in demand

Overall healthcare spending is being cut, there's no doubt about it.

Health reform in the US is as much about stopping healthcare costs from spiralling out of control, as it is about expanding coverage.

However, while this is bad news for hospitals, insurance companies and medical device stocks, it's a different story for those who make drugs - especially those at the cutting edge.

Here's why.

No matter how bad the public spending environment, patients and their doctors will always demand treatments that have the potential to either save lives or radically improve quality of life.

Say you're a hospital administrator. You are given the opportunity to save some money by switching to a cheaper, but slightly less effective generic drug. Now, if we were talking about the difference between branded painkillers and unbranded ones, you'd jump at the chance.

But if we're talking about the potential difference between life and death, you'd think twice you'd certainly look elsewhere to make the saving if at all possible.

So we think it's fair to say that those who make, or are about to market, effective, must-buy treatments can expect to keep growing.

Also, while demand in America and Europe is declining, emerging market demand for better healthcare is booming. When people get wealthier, a few things happen.

Firstly, they have more time to worry about their health and more money to spend on improving it. Secondly, they are increasingly at risk of wealthy world' diseases, such as obesity and heart problems. These are diseases related to more sedentary, urbanised lifestyles; Westernised diets; and also the simple fact of living longer.

Indeed, while spending on drugs in the US has stayed the same since 2008, it has grown at a compounded annual rate of 13% in Turkey and India, and 16% in Russia.

Avoid the 'dinosaur' drug companies

Of course, not all drug companies will benefit equally. The woes afflicting AstraZeneca for example, show how some of the drug giants are in danger of being left behind.

These companies have large numbers of blockbuster' drugs that deliver plenty of cash. They look cheap on paper, paying out solid dividends. But the problem is they are at risk of going extinct.

A lot of these companies have me-too' drugs, which do pretty much the same thing as their competitors'. As their patents expire, they face competition from generic drug makers, who can replicate their drugs at a fraction of the cost.

This means they are most at risk of suffering from government cost cutting. Indeed, if things carry on as they've been going, they could end up facing a sharp fall in earnings.

Profit from the innovation explosion

But at the other end of the spectrum, you have the really innovative firms who are producing drugs that will revolutionise treatments, and which doctors will have to prescribe whatever the price.

While some small pharmaceutical firms fall into the latter category, the biotech sector is the one that's really leading the way. It has been over a decade since the first human genome was sequenced, and the costs and time involved in have fallen sharply. At the same time, the sector has spent the intervening period turning new data into drugs that are now close to approval.

The US Food and Drug Administration (FDA) is also finally showing signs that it realises the potential of this new wave of innovation. It was notorious in the past for sitting on applications, and taking any excuse to pull drugs from the market. But it has now started to identify several priority areas, and is actively working with companies researching in those areas to help speed up the development process.

For example, look at obesity drugs. The anti-fat' pill has been described as the Holy Grail of drug research, but getting any treatments past the regulator has proved tough. However, the FDA shocked analysts recently by approving two such drugs.

In short, the biotech industry is finally living up to the hype that we saw in 2000. Already, six out of the ten largest-selling drugs (and all of the top three), come from biotech companies.

What should you buy?

Of course, big pharma' isn't going down without a fight. To compensate for mediocre portfolios and research pipelines, many big firms are taking over their more nimble rivals. Their attitude seems to be 'if you can't beat them, buy em'.

So if you want to look at individual biotech stocks, it might be a good idea to focus on prime takeover targets. Onyx Pharmaceuticals (NASDAQ: ONXX) has two valuable drugs: Kyprolis (for blood cancer) and Nexavar (a kidney cancer drug). This would make it really attractive to either a big pharmaceutical company or a cancer-focused biotech such as Celgene. Medivation (NASDAQ: MDVN) meanwhile, produces the prostate cancer drug Xtandi, making it another target for bigger firms.

But in doing this, you're taking a lot of stock-specific risk in a sector that's already very high-octane. A company can be made or broken by favourable clinical trials, which means you can wake up one morning to find that the share price has doubled or halved in less than a day.

We'd suggest building a portfolio, so that you spread your risk. You could sign up for my colleague Tom Bulford's Red Hot Biotech Alert newsletter. Tom is an expert on small cap stocks, having invested in the area for many years, so he knows his way around risky sectors.His newsletterisn't accepting new subscribers at the moment, but it will be doing so very soon.

Alternatively, if you want someone else to do the work for you, you could invest in a biotech fund. One option is OrbiMed's Worldwide Healthcare Trust (LSE: WWH). It has a very good record. Its net asset value has grown by nearly 1,000% since it launched in 1995. The only downside is that 30% of the fund is invested in non-drug companies.

If you would prefer a pure biotechnology play, you might prefer to invest in the Biotech Growth Trust (LSE: BIOG), run by the same company. It has been around for a much shorter period, but it also has an impressive record, returning 163% over the last five years, compared with 91% for the sector as a whole.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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