Could this be the next hot sector in the stock market?

'Big pharma', faced with cut-price competition as patents expire, is cutting back on research. That's created big opportunities for innovative small-cap companies - and for investors, says Tom Bulford. Here, he explains why he thinks biotech could be the next hot market sector.

My golfing partner on Sunday works for a small pharmaceutical research company. The business consists of just a handful of clever people and a research laboratory. But despite these apparently skimpy resources my partner was optimistic. "Next January", he told me, "we will open the envelope".

This is the moment when his company discovers the results of the human trials of their drug and this single moment could determine the future of his small business.

You can just imagine the envelope trembling in the hands of the Company's chairman. His colleagues are gathered around, their fingers tightly crossed and false bonhomie hiding their anxiety. The future of the company is at stake. All those shares and options awarded in lieu of hard cash could suddenly be worth a fortune or nothing at all.

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Today, I want to explain why I think biotechs are going to enjoy the envelope moment a lot more in the next few years. I'll tell you about an interesting discussion I had recently with one of the most respected authorities in pharmaceutical industry. And I think you'll like what he has to say.

The terrifying (and exciting) prospect of biotech investing

The fortunes of small pharmaceutical research companies are often determined the moment results of trials are revealed. These are trials of the drugs that have been crafted in the laboratory and analysed in every way possible, except the one that really matters the trial on a live human being.

When it comes to giving drugs to humans, we cannot be too careful. So the success rate is low. Even the slightest complication or side effect is enough to scupper a new drug. And even if it does no actual harm, there is still a question of whether the new drug works better than those already in existence. You have to be optimistic to back this type of business, loosely known on the stock market as biotechs'. But there are enough success stories to keep the flame alive.

"Look at Human Genome Sciences", said my golfing partner. "Its share price zoomed from 45 cents to $34. The reason? It had a drug compound called belimumab' that was shown to improve the health of patients with the chronic inflammatory disease systemic lupus, and with no adverse side effects."

There can certainly be some big winners in this sector. So why has the industry languished for so long?

The pharmaceutical industry is in flux

The pharmaceutical sector has been under a cloud for some time. Many of the larger players are at the edge of the cliff as their big-selling, high margin drugs face cut-price generic competition for the first time. They have been restructuring hard, and cutting back on the very research that was once responsible for delivering these blockbuster products.

Although India and China are fast emerging as important markets for healthcare products, it is still the USA that sets the tone. Last year's hugely controversial health reforms have now gone onto the statute book in the shape of President Obama's Patient Protection and Affordable Care Act' with the worst fears of the industry unrealised. Now it is back to business as usual.

What does this mean for biotechs? Well, for a perspective on the best investment opportunities in healthcare, I turned to Samuel Isaly, investment manager of the Worldwide Healthcare Trust (WWH), a fund that has produced the highly impressive compound annual return of 14.3% since its inception in 1995.

Why biotech could be the next red hot sector

Isaly is optimistic for the sector, but says that "the largest subset of catalyst-driven investment opportunities that we are finding continues to be in the biotechnology sector, in which we see a combination of high growth rates, attractive valuations, clinical catalysts, product pipelines, new product launches, and M&A activity".

"Identifying innovative therapies and the next product cycle", he continues "is critical. The most compelling innovation is often occurring among small-to-mid-capitalisation companies. Several blockbuster drugs are currently being developed by biotechnology companies and are due to be introduced in the year ahead. As these products are launched by smaller biotechnology companies the larger industry players will be actively considering these new product stories as acquisition candidates".

Translated, this means that the places to look for the potentially best selling drugs of the future are the research laboratories of biotech firms. And any one of these that can come up with a winner can expect to command a handsome price. Shire's (SHP) $750m purchase of advanced biohealing is just one of a number of recent acquisitions of promising small biotech companies. The outlook for this forgotten sector looks better than for some time. Last week, I learned that one of the UK's most successful investors is writing a book on the subject. He thinks that biotech could be the next hot stock market sector. I think he is right.

Another Red Hot sector to buy now

Readers of Red Hot Penny Shares will already be aware of my favourite biotech plays we've been investing heavily in the sector for some time now.

But one other really hot sector is gold. And if you haven't had a chance to read Dominic Frisby's Gold Profit Plan report, then I'd urge you to do so.

Because he thinks any one of the 5 gold explorers that he recommends in the report could match even the most successful biotechs in the year ahead.

Gold shot past $1,600 for the first time this week breaching £1,000 in the process. But Dominic sees gold going a lot higher from here. And he has a few cracking gold stocks in this report.

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund.

Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.

Follow Tom on Google+.