Why biotech will command the headlines this year

Big pharmaceutical companies need to develop new drugs to survive - but they are cutting back on essential research. That opens the way for small biotech companies to fill the gaps, says Tom Bulford. Here, he examines the industry's potential.

This year has seen the dramatic revival of a small sector that has long been written off by most investors.

Until now, biotech has been the stuff of nightmares. The medical terminology is baffling. The process of medical discovery is long and expensive. But above all the vast sums of money poured into biotech have paid glorious salaries for chemists and biologists but precious little to outside investors.

But a sea change in the industry could change all that. For years big pharma has lead the way in bringing blockbuster drugs to market. But they can't do it any longer. Racked by costs and under threat from generic drug developers, the big pharmaceuticals are stepping back from research.

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And that opens the door for biotechs. Over the next few years I think it is likely to be biotech stocks that command the headlines in this industry. The advances underway in biotech could prove hugely lucrative for penny investors.

Today I'll point you in the direction of someone who knows exactly how to spot the potential winners in biotech. But first, let's look at the forces behind this dramatic revival.

Penny drugs stocks are doing all the work

It is always wrong to write off the prospects of any industry. Ten years ago the mining industry was a forgotten backwater. Now investors cannot get enough of it.

The reasons that there are so many resource exploration companies are that anybody who can raise the money and acquire an exploration license can get into the business; and because the big miners are happy to let the small pioneers do the hard, risky work of looking for new sources of supply. If the little guys are successful they can expect to sell out to an industry major keen to bolster its own reserves.

The pharmaceutical industry now works in much the same way. It needs to find new drugs. Without drugs to sell it will not have a business. And yet big pharma is doing less and less to find those drugs. Faced by pressure on prices and competition from low cost generic versions of its own drugs, it is increasingly relying on the small players to do the research.

Today big pharma spends about 16% of its revenues on research and development but only 4% of this is on research while the other 12% is spent on the very long and very expensive process of taking promising new drugs through the various stages of testing and approval.

The seismic shakeup in the drug industry

Big pharma's retreat from research is shaking the industry. When I met the boss of one biotech business last week he told me that he could recruit as many biologists and chemists as he could possibly need from the ranks of those leaving big pharma. But he also told me of the difficulty of persuading big pharma to sign licensing and development deals.

And these deals are the lifeblood of biotech. Biotech companies live a hand to mouth existence, surviving on grants from governments and medical charities and finance supplied by industry partners. Biotech executives spend much of their time trying to convince big pharma to back their research efforts with hard cash. The biotech's dream is to see its new compound taken right through the development stage and to the market, in return for multiple milestone payments and, ultimately, a royalty on all sales.

But the upheaval of the traditional industry structure is causing problems. In recent times the research departments of pharmaceutical majors have been in thrall to the marketing departments. The latter have demanded big blockbuster drugs that can sell widely and, even if they do no good to a large proportion of patients, will do no actual harm.

But a major shift in drug development is under way. Advances in medical knowledge, notably through genetic research, are helping us to understand the root cause of disease and why some people will respond to treatment while others do not.

I've spoken about the shift to personalised medicine before. But the upshot is that this will require a shift from the 'one size fits all' approach to therapy, and demand a wider range of innovative drugs that can target only those patients with well-defined conditions.

There are spectacular prospects in biotech

This should play into the hands of biotech researchers able to invent these new drugs. Executives at pharmaceutical majors, who have previously been able to lay the blame for product deficiencies at the door of their colleagues in the research laboratories, are now being asked to back third party research projects with large sums of money knowing that the risks of total failure and loss are all too real.

Not only do these decision makers have little experience with which to judge the merits of biotech research programs but, at a time when their employers are under financial pressure and are shedding staff, they are understandably reluctant to put their necks on the block.

Despite this impasse the balance of power seems to be shifting towards biotech. Big pharma is increasingly reliant upon buying into third party drug projects and that means putting real money behind biotech ventures. This year has seen some spectacular share price gains from biotech minnows such as Sareum Holdings (SAR), Valirx (VAL) and Nextgen (NGG).

My colleague, Dr Mike Tubbs, has a few favourite biotechs of his own. Dr Tubbs has invested in a clutch of biotechs that are already leaching huge funds and workers from big pharma.

Find out about Dr Mike Tubbs' portfolio here.

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

Dr Mike Tubbs' Research Investments is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares; never risk more than you can afford to lose. Please seek independent financial advice if necessary. Customer Services: 020 7633 3600.

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.