Biotech stocks look tempting

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If you've ever been tempted to consider North American biotech stocks, 2010 could be the year to yield to temptation. One analyst goes so far as to predict 2010 will be the year of a new biotech boom, fuelled mainly by a round of consolidation as a futuristic industry starts to mature.

As a sector, biotech has risky fundamentals. Companies that depend on heavy research and development investment for their success are more expensive than those that don't. Biotech companies also face an array of clinical and regulatory setbacks before they get approval. Then they're suffering from the scarcity of capital that characterizes a post-recession climate that has yet to stabilize into a full-blown recovery.

Despite those fundamental risks, senior analyst Marc Lichtenfeld of the Smart Profits Report sees 2010 as the dawn of a biotech stock boom because small caps, in particular, are cheap, and it will be difficult for big pharmaceutical companies to resist low valuations, as a cheaper and more reliable route than direct research and development.

Biotech, which the Biotechnology Association Industry Association defines as: "the application of molecular and cellular processes to solve problems, conduct research, and create goods and services," is usually seen as an exciting, research-driven sector, which makes it a source of "ten-baggers" - 1,000 per cent gainers, but it also includes a larger cast of losers.

Jon Ogg of BioHealth Investor compares looking for 10-baggers to a like quarterback throwing Hail Mary passes on every down. "There will be touchdowns, but there are going to be many interceptions and probably a lot of injuries."

Biotech's reputation as what Motley Fool commentator Karl Thiel calls "the province of gamblers and small-f fools" keeps prudent investors away. Over the last decade, the Nasdaq Biotech Index, which follows 125 public biotechs, is down 40 per cent. Still, it would be large-f foolish to ignore the sector's recent show of strength.

You don't have to be on a quest for 10-baggers to take note of the current upswing in the fortunes in biotech stocks. Advisers have started to notice that the sector has been quietly outperforming the S&P 500 for the last couple of years, and that biotech is the engine causing the Nasdaq to outperform the S&P 500.

Perhaps the clearest indication that something interesting is going on is that 20 of those 125 companies on the Nasdaq Biotech Index produced triple-digit gains in 2009. Two of them, Vanda Pharmaceuticals Inc. and Human Genome Sciences Inc. posted quadruple-digit gains - 2,150 per cent and 1,342 per cent, respectively.

Vanda is a case study for the Hail Mary nature of biotech. Vanda's schizophrenia drug, Fanapt, was rejected by the U.S. Food and Drug Administration in 2008, sending its stock into freefall. The FDA later reversed its decision in May last year, approving the drug for market and resulting in one of the industry's biggest turnarounds. Vanda still has some room to grow, according to some analysts. Jeffries & Co., the New York-based investment bank, has a buy rating on the stock and a target price of $22 (U.S.) As Vanda is still trading in the neighbourhood of $11.50, there is still an upside.

HGSI's future is a little less certain. Its promising lupus treatment, Benlysta, goes for FDA approval in the second quarter. If it is approved, it will be the first new treatment for lupus in 50 years, but the anticipation of success could already be reflected in its current share price near $32.

Smaller cap biotech companies did better than the giants last year. Michael Becker of Life Sciences Digest points out that the NYSE Arca Biotechnology Index was up 46 per cent in 2009, while the larger Biotech Index had an overall gain of only 16 per cent, lower than the Dow Jones at 19 per cent, the S&P 500 at 24 per cent and the Nasdaq at 44 per cent.

The main reason for the discrepancy, according to Mr. Becker, is that the Nasdaq Biotech index includes the total market capitalization in its account, so companies with the largest market caps - greater than $10-billion - will have the greatest weighting in the index.

With all of the above in mind, it is possible to plot a (relatively) conservative strategy in biotech stocks. You just have to look for consistency in a sea of volatility. A Motley Fool feature headlined "Avoid the Shiny Happy Morons," referring to the over-the-top market optimism that reached its apex in 2000, includes a list of 10 stocks from the Nasdaq Biotech Index that have held their value over the last 10 years. The list includes the largest biotech in the United States, Amgen and Gilead Sciences , which has climbed from a March 10, 2000 price of $4.48 to more than $45 now. With a 949-per-cent gain over the decade, Gilead is a 10-year, 10-bagger.

A year ago, Gilead followed Mr. Lichtenfeld's dictum, and acquired CV Therapeutics and its heart medications for $1.4-billion. And it is not done yet. The company, which owes its success to HIV treatment Atripla, increased its cash flow by 40 per cent between 2008 and 2009 and has a quadruple drug cocktail in the pipeline. Gilead will use that extra cash to acquire to continue to diversify beyond HIV treatments.

Amgen is interesting, because it leads speculation that it could be among the first of the biotechs to pay a dividend, an indication that some biotech companies are starting to trade exponential growth for ongoing performance. However, even though the company has plenty of cash, it has so far been content to sit on its big bank account and has instead bought back stock - lowering its number of shares on the market by 20 per cent since 2004.

A better candidate to pay the first biotech dividend is Warner Chilcott , the company that acquired Proctor and Gamble's pharmaceutical business in October, 2009. Thomson Reuters estimates 2010 earnings of $3.37 a share on revenue guidance of $2.9-billion to $2.95-billion, and that could lead to the company declaring a 60-cent to 75-cent dividend on shares. Its shares currently trade at just over $26.