From the December 2005 issue of Investment Advisor • Subscribe!

December 1, 2005

Buying The Future

Prudent investing in biotechnology can offer great returns for clients. It's also the wave of the future

If you were to suggest to colleagues or clients that the biotechnology sector presents a good opportunity for investment, they might very well respond with a shrug. There are plenty of less risky ways to make money. Those folks would have a point. If you're not participating in biotech, however, you're missing out on the next major wave of technological innovation and the resulting opportunity for returns.

Consider these points:

  • Biotech has outperformed the general markets in both the second and third quarters of this year by a factor of three. The CBT200 (the Centient Biotech 200 Index, our proprietary list of selected biotech stocks on U.S. exchanges) rose 20.4% while the NYSE was up 6.5% and Nasdaq 7.6%.
  • Biotech has replaced pharmaceuticals as the source of health care innovation.
  • Biotechs created 20 new drugs last year, while big pharma produced 11.
  • Biotech is on a long-term up trend, driven by an aging population and rapidly advancing science.

There's another reason to invest in biotech: "To do good while doing well." One of the benefits of investing in biotechnology is that you are contributing to the success of companies that are striving to extend patients' lives and find cures for deadly diseases such as cancer. Advances are made nearly daily, and by investing in biotech you are contributing to that progress while pocketing some profits.

While there are many opportunities to profit from unfolding technological and scientific advances, biotechnology is a complex, high beta industry. As such, advisors should be armed with some basic knowledge and principles before they invest client funds in biotech.

What Is Biotech?

The term "biotechnology" was coined in 1919 by the Hungarian engineer Karoly Ereky to define the concept of products made "from raw materials with the aid of living organisms." But it wasn't until April 1976 that the first biotechnology company--Genentech--was formed. Prior to that, all drugs were developed from chemical compounds, often discovered in unexpected places like the soil or insect secretions.

Since biotechnology-based drugs, or "biologics," must literally be grown from something living, they are much more complex to discover, develop, and manufacture than traditional "pharmaceuticals." It was nine years before Genentech achieved FDA approval for its first biologic, a growth hormone. But it was really in 2004 when Avastin and Tarceva were approved that Genentech's true potential became apparent. Genentech now has a larger market cap than all but three U.S. pharmaceuticals--Johnson & Johnson, Pfizer, and GlaxoSmithKline.

The term biotech is now part of our everyday vocabulary. You know that the U.S. Food and Drug Administration (FDA) controls which drugs reach the market, and you've probably read about the potential impact of emerging technologies like stem cell research.

It's an ironic twist that the intrinsic complexity of the biotechnology industry has served as the catalyst for the FDA to create a clearly defined process that makes it easier for us, as investors, to predict when inflection points in a company's value will occur. All you need to do is follow the drug.

Follow the Drug

The fortunes of a drug company are directly tied to the success or failure of its new drug development programs. The steps for achieving that success are clearly defined by the FDA's "clinical trials" process.

By knowing the milestones at which the FDA grants an "approval," you can predict when an inflection point occurs. You can even predict the relative magnitude of the inflection, as we'll see later. The Drug Lifecycle (see above) illustrates how a drug goes from a concept to a product and some of the terminology applied to the process.

The first step in drug development is called discovery. This is an unregulated process where the focus is on the science--identifying and testing potential drug candidates that the company believes may affect a particular disease. The company is attempting to confirm its theories by measuring the impact that 100s or even 1000s of molecules may have on the targeted disease. The hope is to identify one or more that show sufficient promise to proceed, thereby creating a "proof of concept."

In the pre-clinical step, candidate drugs determined to be promising in the discovery step undergo testing in the laboratory and in animals to assess safety (toxicity) and demonstrate effectiveness (efficacy) on a preliminary basis. This is in support of the preparation of an Investigational New Drug (IND) application to the FDA, which must contain information about toxicology, manufacturing procedures, and plans for clinical testing in humans. Once the IND is approved, clinical trials can begin.

Clinical trials occur in three phases that may take up to 10 years and involve hundreds to thousands of patients. Each phase begins with the submission to the FDA of a specific plan for that phase, including the targeted results, called endpoints. The phase ends with the submission of the results to the FDA, which reviews and approves (or rejects) them. It may also request that additional testing be performed prior to issuing its final approval or rejection of the phase.

FDA Approval Criteria

The FDA's approval of any drug is ultimately tied to two elements. One is efficacy--Does the drug work?--and the second is toxicity--Does it do harm?

There are varying degrees of each, of course, but it's generally clear when a drug doesn't work, that is, when its "outcome" misses its targeted "endpoint." Potential endpoints to a clinical trial could be extending a patient's life (survivability) or reducing or eliminating the occurrence, severity, or frequency of the symptoms.

Or a drug may work (that is, demonstrate efficacy), but causes an undesirable side effect, what the industry euphemistically calls "an adverse event." An adverse event (or AE) can be anything from a minor headache to the most severe of adverse events: death. Nothing gets a drug killed faster than a death or worse yet, multiple deaths that are tied to the drug's use.

If a drug safely meets its targeted endpoint(s), it passes. Recently, Genentech's Avastin was acknowledged to have met its endpoint for the treatment of colorectal cancer by extending survivability 11.8 days. While one could argue that 12 days is not statistically meaningful, who of us wouldn't want to take the chance that we might be one of the lucky ones whose life is extended longer than the average 12 days?

In Phase I of the clinical trials, the new drug is tested primarily for safety in a small number of patients, usually from 20 to 100 healthy volunteers. Some efficacy data may also be collected. Phase I typically lasts a few months to a year; about 30% of the drugs entering Phase I fail.

Phase II uses trials with a larger number of patients, usually 100 to 500, who have the targeted disease. Usually half get the drug and the other half get a placebo, but don't know which they're taking. The purpose is to determine if the drug is effective against the disease and to test its safety in a larger population. Phase II usually lasts up to two years, and 50% of the drugs fail, often making it the "make or break" phase.

Phase III trials are the most costly as they involve testing large populations of patients, usually 1,000 to 5,000, to determine the drug's effectiveness and to identify any side effects. These trials typically take up to four years, and approximately 33% of them result in failure. With hundreds of millions of dollars invested by the end of Phase III, failure here means a significant loss.

Once Phase III is approved, the company can submit a New Drug Application (NDA), or Biologics License Application (BLA), which begins the FDA's 10-month-to-two-year process to review all the results in detail and (hopefully) give the final okay to market the drug. If the drug meets a previously unmet medical need, it may qualify for "Fast Track" or "Priority Review" status with the FDA, shortening approval time for market approval to as little as six months.

While the clinical trials are proceeding, there are parallel activities the company must undertake, such as preparing for manufacturing. While this is an additional lost investment should the drug fail, it can enable quick ramp-up on approval.

When to Invest?

It may not be obvious yet, but you now have the tools to know when to invest in a biotechnology company. What Are the Odds? Developing One Drug (above) puts it into perspective.

Investing in a company that is in the discovery or pre-clinical stages is a very risky proposition, with less than 1% chance of getting a drug to market. This is the domain of the government, with grant funding, angel investors, and a few brave venture capitalists. Investing in companies at this stage takes a deep understanding of the science and business of biotech, and is not for the faint of heart. So we'll focus on development-stage companies.

As a company moves through the drug development process, the risk decreases with each major milestone. Drugs entering Phase I of the clinical trials process with an approved IND have approximately a 20% probability of becoming a marketable drug. Once they have completed Phase III they have a 90% chance of succeeding--a 450% improvement in their odds!

This translates to an increase in the valuation of the company. If it is the only drug program the company has, it may translate proportionately. If the company has many other programs, it may be seen as just a blip in the market cap.

But let's get back to the successful completion of Phase III. You might be wondering why it's only a 90% probability of success, instead of 100%. There are two reasons:

  1. Some drugs are withdrawn by the company because there are enough problems that they do not want to risk a highly visible failure of a marketed drug; and
  2. The FDA may find sufficient reason on examination of all the results to request additional testing, which the company may refuse, or reject the drug outright.

While these events are relatively rare, do not assume the completion of Phase III will necessarily yield a marketable drug.

In The Probabilities of Success (above), we summarize the milestones and inflection points in the clinical trials process, and the probability of success from that milestone forward. Each of the milestone events will represent an inflection point in the company's valuation. The Improvement column represents the increase in the probability that the drug will succeed after that milestone. The greater the improvement, the greater the effect on the company's valuation. With an 82% improvement in the probability of success, a Phase II approval should, in theory, represent the greatest inflection point during a drug's life cycle.

Of course, you also need to know which direction the inflection will take, which isn't so predictable, but there are good indicators. For example, the FDA usually has a review panel make a recommendation prior to the official approval by the FDA. It is unusual, even rare, for the FDA to counter the panel's recommendation. Prior to the recommendation, there are often studies providing interim results, as well as the results from the prior phase. There's a certain art to it, but by reading publicly available information, you can sense when the momentum is shifting toward or against an approval.

You can monitor the progress of the clinical trials on the company's Web site, on Yahoo! Finance (which has a biotechnology section), or any number of other sources (see Sources of Information sidebar).

Biotech-Specific Factors

In addition to the inflection points discussed above, and the traditional investment criteria you normally rely on when making any investment decision, there are several additional factors that should be considered when investing in biotechs:

  1. Science:

    a. Is the science sound? Does it utilize proven, emerging or unproven technologies? (The more proven, the lower the risk, but the value may also be lower.)

  2. Patents:

    a. Have they been issued or are they provisional?

    b. Do they thoroughly cover the science and protect the company from competition?

    c. How long will they be in effect? (They must give the company time to make a profit from the drug prior to expiration.)

  3. Demand:

    a. Does the targeted disease affect a large number of patients?

    b. Is it an acute disease (with short-term treatments) or chronic, with ongoing treatments (giving larger revenue potential)?

    c. What is the cost per treatment?

    d. Could this become a blockbuster drug (yielding a higher valuation)?

  4. Management:

    a. Science: Is there a strong chief scientific officer who can lead the company through the development of multiple drugs and indications?

    b. Regulatory: Has the VP of regulatory affairs successfully taken similar drugs though the FDA process before?

    c. Business Development: In biotech, it's all about partnering. Does the VP of business development have established relationships with big pharma and larger biotechs? Have they done complex out-licensing and collaborative development deals in the past?

To sum up, it's always best to pick biotechs that have a drug; are in clinical trials; have additional uses ("indications") for the drug; have a "pipeline" of new drugs; and, ideally, have revenue, or even better, earnings, or better still, profits.

Many biotechs do not meet all of these criteria, as they are still relatively early stage. But the more criteria they meet, the lower the risk.

As in any industry, there are occasional fluctuations in a company's value that may be independent of the "normal" process. For example, there may be an opportunity to move when, as in the case of ImClone, it was hit with a business issue that has no impact on the science or efficacy of the drug. Market timing is always a tricky business, but technical analysis can help.

Wrapping It Up

Biotechnology is an incredibly exciting industry that is changing people's lives in a very positive way, helping them to better survive some of the world's most deadly diseases. It is also a complex industry controlled by the policies and regulations of the FDA.

But armed with a basic understanding of the dynamics of the industry and the valuation inflection points, intelligent investors can make significant returns, or even hit the occasional home run like Genentech, up 90% in the last 12 months, or New River Pharma, up almost 500% since its IPO in August 2004.

Greg Scott is the founder and principal analyst for Centient Consulting, Inc., which provides investment consulting services to professional investors and publishes The Centient Biotech Investor newsletter and Web site. He is also the president and co-founder of Life Science Angels, Inc., a non-profit private equity investment organization. He can be reached at

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