From the October 2009 issue of Research Magazine • Subscribe!

October 1, 2009

High Hopes and Altered Genes

Biotech has had a turbulent history. Its future is unlikely to be staid.

Biotech has long been a high-risk, high-reward industry. It is an industry in which numerous firms, including many small-caps and start-ups, intensively research possible new products that could lead to high profits and rapid growth, but which also carry significant chances of never reaching any customers or generating any revenues.

Biotech also has a history of being buffeted by the vicissitudes of politics. The industry has been a political lightning rod, with criticisms coming from diverse parts of the ideological spectrum; genetically modified foods have generated much opposition on the left, for example, while embryonic stem cells have met much resistance on the right.

Health care reform efforts have repeatedly shown a capacity to roil biotech stocks. During the Clinton administration's reform push in the early 1990s, biotech stocks underperformed not only the broader market but also traditional pharmaceutical stocks on concerns that price controls would strip away profits from breakthrough drugs. The Obamacare debate also has fueled an up-and-down ride for biotech, albeit mitigated by expectations that health insurers, rather than biotech or drug firms, faced the greater vulnerabilities in the legislative maneuvering. Indeed, biotech got a boost from its summer victory in lobbying for extended patent protection for biological drugs.

Nevertheless, a decade into the 21st century, this most futuristic of industries faces major financial challenges as well as political uncertainties. In May, merchant bank Burrill and Co. estimated that 135 out of 342 publicly traded biotech firms were operating with less than a year of cash, and that 42 percent of these were down to less than six months of cash.

Unlike Big Pharma, which can fund much R&D from existing product sales, biotech firms typically depend heavily on equity financing. Yet biotech IPOs have become notably rare amid market volatility. Consequently, capital for the biotech sector has depended to a growing degree on acquisitions -- with pharmaceutical companies buying large and small biotech firms, and large biotech firms absorbing smaller ones.

Such transactions have included Roche's $47 billion takeover earlier this year of the remaining 44 percent of Genentech (in which it had long held a majority interest), Eli Lilly's acquisition of ImClone Systems in 2008, Gilead Science's purchase of CV Therapeutics earlier this year and Bristol-Myers Squibb's recent acquisition of Medarex.

The industry's future profile thus may be different from its historical one, with more big players and fewer small ones. Still, any resulting moderation in the volatility of biotech stocks will likely be limited by the inherently uncertain nature of biotech research and by recurrent political clashes over the costs and uses of biotech products. Provided that political pressures do not actually cripple its capacity for innovation, biotech can be expected to remain an industry with high risks punctuated by occasional large payoffs.

Biotech's Rise

The roots of biotech can be traced back over centuries, involving such precursors as the fermentation of yeast in beer production. The modern biotech industry, though, began on April 7, 1976, when biochemist Herbert Boyer and venture capitalist Robert Swanson founded Genentech to develop drugs based on the technology of recombinant DNA, in which genes from multiple sources are combined into a single molecule. Boyer and geneticist Stanley Cohen had pioneered such gene splicing earlier in the decade.

Genentech went public on Oct. 14, 1980, with 1 million shares offered at $35 each. Investors bid the price up to $89 in a matter of minutes, and the stock closed for the day at $70. The company, by the way, at this point still had no actual products, though it had achieved some important laboratory milestones, such as cloning human insulin.

This vivid demonstration of investor appetite for biotech opened the way for waves of new issues. Early entrants included Cetus (later part of Chiron, which in turn was bought by Novartis), which tapped the market for $107 million in March 1981. The pace of IPOs quickened in 1983, with Amgen and Biogen among the firms going public. A further surge of offerings in 1986 conveyed Genzyme and ImClone, among others.

Increasingly, the biotech industry's products reached market as well. In 1982, Genentech's Humulin, a diabetes treatment using human insulin produced by genetically engineered bacteria, became the first biotech drug to get FDA approval. By the late 1980s, biotech drugs had been approved for illnesses ranging from cancer to heart disease to kidney transplant rejections.

Industry revenues reached $8 billion in 1992. New biotech drugs in the early 1990s included Amgen's Neupogen, to boost low white blood cells during chemotherapy, and Chiron's Betaseron, to treat multiple sclerosis. Biotech firms pushed into agriculture as well. Calgene's Flavr Savr tomato, with an added gene to resist rotting, was the first commercially available genetically modified food, arriving on supermarket shelves in 1994.

The Clinton Effect

The clash over the Clinton administration's health care reform effort demonstrated the vulnerability of biotech stocks to political pressures. The prospect of price controls on pharmaceuticals was particularly damaging, as it threatened to undercut the rationale for the huge up-front expenditures that biotech firms were making to develop new products.

According to a 2007 National Bureau of Economic Research working paper by University of Connecticut finance professors Joseph H. Golec and John A. Vernon, biotech stocks dropped by 51 percent during a period in 1992-1993 when the Clinton proposal was developed and debated. Traditional pharmaceuticals were also hit but less hard, losing 32 percent, while broad market indicators gained by more than 10 percent.

Biotech stocks began edging upward after the Clinton health care plan was defeated in the summer of 1994, and by the following year the industry was in a full-fledged rally. The Nasdaq Biotechnology Index rose 88.5 percent in 1995, compared to 37.6 percent for the S&P 500. Biotech then leveled off for a couple of years, with Nasdaq's sector index generating slight losses while the broad market continued to soar.

The industry became decidedly hot again in the late 1990s. The Nasdaq biotech index registered gains of 44.3 percent in 1998 and 101.6 percent in 1999. This rise was not simply a side effect of the Internet boom, even though investor enthusiasm for all things technological helped boost biotech shares. Biotech now had a major portfolio of products with revenues (in contrast to many dot-com firms). By January 2000, there were 92 biotech drugs and vaccines on the market, and dozens more FDA approvals when counting new uses of existing drugs. Progress toward mapping the human genome was raising the prospect of a new frontier for the industry. Plus, biotech was pushing further into agriculture, with transgenic soybeans, corn and cotton among its products.

New Century Tumult

Biotech stocks continued surging early in 2000, with Nasdaq's biotech index closing at 1,596.53 on March 6. Nearly a decade later, that remains its all-time high. The index fell by 12 percent on March 14 after President Clinton and British Prime Minister Tony Blair sparked fears that their governments were broadly opposed to patenting gene-based products. (In fact, the politicians were merely noting that raw data of the human genome cannot be patented, but a misstatement by a White House spokesman fed the confusion.)

The misunderstanding hastened a biotech stock slide driven by larger forces, as the dot-com bubble burst and the stock market overall lost momentum. The Nasdaq biotech index closed 2000 at 1,084.51 In the equity-averse years of 2001 and 2002, the biotech benchmark lost 16.2 percent and 45.3 percent respectively, compared to drops of 11.9 percent and 22.1 percent for the S&P 500.

In 2003, biotech staged a rebound, Nasdaq's index for the industry rising 45.7 percent, outpacing the S&P 500's gain of 28.7 percent. But the biotech marker's annual returns over the next four years were in the single digits, consistently underperforming the overall market. In 2008, Nasdaq's biotech index fell another 12.6 percent, making biotech a relatively tranquil sector amid the S&P benchmark's 37 percent drop.

After starting 2009 around 730, the biotech index hit lows just above 600 in early March. Aiding the decline were concerns that a stepped-up government role in health insurance would bring new pressure to lower drug prices. The sector recovered in subsequent months, the index hitting 822 on August 4, shortly after the House and Senate passed amendments granting biotech firms 12 years of patent protection against generic competitors (the Obama administration had suggested a limit of seven years).

As the health care conflict plays itself out, biotech stocks may undergo further gyrations in reaction to policy developments. As has long been the case, the biotech industry has much riding on what happens in politics, as well as in labs and clinical trials.

Biotech's Diverse ETFs

Exchange-traded funds offer a way to invest in biotech while reducing exposure to the hit-or-miss nature of the sector's individual stocks. Here are six ETFs focused on biotech:

- iShares Nasdaq Biotechnology (IBB)

- SPDR S&P Biotech (XBI)

- Biotechnology HOLDRs (BBH)

- First Trust Amex Biotechnology Trust (FBT)

- PowerShares Dynamic Biotech & Genome (PBE)

- PowerShares Global Biotech (PBTQ)

The funds vary considerably in their holdings. IBB, which tracks the Nasdaq Biotechnology Index, holds over 120 stocks on a cap-weighted basis, giving broad exposure to the sector. FBT, tracking the NYSE Arca Biotechnology Index, holds 20 stocks on an equal-weighted basis with quarterly rebalancing. BBH, a grantor trust, is highly concentrated, recently holding some 68 percent in two stocks (Amgen and Gilead).

XBI, which tracks the S&P Biotechnology Select Index, holds some 25 equal-weighted stocks. PBE focuses on 30 stocks, using a methodology that evaluates firms based on investment merit criteria. PBTQ, tracking the Nasdaq OMX Global Biotechnology Index, offers exposure to foreign as well as domestic biotech stocks.

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