Biotech Funds: Handle With Care

March 30, 2004 — Biotech funds have been red-hot recently — the average biotech fund shot up 50.5% for the one-year period through last month, outdistancing the S&P 500-stock index, which rose 38.5% for that period. While biotech fund returns have been handsome lately, the longer-term results suggest investors should be cautious. The average biotech fund fell 9.6%, annually, for the three-year period through February, a steeper drop than the S&P 500′s 1.0% decline for that period.

“Biotech funds are very volatile with an average three-year standard deviation almost double that of the S&P 500,” said Rosanne Pane, Standard & Poor’s mutual fund strategist. “This sector should represent no more than 5% of an investor’s growth portfolio.”

Despite these pitfalls, Pane sees advantages to investing in biotech funds. “Biotech funds provide investors with opportunities to share in new product introductions and delivery systems,” Pane said. “Biotech stocks benefit from the demographics of an aging population, but these stocks are vulnerable to changes in Medicare pricing policies and changes to reimportation rules.”

Biotech stocks are likely to show gains this year, according to Frank DiLorenzo, S&P’s biotech analyst. “We project 12-month stock appreciation potential of about 20% for profitable biotechs, assuming gains tracking our EPS growth rate projections,” DiLorenzo predicts. “We expect underlying fundamentals to remain strong in 2004, with industry revenue growth exceeding 20%, and the earnings of profitable companies rising in the low-20% range.”

Stocks of biotech companies with marketed products tend to have lofty valuations. The market often prices these stocks based on projected revenue streams. Moreover, as high-beta stocks, biotechs typically outperform during bull markets, like 2003, and suffer crushing blows when the overall market weakens, as in 2002. Any bad news from the Food and Drug Administration (FDA) can send a biotech stock’s price plummeting.

Despite last year’s surge in stock prices, biotech is not yet fully valued, said Thomas Dietz, senior biotechnology analyst and director of research at Pacific Growth Equities. “In 2004, biotech will probably move more in line with, or slightly outperform, the overall market,” he said. “There are many biotech companies, particularly those undergoing Phase III trials, which remain undervalued relative to their products’ market potential.”

Most of last year’s gains among biotech came from undervalued small-cap biotech stocks, according to Dietz. “These issues had a tremendous recovery as investors rotated out of technology,” Dietz said.

Last year, the biotech industry growth “was driven by a host of new FDA approvals, which seemed to reflect the FDA’s new focus on approving drugs in a timely fashion,” said Sunaina Murthy, senior health-care analyst for the AIM Global Health Care Fund/A (GGHCX). “We have also witnessed several positive Phase II and Phase III clinical trials data. Biotech companies with products that are targeting larger, unmet medical needs, like cancer and cardiovascular disease, performed particularly well.”

According to the Biotechnology Industry Organization, the FDA approved 25 new biotech drugs in 2003, up from 20 in the prior year.

In first quarter of 2004, biotech investors have been rewarded with a flurry of good news: Avastin, a drug developed by Genentech Inc. (DNA), was approved by the FDA; Irish drugmaker Elan Corp ADS (ELN) and its U.S. partner Biogen Idec (BIIB) said they were seeking early approval of their multiple sclerosis drug, Antegren; and scandal-tarred ImClone Systems’ (IMCL) long-awaited colorectal cancer drug, Erbitux, also received FDA approval.

Merger and acquisition activity has also picked up in the sector — a few weeks ago, Genzyme Corp. (GENZ) agreed to acquire ILEX Oncology (ILXO) for $1 billion; while drug behemoth Pfizer Inc. (PFE) acquired Esperion for $1.3 billion. Big pharma, facing a dried up product pipeline, patent expirations and weak earnings growth, will likely continue to pursue partnerships with promising biotech firms, Murthy noted.

Drug development is a risky business,” said Evan McCulloch, manager of the Franklin Biotechnology Discovery Fund/A (FBDIX). “The length of drug development varies widely based on the disease. But in general, ranges from five to 15 years.”

There are other dark clouds on the horizon — proposed reductions in Medicare reimbursement rates could cut into the sales of the bigger-cap biotech companies. McCulloch said that while he didn’t think Medicare cuts will have a “large impact” on the products of the companies he follows, he continues “to analyze how further cuts in reimbursement in 2005 and 2006 could effect sales trends.”

RECENT PERFORMANCE & VOLATILITY OF BIOTECH FUNDS

1-YEAR RETURN THRU 2/27/04 3-YEAR RETURN ANNUALIZED THRU 2/27/04 3-YEAR STANDARD DEVIATION