Where to Bet on the Biotech Breakout


By Sam Stovall The biotechnology group's winning streak continues. Witness the dramatic run-up in Genentech (DNA) shares on May 19 -- after it announced favorable trial results for its Avastin compound in treating colorectal cancer. And that comes on top of what has already been an impressive performance for the biotech industry in 2003. Year-to-date through May 16, the S&P Biotechnology index gained 23.7%, vs. a 7.3% rise for the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes).

That performance has propelled the group into the Industry Momentum portfolio -- the list of industries with top S&P Relative Strength rankings. And S&P's investment outlook for biotech is positive for the intermediate to long term. Frank DiLorenzo, the S&P analyst who follows the group, remains upbeat on selected biotech issues, and he continues to recommend that investors focus primarily on profitable companies.

Overall, says DiLorenzo, first-quarter financial reports were solid for the majority of profitable biotech companies among those in his coverage group. He sees strong results for these concerns for the rest of 2003. Things aren't as rosy for companies in the group that have yet to establish profitable operations. DiLorenzo says their outlook remains mixed due to their high cash burn rates, uneven clinical development progress, and lack of funding.

MORE APPROVALS. The upshot: S&P recommends that investors allocate the vast majority of their biotech investments to profitable concerns with solid growth prospects. They should consider unprofitable biotechs only if the companies have significant cash balances and promising drug candidates in Phase III trials. (Phase III is the largest and most important testing stage for a drug candidate, and often precedes its submission for approval to the U.S. Food & Drug Administration.)

DiLorenzo believes several factors are creating an improving FDA approval picture. These include the appointment of a new FDA commissioner, Mark B. McClellan, a procedural change to having biologic drugs reviewed by the agency's Center for Drug Evaluation & Research, and a new Prescription Drug User Fee Act (PDUFA). S&P feels these events have been positive for drug-review times and approvals thus far, with several important FDA O.K.s for biotech medications granted in 2003.

DiLorenzo estimates that the S&P biotech industry index could appreciate by approximately 20% over the next 12 months. S&P believes a p-e-to-growth (PEG) ratio of 1.5 times its 2004 EPS estimates would be reasonable in 12 months' time. The ratio on its 2003 EPS estimates was 1.5 times as of late May.

MERGERS, YES. IPOs, NO. Strong sales of approved drugs, combined with expected new approvals in the U.S. and Europe, should lead to annual increases in industry revenues of nearly 20% through 2004, according to DiLorenzo. Biotech acquisitions have picked up steam since late 2002, with acquirers concentrating on smaller candidates with approved or late-stage medications.

On the other hand, DiLorenzo expects IPO activity and funding opportunities for emerging biotechs to continue to be sparse into 2004. However, he says activity on the collaborative-partnership front should remain brisk.

DiLorenzo's favorite names in the group are Amgen (AMGN), Gilead Sciences (GILD), and MedImmune (MEDI). He has 5-STARS (strong buy) rankings on each.

And Genentech? DiLorenzo maintained his 3 STARS (hold) opinion on May 19 after the Avastin news. Based on S&P's revised net present-value analysis of the shares, he feels a case could be made that Genentech is "reasonably priced."

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the 116 industries in the S&P 1500) as of May 16, 2003.

Industry/Sector

Company

S&P STARS* Rank

Biotechnology/Health Care

Amgen (AMGN)

5 STARS

Brewers/Consumer Staples

Anheuser-Busch (BUD)

5 STARS

Computer Storage & Peripherals/Info. Tech.

Storage Technology (STK)

4 STARS

Consumer Electronics/Consumer Discretionary

Harman International (HAR)

Not Ranked

Fertilizers & Agricultural Chemicals/Materials

IMC Global (IGL)

4 STARS

Health Care Equipment/Health Care

Medtronic (MDT)

5 STARS

Homebuilding/Consumer Discretionary

KB Home (KBH)

4 STARS

Internet Software & Services/Info. Tech.

Yahoo! (YHOO)

1 STAR

Office Electronics/Info. Tech.

Xerox (XRX)

2 STARS

Reinsurance/Financials

Everest Re (RE)

Not Ranked

Water Utilities/Utilities

Philadelphia Suburban (PSC)

4 STARS

* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (strong buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's


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