Even though biotech is a young industry facing many challenges, it does offers some dazzling investment opportunities.

There are more than 3,000 publicly listed biotech companies, but most are less than 10 years old and tend to be small. Only three of those 3,000 have annual sales greater than $1 billion (all figures are in U.S. dollars unless otherwise noted) and only 20 to 25 of them are profitable, says Richard Wong, portfolio manager at Investors Group Inc. in Winnipeg.

In most cases, when you invest in these companies, you are betting on a blockbuster product — or the probability that one of the bigger biotech companies, or a major pharmaceutical company that badly needs a presence in this area, will step up and pay a premium to acquire your stake.

And if a biotech company is successful, it can really pay off for investors. Unlike traditional pharmaceutical companies, biotech companies use living organisms rather than chemical compounds to create pharmaceutical products that are usually injected or inhaled. As such, if a biotech company develops a product that fills a hole in the market, it can charge a lot for the product — upward of $20,000 for some oncology products.

And because of the sector’s youth, generic products don’t pose the same threat as they do for the older pharmaceutical companies. Most products have been approved for sale only in the past five years. Because patents last for 20 years — with development, three phases of clinical trials and regulatory approval usually taking about eight years — most products have seven to 12 years of patent protection.

In some cases, approval can take less time — if there is strong data in the Phase 2 clinical trials and if there is a strong market need for the product, which is often the case in oncology. This can result in an even longer patented selling life, says Heather Peirce, portfolio manager at AIM Funds Management Inc. in Toronto.

As well, the high cost of manufacturing and purifying limits the potential for generic competition. Thirdly, there is no process yet in place in the U.S. and Europe to approve generic versions of biotech pharmaceuticals.

As a result, biotech firms find themselves in a strong position these days. The success rate of biotech drugs is higher than chemical-based drugs, Peirce says, at almost 15%-20% once the product starts clinical trials vs 10% for traditional-style pharmaceuticals. And biotech firms now have more money and can usually fund their own clinical trials. In the early 1990s, when they didn’t have much money to develop treatments, they often had to partner with big pharmaceutical companies to finance clinical trials. This usually left the biotechs with single-digit percentage royalties on a product when it was launched, says Peirce.

Biotechs may still lack the financial capacity or expertise to market the products they develop. But such companies will usually partner with a large pharmaceutical firm in Stage 2 or early Stage 3 of the clinical trials for much higher royalties — usually about 50%. And some of the big biotechs can do everything themselves.

Wong likes the sector over the long term. “Biotech companies are working on treatments we need in areas in which there is scarcity, in which high prices can be charged and in which there is no generic threat,” he says.

But unlike other sectors, in which investment decisions are commonly made based on revenue and profit, that doesn’t necessarily work for biotechs. Wong says that, when choosing investment opportunities, he looks at the science rather than the financials because so few biotech firms are actually making money.

Peirce would seem to agree. “Valuation of early-stage biotechs is no simple feat,” she says. “I look at products, [and] assume price and size and penetration of the market, given reasonable success rates.

Peirce is representative of a group of managers who look for companies with broad-based products and research. “I’m not interested in one-product stories, so I look for broad pipelines and very strong management teams with a history of successful commercialization,” she says. “By our definition, cash flow and potential cash flow is the lifeblood of [the biotech] industry.”

Robert Beckwitt — a portfolio manager at Trilogy Advisors LLC in New York, who manages a number of funds for CI Investments Inc. — takes a slightly different approach. He looks for firms that are “either likely to be successful on their own or are acquisition targets.”

@page_break@Then there are managers who don’t want to invest directly in biotechs — at least, for now — and prefer to get exposure through drug companies that themselves have substantial biotech exposure. Charles Burbeck, head of global equities at HSBC Halbis Partners in London, for example, invests in Switzerland-based Roche Holdings AG, a major pharmaceutical company that has a majority interest (56.1% as of Dec. 31, 2004) in the second-largest biotech company, California-based Genentech Inc. Genentech had sales of $4.7 billion in the nine months ended Sept. 30.

In interviews with global money managers, eight biotechs were recommended — or nine, including exposure to Genentech through an investment in Roche. Three are the largest biotech firms — California-based Amgen Inc. , with revenue of $9.2 billion in the first nine months of this year, Genentech and Switzerland-based Serono International SA, which had revenue of $1.9 billion in the same period.

The next three are mid-sized and based in the U.S.: Marlborough, Mass.-based Sepracor Inc. , with nine-month revenue of $510 million; New York-based ImClone Systems Inc. — the company at the centre of the Martha Stewart fiasco — with $285 million in revenue; and Fremont, Calif.-based Protein Design Labs Inc. (revenue of $193 million).

The final three are much smaller: Britain-based Acambis PLC, with revenue of $30 million, and two U.S. firms, BioMarin Pharmaceutical Inc. at $16 million and Rigel Pharmaceuticals Inc. at $11 million.

Here is a closer look at two — the largest and the smallest — of these recommended companies:

> Amgen Inc. This is one of Peirce’s top 10 holdings. Its management team is one of the best in the industry, she says, with “extensive commercial experience, broad research capabilities, manufacturing experience and all-around visionary leadership.”

New York-based independent investment research firm Sanford C. Bernstein & Co. LLC expects Amgen to outperform the market. In a recent report, Bernstein has a 12-month target of $91 a share for Amgen, vs a recent price of around $80. That is without factoring in the opportunities that will emerge from the pipeline in the next one to two years. That price reflects the market’s expectations that revenue and earnings will decline — but Bernstein does not expect a decline to materialize. Instead, it believes both 2006 and 2007 will surprise on the upside. “After many years of disappointment, the company’s pipeline is now showing real potential,” says the report. The research firm expects news about this potential to emerge throughout the rest of this year and into the next, “supporting higher long-term revenue forecasts, higher growth rates and higher multiples.”

Amgen has 28 products working their way through the regulatory system, five of which are in Phase 3 clinical trials.

Peirce considers Amgen’s pipeline to be very interesting. It includes several oncology products and what she calls one of the “most exciting compounds” for osteoporosis.

Amgen’s net income of $2.8 billion was up 70% in the first nine months of this year vs the same period a year earlier, on revenue growth of 20%. Research and development expenditures of $1.7 billion were equivalent to 18% of revenue, and long-term debt was $2.2 billion as of Sept 30.

The company has 1.2 billion common shares outstanding and, as of Feb. 28, 2005, no one owned more than 5% of the shares. The shares have been trading in the $75-$85 range on the Nasdaq since late July — or about 22 times Peirce’s expected 2006 earnings per share of $3.70. She considers that to be very attractive, given Amgen’s “superior management team, excellent current growth and future growth prospects and tremendous cash flow.”

The company has come a long way since it started in 1980. Its first product, EPOGEN, which is used to treat anemia in patients with end-stage renal disease, was approved in 1989. Its second product, NEUPOGEN, which is used to decrease infection associated with chemotherapy-induced neutropenia in patients with non-myeloid cancers, was approved in 1991. In terms of sales, the company passed the $1-billion mark in 1992, $2 billion in 1996 and $3 billion in 1999.

In 2002, Amgen acquired Immunex Corp., which had received approval for the rheumatoid arthritis drug Enbrel in 1998. Sales of Enbrel were $1.9 billion in the nine months ended Sept. 30, making it the company’s third-biggest seller. Its top seller is NEUPOGEN/Neulasta — Neulasta, approved in 2002, is a longer-lasting version of NEUPOGEN — at $2.6 billion. Aranesp — approved in 2001 and used for anemia caused by chemotherapy and end-stage renal diseases — was second, at $2.4 billion; with EPOGEN at fourth, with $1.8 billion in sales.

Besides Neulasta and Aranesp, two other products have been approved in recent years: Sensipar, which is used for patients on dialysis and with parathyroid carcinoma, in 2004; and Kepivance, used for severe mouth sores in patients with blood cancer who are undergoing high-dosage chemotherapy and bone marrow transplants, in 2005.

Besides Immunex, Amgen has made three other acquisitions: Synergen Inc. in 1994, Kinetix Pharmaceuticals Inc. in 2000 and Tularik Inc. in 2004. The last, which was purchased for $1.5 billion, is engaged in drug discovery related to cell signalling and the control of gene expression.

> Rigel Pharmaceuticals Inc. , based in California, is the smallest of the recommended companies, with revenue of just $11 million in the nine months. However, it has a potential blockbuster nasal spray in its pipeline for the treatment of allergies and asthma, Beckwitt says.

Early trials of R112 nasal spray have shown it to be as effective as steroids, but much quicker — providing help within 30 minutes rather than one or two days — and with no safety issues. More than 59 million Americans suffer from allergy-related disorders and the company estimates that the global market for allergy medications has a potential of $10.5 billion.

The company is a classic biotech with no interest in marketing. Instead, it partners with large pharmaceutical companies to develop and commercialize its products. In January, it signed a “collaborative research and licence agreement” with Pfizer Inc. for treatment of allergic asthma and other respiratory diseases (R112 was excluded from the deal). Rigel received $10 million up front and Pfizer bought $5 million of Rigel stock at a premium. Rigel will receive “milestone payments and royalties on future product sales.” The deal focuses on pre-clinical, small-molecule compounds, which Pfizer is expected to bring to the clinical trial stage. Rigel says the asthma market has a $13-billion potential.

Although R112 was excluded, Pfizer has a limited option to license R112 under different financial and other obligations after further trials are completed. Beckwitt expects this to happen.

In October, Rigel signed a deal with biotech company Serono to develop and commercialize cancer drug candidates from its Aurora kinase inhibitor program, including R763, which is about to enter clinical trials. The deal is worth up to $160 million to Rigel, with an up-front payment of $10 million in cash and a purchase of $15 million in Rigel stock at a premium. This is Rigel’s fifth oncology deal since 1998.

Rigel also signed an agreement with Merck & Co. Inc. in 2004 to investigate ubiquitin ligases — enzymes that regulate protein degradation within cells, which affects many important cellular functions, including cell division — to find treatments for cancer and other diseases. Rigel received $7.6 million up front and research funding for two-and-a-half years.

Rigel is also working on a medication for rheumatoid arthritis, which is in Phase 1 clinical trials, and a medication for hepatitis C, which is still in pre-clinical trials.

Not surprising, Rigel is still losing money. It lost $36.4 million in the nine months ended Sept. 30 — far higher than its $11-million revenue, although those losses are down from $41.5 million a year earlier. The reason Rigel lost that much money: it spent $38.7 million on R&D. Long-term liabilities were $17 million as of Sept. 30.

Operations are funded mainly through issues of common stock, which brought in $87.7 million in the nine months and $60.3 million a year earlier. There were 24.2 million shares outstanding as of Sept. 30, vs 19.7 million on Dec. 31, 2004, and there are 100 million shares authorized. No one owned more than 10% as of Mar. 31.

Shares were trading in the $23-$24 range in mid-November. Cash or cash equivalents were $91.8 million and “available for sale securities” were $36.2 million as of Sept. 30. IE