Science is golden
There is some smart money in biotech shares and David Potts has the lowdown on the most attractive prospects.
There is some smart money in biotech shares and David Potts has the lowdown on the most attractive prospects. They might not make any money but, hey, that has never stopped a boom.Many biotech stocks have been surging in this sluggish sharemarket and the only non-mining stock in the top 10 performers in the financial year just passed - and good riddance, I say - was a biotechnology one.In fact, Mesoblast, which is developing stem cell treatments, shot up nearly 400 per cent in just 12 months.That should put the more than 100, generally tiny, biotech stocks on the map."This is the best year I've seen," says a broking analyst experienced in biotech stocks from Shaw Stockbroking, Matthijs Smith.Although the sharemarket is no higher than it was in 2005 despite a lot of movement, a benchmark index of biotech and medical device stocks compiled by Southern Cross Equities has soared more than fourfold.And Shaw Stockbroking's index shows biotech stocks jumped 38 per cent in the past 12 months, easily leaving the overall market for dead.Takeovers have been brewing, too. Cellestis is under offer and Chemgenex has just been swallowed up, so to speak.Even Mesoblast might be a target, with the same multinational that snaffled Chemgenex sitting at 19.9 per cent, the maximum before a bid has to be made.But the real, er, life-changer came in March, when a speculative biotech stock for the first time paid, gulp, a dividend."Acrux delivered not promises but money in the hands of investors," says David Blake, whose Bioshares newsletter (bioshares.com.au) is the biotech bible."I've seen good projects driven into the ground because of stupid management."A company must pay attention to funding. Many get that wrong. But there have been changes in the sector."Biotech stocks are possibly even more speculative than junior miners.While they all want to improve lives, some seem to have a death wish as well."A lot have a bias to a slow death," Blake says. "Some companies have come and gone and so we never got to look at them."At least miners have regular drilling reports and updates to keep you going.But once a biotech stock has started clinical trials, it can be years between drinks. Even after a successful Phase III trial, the last hurdle before approval by the all-powerful US Food and Drug Administration (FDA) can take up to two years.And if a trial goes badly, it's panic stations.When Pharmaxis, which has developed an improved treatment for cystic fibrosis, got what it called a "negative opinion" from the European Medicines Agency, its shares lost almost three-quarters of their value in a day.But at least biotech stocks aren't hurt by the strong dollar.True, by the time they turn a profit, who knows where the dollar will be but since many of them carry out trials in the US, its strength suits them.Being speculative also makes for potentially enormous gains, so experts suggest a portfolio of about half a dozen biotech stocks.Five out of the six will probably fail but the sixth will make up for them in spades.A biotech analyst for Southern Cross Equities, Stuart Roberts, has narrowed the field to 14 worth watching and says one criterion is they mustn't look too desperate. "A lot will overpromote themselves," he says.So, what should be in the portfolio?A mix of early- and late-stage clinical results is probably best.Smith says that if you get in quite early, "the risk is very high and you have to be quite patient. By Phase III, there's less risk but you won't make as much money," he says.His preference is Nanosonics, which markets a cheaper and better way of disinfecting surgical instruments using ultrasound and has just started selling in the US.Along with Starpharma (see panel) and Nanosonics, other stocks recommended for beginning a biotech portfolio are:Mesoblast Its performance says it all. "It uses its technology for lots of products, even though they're really the same," Blake says.Its biggest shareholder has deep pockets and it has $280 million in the bank. And it is also working on a cure for chronic back pain. How could it lose?Acrux For all the advantages of its testosterone replacement drug being licensed to the huge Eli Lilly group and of paying a dividend, not to be overlooked is that it's a pooled development fund. That means capital gains and dividends are tax free. Knew you'd like that.Unlike most biotech stocks, it has developed its treatment without a partner so there's nobody else sharing the spoils.Pharmaxis A good example of how regulatory risk is ever present for a biotech stock. It also had a setback in the Phase III trial of its cystic fibrosis drug.But Smith says "its risk profile has changed" for the better and "it's always well funded".Or, as Blake points out, "nothing goes perfectly in this sector. It tripped up but that makes it a buying opportunity."QRxPharma Less risky is this US-based company, which originated at the University of Queensland but has become, in the words of the managing director, John Holaday, "a proud Aussie company with an American accent".It combined two well-established pain-relieving drugs that had side effects and discovered the sum was better than the parts.Or, as Holaday says, "old drugs were taught new tricks".In fact, the side effects have been relieved by 50 per cent to 75 per cent. It has passed the crucial Phase III trial, will have a strategic partner this year and is expected to market the drug by the middle of next year, FDA willing.Bionomics "It may have developed the next Valium without nasty side effects. It is looking at licensing some time this year," says Blake, who adds the key to a good drug is that "it's better and safer". Bionomics is also developing a promising treatment for solid tumours.Phosphagenics It has successful early trials for a patch that will deliver medications, including insulin, through the skin. One partner is the giant 3M, so "it'll never have to raise capital again", Roberts says. It's been around since 1993 in various incarnations and "was quite rightly avoided by investors for many years but it's starting to do something interesting", Smith says.Starpharma no one-drug wonderUNLESS you were paying attention during biology lessons at high school, biotech stocks can be hard to get your head around.Never mind it's not how the technology works but what it does that really matters.So the usual investment rules kick in, such as the size of the market, how the company is run and whether you can trust its management.Take a dendrimer, for example. It isn't some nasty fungal infection but a molecule oops, getting technical that makes prescription drugs work better and last longer, with fewer side-effects.The amazing thing about dendrimers isn't so much what they can do or why somebody hadn't thought of them earlier but that just one company has them cornered.An Australian company, at that. Starpharma holds more than 100 patents for dendrimers, which can be used from coating condoms with an antiviral, anti-HIV, anti-herpes gel to prescription drugs and purifying water, pesticides, cosmetics and even inks.If it flows, a dendrimer will make it fly. "It can make old drugs safer, give new life to a patent and last longer in the body, which is critical, for example, for insulin-dependent diabetics," says the chief executive of Starpharma, Jackie Fairley.Yet, unless a giant pharmaceutical company is interested, a small biotech stock has neither the money nor the clout to make a go of a discovery.Extending the life of a patent about to expire is a sure way to grab attention."A pharmaceutical company can breathe new life into a drug coming off a patent by using a dendrimer to improve it," Fairley says."It's a very attractive strategy to the industry because it's a lower risk than developing a new drug."Although it doesn't yet make a profit, which might change next year, analysts say Starpharma is a model stock.For one thing, "it lives off the smell of an oily rag," says Shaw Stockbroking's Matthijs Smith.He calls it "one of the most exciting investment opportunities in the Australian biotech sector".In fact, Starpharma has a staff of just 28, notably including "commercial staff who do nothing but deals", Fairley says.That's something else analysts like: it's not a one-drug wonder.Starpharma has countless projects on the boil and doesn't depend on just one income earner."They're unconnected potential revenue streams," Fairley says.It also licenses its technology out and collects the royalties, which avoids the need to raise large dollops of capital for every clinical trial.And it's smart enough to get the big drug companies in early."Our partners will fund our chemists' time while they work on the project," Fairley says.It also means the expense of commercialising a drug is borne by the partner, while Starpharma collects the royalties.Those partners include the biggest drug companies in the world.Condom manufacturer Durex has just been signed up, as well as Okamoto, the biggest supplier of prophylactics in Japan.Like all small biotech companies, though, Starpharma burns up cash.It is losing almost $4 million a year but is well capitalised, Fairley says, ruling out an imminent capital raising.And at least its clinical trials are in the US, so they have been made cheaper by the stronger dollar.The stock trades at about $1.50 but analysts say it is worth between $2.30 and $3.69, based on the latest clinical trial results.As an aside, in the small world of biotechs where everybody knows what everybody else is doing, Fairley says QRxPharma, Acrux, Pharmaxis and Metablast are "very interesting".