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Biotech Investing for the Long Haul

Three ways to separate long-term winners from stocks that fizzle.

Karen Andersen, 02/27/2006

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Many believe it takes guts to invest in biotechnology. Like any cutting-edge industry, huge potential upside mingles with potential disaster. Shares of Irish biotech Elan ELN dropped 70% in one day last year after the company and its partner Biogen-Idec BIIB removed their new drug Tysabri from the market due to possible lethal side effects.

However, a quick glance at the 2005 performance of the Amex Biotechnology Index (BTK) shows that this basket of biotechs had an annual return north of 25%. How can individual investors tap into biotech's potential without being obligated to pounce on any bit of clinical data that dribbles out of a company?

Investor myopia makes the performance of many biotech stocks highly volatile. With a focus on short-term performance, investors regularly overreact to both positive and negative news, trading in and out of stocks in an attempt to get a big return when clinical trial results are announced. Here we suggest three key qualities to look for when selecting biotechs as long-term investments.

1. An Established Competitive Advantage

A diversified toolbox is the first clue to a biotech's competitive advantage. If a company only has the tools to create one type of drug, the range of applications for these drugs will be limited. Too much reliance on a given technology or therapeutic area also reduces a company's ability to adapt to future changes in the market. As competitive forces shift, technologies can become obsolete and markets that were previously highly profitable can become fiercely competitive. Many larger biotechnology companies such as Amgen AMGN have the tools to create the right type of drug, from recombinant proteins and antibodies to small molecules, for any therapeutic area they would like to tackle.

That said, there are a few established biotechs that have chosen to specialize in one therapeutic area and have managed to stay on top despite heaps of competition. Gilead's GILD competitive advantage stems from its ability to develop and market HIV drugs that dominate the field, despite the existence of 27 FDA-approved HIV antivirals. Even after Viread and Truvada were approved, the company continued to test these drugs against those of key competitors, gathering the strongest case possible for prescribing them over alternative therapies.

2. Attractive Fields of Research

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