May 20, 2004
Biotech's Dismal Bottom
As Scientists Search for Cures, They Gobble
Investor Cash; A Handful Hit the Jackpot
'The Ultimate Roulette Game'
By DAVID P.
Since the first biotechnology company went public a quarter-century ago, stock-market investors have put somewhere close to $100 billion into the industry.
The results so far: More than a hundred new drugs and vaccines, several hundred million people helped by biotech medicines -- and cumulative net losses of more than $40 billion for the industry's public companies.
Biotechnology, which harnesses the science of genetics to develop medicines, may yet turn into an engine of economic growth and cure deadly diseases. But it's hard to argue that it's a good investment. Not only has the biotech industry yielded negative financial returns for decades, it generally digs its hole deeper every year.
This often gets lost during periodic bursts of enthusiasm for biotech, one of which is under way right now. After a three-year slump, biotech companies raised $1.5 billion from new stock offerings in the first quarter of 2004, almost three times the level of a year earlier.
The buzz surrounding these stocks reflects the unusual role that biotech has come to play in finance and medicine: a casino that sends capital to otherwise neglected high-risk corners of research -- and rewards a very few with huge paydays.
Home runs in biotechnology are scarce, but they can be lucrative. A $1,000 investment in Amgen Inc. at its initial offering in 1983 would now be worth almost $150,000. During a brief biotech-stock bubble in 1999 and 2000, a well-timed investment in unprofitable Human Genome Sciences Inc. could have yielded an 11-fold return in just eight months. The company's shares have since fallen almost 90% and in 2003 it posted a net loss of more than $185 million.
"Biotechnology is the people's lottery," says Thomas Eadington, a medical-technology entrepreneur turned investor in Newport Beach, Calif. "It's like the ultimate roulette game. If you hit it, the returns are astronomical."
A few biotechnology companies have achieved undeniable success. Amgen, the most successful biotech to date, earned $2.3 billion in net profit last year. Its nearest rival, Genentech Inc., earned $563 million. Overall, however, publicly traded biotech companies in the U.S. posted a net loss of $3.2 billion in 2003, thanks to vast research and development spending.
The biotech industry traces its origins to the mid-1970s, when Genentech created a scientific sensation by splicing genes into bacteria to produce human proteins. Since then, the term biotech has generally referred to such "genetic engineering." Scientists insert a stretch of synthetic or human-derived DNA into living cells, which then interpret that genetic code and produce large amounts of a protein useful in treating diseases.
Enormous investments in biotech have made possible the industry's medical breakthroughs. These include proteins that help the blood clot -- a boon for hemophiliacs -- as well as new cancer drugs that take specific aim at tumor cells and gene-based diagnostic tests for the AIDS virus. The Biotechnology Industry Organization counts more than 155 such advances approved by the Food and Drug Administration, 70% of them in just the past six years.
Every success, however, is accompanied by far more failures. Since it is almost impossible to tell which of the thousands of promising ideas will turn into a hit, the losers of the biotech lottery effectively fund the windfalls of the handful of lucky winners.
In other industries, much smaller losses have raised investors' hackles. Shortly after his investment in USAir went south in the early 1990s, Warren Buffett famously castigated the airline industry for squandering investors' money and joked that capitalism would be better off if someone had shot down Wilbur Wright's first flight. "The net return to owners from being in the entire airline industry, if you owned it all, and if you put up all this money, is less than zero," Mr. Buffett, the chairman of Berkshire Hathaway Inc., said at the time.
Overall, airlines accumulated a net loss of $5 billion from 1947 to 2003. Publicly traded biotechnology companies in the U.S. lost $41 billion from 1990 to 2003, according to Ernst & Young LLC.
Biotechnology research spending now consumes roughly $18 billion a year, more than the federal National Institutes of Health spends on heart disease, cancer and infectious disease, and close to two-thirds of the pharmaceutical industry's research spending. Taxpayers fund the NIH, while buyers of profitable prescription drugs pay for the billions that companies such as Merck & Co. and Pfizer Inc. plow into research.
The primary driver of biotechnology research, by contrast, is the apparently boundless optimism of investors. Biotech's mostly small, research-driven start-ups can spend years on basic-science studies before they even start testing a drug, yet investors nurture hopes of huge rewards far in the future.
The biotechnology industry also draws financial support from venture capitalists and drug-industry partners seeking access to promising experimental drugs. But in most years it raises far more from share offerings. Even venture-capital investments are tied to stock-market sentiment, since venture capitalists ultimately hope to take profits by publicly offering the shares of the start-ups they fund.
In 2003, U.S. biotechnology firms raised almost $4 billion by selling new stock issues to institutional and individual investors, according to Burrill & Co., a San Francisco investment bank that specializes in life sciences. The same year, U.S. biotechs as a group managed to post almost that much in aggregate net losses. Only 12 of the 50 largest biotechs, measured by market capitalization, turned a profit in 2003.
The industry's losses have generally grown larger over time, despite occasional years such as 2003 when they narrow. One reason: The success of companies like Amgen and Genentech draws attention to biotech, leading to the founding and public listing of more and more money-losing concerns.
Fourteen years ago, net losses at the 194 U.S. biotechs then listed publicly amounted to $900 million, according to Ernst's figures. In 2003, 314 public companies in the U.S. racked up total losses of $3.2 billion. That was better than the $9.4 billion total loss in 2002, when Ernst says merger- and restructuring-related accounting charges made losses unusually large.
S.G. Cowen Vice Chairman Stelios Papadopoulos, a biophysicist turned investment banker, has maintained an index of biotech stocks weighted by market capitalization since 1981, shortly after the first biotech companies went public. Had it been possible to buy shares in his index back in January of that year, every dollar invested would have been worth $7.92 by the end of 2003.
By contrast, a dollar's worth of the Dow Jones Industrial Average in 1981, with dividends reinvested, would have grown to $20.78 over the same period. Sunk into 20-year Treasury bonds with the proceeds reinvested, that dollar would have been worth $11.94, according to Ibbotson Associates, a Chicago investment-research firm. No biotech has ever paid a regular cash dividend, Dr. Papadopoulos says, although some have occasionally made one-time cash distributions. Such payments shouldn't affect the comparison, he says.
Almost one-sixth of the more than 350 U.S. biotechs that have gone public over the past two decades either were bought out for pennies on the dollar, dissolved themselves or had filed for bankruptcy protection by the end of 2003. Names that once raised hopes of medical miracles are now forgotten: Escagenetics, Advanced Tissue Sciences, ImmuLogic, Gliatech.
These are the headstones in a graveyard of investors' dreams. Early in the industry's history, biotech pioneers argued that genetic engineering could cut short the years-long testing process that traditional pharmaceuticals must go through. Since biotech drugs are often versions of the body's own proteins, the thinking was that they'd sail through safety tests. That didn't turn out to be the case, and these days genetically engineered medications generally take 10 to 15 years to win approval, much the same as other drugs.
A decade later, drugs made from bioengineered antibodies were touted as potential magic bullets against cancer and other diseases. Such antibodies have only come into general medical use within the past five years or so.
By the turn of the millennium, the deciphering of the complete human genetic code or genome appeared to herald a new age of treatments personalized for individual genetic differences. This sparked an astonishing 170% rise in biotech stock prices in just four months -- followed by a steep crash over the next year. Four years later, such treatments are still mostly hypothetical.
Biotechnology companies are essentially research and fund-raising machines devoted to selling their scientific and medical "story" to investors and spending the resulting cash on laboratory studies and clinical testing. Some companies survive as long as two decades on investors' largesse without developing a revenue-producing drug. Like the dot-coms that populated the landscape during the late 1990s, the vast majority of biotechs have neither profits nor meaningful revenue and no guarantee they'll ever have either.
To biotech enthusiasts, that merely underscores the need for investors to have patience. "Amgen and Genentech are just the first ones to finish the race. They hold the promise of what so many of these companies could become," says Laurence Bleicher, an analyst for portfolio managers at Marsico Capital Management LLC.
Ernst analyst Scott Morrison believes that biotech as a whole might be profitable as early as 2008, although that prediction omits many generally accepted accounting charges, assumes further consolidation in the industry and doesn't take into account any future moves to control health-care costs by limiting payments for high-priced biotech drugs.
Biotech stocks are tremendously volatile because they are so often driven by speculation about the unknowable. Investors chase scientific fads but drop a company instantly at word of bad news. When La Jolla Pharmaceutical Co.'s lupus drug failed to demonstrate efficacy in a trial last year, its shares fell 72% in a day.
The reverse is also true: Genentech shares soared 45% one day in May 2003 when a tumor drug called Avastin showed surprising efficacy against colon cancer. The company's shares have more than tripled since that announcement, adding almost $40 billion to Genentech's market capitalization despite warnings by skeptics that future Avastin sales can't possibly justify the increase. Genentech insiders have been steadily exercising and cashing out stock options since last May.
Bankers such as Dr. Papadopoulos suggest that such rapid stock-price moves are themselves a primary reason to consider biotech investing. Since few investors buy biotech index funds or invest across the entire industry, he argues, industrywide returns are beside the point. Instead, investors look for good opportunities to pick winners in the short term. "If not for the volatility of the sector, there wouldn't be a sector," he says.
Ned Davis Research Inc., a Venice, Fla., firm that advises institutional investors, calculates that over the past decade, shares of smaller biotechs experienced more rapid ups and downs than all but four other sectors -- Internet software, computer chips, and chip-making and networking equipment. Shares of larger biotechs were less volatile but still bounced more than those of gold-mining and airline companies.
Some individual investors say they're perfectly satisfied with that. "Biotech for me, really, is speculation -- it's high risk, high reward," says Tom Jacobs, a biotechnology investor and until recently a senior analyst for the Motley Fool online stock-information board. "I love this stuff."
Biotechnology executives have become adept at turning the market's mood swings to their advantage. Despite their individual volatility, biotech stocks tend to move up and down as a group -- a trend illustrated most vividly during the 1999-2000 bubble, when the entire sector shot up on excitement related to the sequencing of the human genome even though most companies did little business in that area.
When biotech stock prices pick up, as they have since mid-2003, companies rush to the markets with fresh stock offerings. Industry executives like to repeat a maxim often attributed to George Rathmann, Amgen's first chief executive: Take the hors d'oeuvres while they're passing the tray, not just when you're hungry. (Mr. Rathmann says he didn't coin the maxim, although he often uses it.)
Such stampedes often glut the market with new shares, triggering a general decline in biotech stocks and the start of the next cycle. Since last November, 22 biotechs have issued shares to the public and another 21 are waiting in the wings, according to Recombinant Capital, a Walnut Creek, Calif., research firm. Some analysts suggest the long line is a signal that biotech shares have peaked.
But many biotech investors are determined to hang on for the ride. Says Mr. Eadington, the Newport Beach, Calif., investor: "I like the odds here better than in Vegas."
Write to David P. Hamilton at email@example.com
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