Although we are still technically in a bear market for early-stage biotechnology due to lack of speculative funding from both VC’s and investment banks syndicating IPO’s, many public companies have been doing well. As a result we have a more bifurcated market with larger caps stable or growing and smaller caps in a funk. Nonetheless there is plenty of money on the sidelines that will drive stocks of companies with compelling products and technology. At the recent Rodman and Renshaw Investment Conference in November of 2009  the buzzword was “cash runway” as smaller cap companies with weak balance sheets need to retrench until new money comes back into the market. Nonetheless, Rodman continues to fund PIPES in the biotechnology sector as technology is progressing and deals are being done. Negative articles and “hand wringing” abound in the biotech market citing clinical trial failures, political concerns, a dearth of funding and a “breakdown of the business model." But these critics miss the point: the universe of companies and universities in the biomedical sector are trading and investing in R&D programs that result in drugs, diagnostics and services with the objective of improving healthcare. Yes R&D may be becoming less efficient with fewer drug approvals (only 18 in 2008) and costs are increasing but the market will always be there because of growing demand from consumers and the core engine -NIH and university research. Healthcare spending grew at 6% in 2007 for a total of $2.2 Trillion and that is the available market for innovation with improved products and services that cut costs or improve quality of life. And the core driver is the “food chain” effect where licensing and acquisitions make the market until capital markets revive. Politics as Usual I recently commented on the political backdrop for healthcare. It may be an investment opportunity for niche companies focused in areas where they are  partnering with larger pharmaceutical companies. National health care will be a focus and expect any proposals to try to find money in the 20% share of the insurance companies’ take. The dems are likely to be tougher on blockbuster drug pricing and big pharma because that is where the government spending looms large. The Medicare Drug benefit costs $47.6B in 2007. Overall the political environment should favor biotech as the NIH $28B research budget should be expanded with new champions (Eric Lander and Harold Varmus) and stem cell research controls are lessened. A 10% return should be achievable with a diversified portfolio with a weighting toward large caps and mid caps with strong balance sheets. Balance out the portfolio with niche themes by adding positions in generics, diagnostics, IT and tools. Politics will not have a negative impact and in fact should be favorable for life science research. Some overhang is expected from the credit crunch but there is plenty of money on the sidelines and little else to do with it. My investing model as in previous years is to have a balanced portfolio but to be opportunistic with speculative small caps when momentum returns. Small and mid caps were more beaten up than large caps so well funded companies should make a comeback. I have also added more diversification outside biopharma with tools and Dx than in previous years to reflect their increasing importance in drug discovery and targeting therapy. Below is a suggested allocation for those who want exposure to the biotech sector.

Allocation of funds

60% in large cap biotechs and ETF’s:

If there is market strength in biotech the top tier will do well. Moreover there is less risk as biotech is deemed a defensive growth replacing large cap pharma which is languishing due to slower sales growth, a generic threat for blockbusters and ongoing FED litigation due to improper marketing practices. 25% in XBI, 10% in IBB, 25% in large caps: Amgen (AMGN), Biogen Idec (BIIB), Cephalon (CEPH), Genentech (DNA), Gilead (GILD)

25% in mid-caps:

Auxilium Pharma (AUXL),  Cubist Pharma (CBST), Isis Pharma, (ISIS) Regneron (REGN), Seattle Genetics (SGEN), United Therapeutics (UTHR),  ViroPhaarma (VPHM)

10% in Devices, Diagnostics and Tools

• Abaxis (ABAX): $100M+ Dx Co. in human and veterinary IVD’s; good balance sheet
• Celera (CRA): Celera morphed into “personalized disease management”-stock is stalled
• GenProbe (GPRO): $500M+ leader in nucleic acid tests for infectious disease
• Hologic (HOLX) Hologic -- diverse product line
• Illumina (ILMN): Premier SNP array player in buying range
• Inverness (IMA): Inverness.

5% or more in speculative value

(10% for aggressive position taken out of Mid Caps) Stocks to avoid Look for these flags: less than 15 mos. of cash, broken down charts with no January recovery, stock price under a dollar. Also look at retained earnings to see how much investment was made in the Company since inception compared to current enterprise value.

Market Dynamics

Other than the large caps the market is currently skewed toward traders so investors should be aware of seasonality and volatility that masks long term trends. Despite other opinions my experience is that Q1 is not the best time to add new positions but Q3 is a better window because you can position yourself for a stronger Q4. Moreover an early Q1 rally can be over by Feb 15. The retail trade, sell side and investment banks are not major participants as in previous years so hedge funds and institutional investors are the significant drivers of stock performance. Detailed research reports on the healthcare industry and specific opinions on biotechnology companies are available from emerging players such Leerink Swann and Rodman & Renshaw. Rod Raynovich, a contributor to The Rayno Report, is the principal at Raygent Associates (www.raygent.com), a biotech investment consultancy.