Bloomberg yesterday started the rumor-mill going that Sanofi-Aventis is on the prowl for a large biotech company, sending many biotech stocks higher on Friday (on a day in which the market is down).

The rumors make sense, as big pharma is constantly on the prowl for solid biotech companies. Let's take a look at the dynamics and which companies would be most attractive from a valuation standpoint. The three companies mentioned cited by Bloomberg as targets include Allergan (AGN), Biogen-Idec (BIIB), and Genzyme (GENZ).

The Wall Street Journal, trying to catch up with Bloomberg, has tossed in Amgen (AMGN), Gilead (GILD), and Celgene (CELG).

Let's take a closer look at all of these stocks to try to see who is the best bet. Biogen jumps out to me the most. Including the most recent quarterly results, Biogen is trading at a forward P/E of 10. It has an operating margin of 30%, return on equity of 16%, and has been growing at a 7% clip. The market cap is $13B.

  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.

A summer Biotech rally was sparked by deals. Life sciences stocks kept pace with market sectors that offer comparable risk and performance such as small-cap growth, science and technology, and midcap growth. The broadly diversified biotech ETF -- IBB -- was up 16%, moving from 70 to 81 in the three-month period. About 50% of the IBB holdings are large cap companies such as Amgen (AMGN), Celgene (CELG), Genzyme (GENZ), Gilead (GILD) and Teva (TEVA). The IBB was flat for the year as of July 1, so all the gains came in Q3. The Fidelity Select Biotech Fund was up 9.4% YTD and underperformed due to overweighting in large caps such as Cephalon (CEPH), Genzyme (GENZ), and Gilead (GILD). The fund was underweight in tools and diagnostics, where a lot of upside performance was found. The key drivers to biotech performance have not changed over the past few years, but M&A activity has come to the forefront as several acquisitions have sparked the sector: * Abbott announced a play to buy Solvay for $6.6B. * Bristol Myers completed the acquisition of Medarex for $2.4B * JNJ bought Cougar for $1B, 18% of Crucell for $441M, and 18% of Elan for $885M. * Sanofi bought Merial for $4B The vaccine area was almost entirely abandoned by large pharmaceutical companies in the 1980s, but now that area accounts for many of the deals. New immunotherapy technologies and a greater market need for disease prevention against new infectious agents such as swine flu has brought vaccines to the forefront. Building a long-term product pipeline has always been an arduous process for large-cap pharma companies, as it requires a development process of 7-10 years with costs in the range of $1B per drug and a high risk of failure. The acquisition route has become more attractive because of good technology value. The deal-making is helped by the fact that there is a shortage of capital for smaller biotech companies in the current post-meltdown market environment. Over the past few weeks, several analysts have rushed to put out their biotech acquisition lists spurring rallies across the screen. Another factor mentioned is that biotech products may be less affected by healthcare reform than more mature drugs. A Portfolio that we track -- The Rayno Life Science portfolio -- was up 13% YTD and higher for Q3.With higher weighting of selected stocks as we recommended, it could be up as high as 15%. The big winners in the portfolio with Sep 30 prices and in order of stock appreciation YTD: Targacept (TRGT): up 700% at 21.3 Abaxis (ABAX) up 65% at 26.75 Inverness (IMA) up 58% at 38.75 Illumina (ILMN) up 55% at 42.50 United Therapeutics (UTHR) up 45.5% at 49 Among the losers in the portfolio were Array BioPharma (ARRY), Celera (CRA), Cephalon, Cubist (CBST), Gilead (GILD), and Viropharma (VPHM). Cubist, Gilead, and Viropharma are now recovering. The results from life science stock performance YTD illustrate the following principles of biotech portfolio management: 1) It is important to overweight large caps to protect losses due to events and volatility. 2) Tools and Diagnostics companies provide good returns and excellent diversification without binary clinical trial risk . Some of these include Abaxis (ABAX), Illumina (ILMN), and Inverness (IMA). Those looking for speculative plays on beaten down tools stocks should look at taking profits in Illumina (ILMN) and buying Helicos (HLCS) and Sequenom (SQNM). 3.) Stock picking can be difficult with the smaller caps due to clinical trial risk so if you are going to invest in small caps, a larger pool of stocks is necessary. If the small-cap growth market holds up and we continue to get good news on clinical trials, the M&A backdrop should support higher biotechnology valuations. Contributing Analyst Rod Raynovich is the Principal of Raygent Associates, a biotech research and business development firm. Raygent Associates may be long or short stocks in the Rayno Life Science portfolio from time to time and as of this writing we are long CBST, GILD and VPHM.