Drugs are on a high, but will it last?

While world stock markets have been busy nose-diving over the past 18 months, many pharmaceutical, healthcare and biotechnology companies have been enjoying much better fortunes. In the UK, the FTSE 350 Pharma and Biotech Index is up by about 7 per cent over the past year – during which period the overall FTSE 350 index has fallen by more than 28 per cent.

Meanwhile, the professional fund managers have performed even better. Franklin Templeton's biotechnology fund, for example, has risen by more than 35 per cent, while even the worst-performing healthcare fund has managed to generate a positive return – no mean feat in these markets.

But these figures don't tell the whole story. While biotechnology and pharmaceutical companies may seem, to the untrained eye, like the same thing, they are in fact very different businesses. Furthermore, the success stories of each of these sectors have been driven by very different factors – and the future prospects for each of them are very different, too.

Pharmaceuticals

According to Felix Wintle, the manager of Neptune Investment Management's US Opportunities fund, the difference between traditional pharmaceutical and biotech companies comes down to the way that they develop their drugs. "Pharma companies make drugs out of chemicals," explains Wintle, "while biotech companies make drugs out of biological components, such as antibodies and proteins."

Although many pharmaceutical firms have begun to work in the biotech arena, or have acquired biotech companies, this distinction broadly still stands.

When the dark clouds of recession began to gather last year, pharmaceutical companies performed relatively well as investors saw them as a comparatively safe place to put their money. Most pharma companies are very large and well capitalised, and pay steady dividends.

But many of these stocks rose too far too fast, and in recent months, investors have been left to face up to the fact that there is not much growth in these businesses – hence share prices have fallen back again. While many of these companies own popular and profitable drugs, Wintle says that their research and development pipelines have been poor – meaning that there is not much hope for any major growth in the near future. He adds that most pharma companies are so large that they need a massive shot in the arm if investors are going to be impressed. Small acquisitions, or the successful development of new niche drugs, often succeed only in helping these companies' share prices to stand still.

Andy Smith, the manager of the Axa Framlington Biotechnology fund, says that the biggest problem faced by many pharmaceutical companies is that the patents on some of their biggest drugs are set to expire within the next few years. For example, Pfizer's Lipator – a treatment for people with high cholesterol – is one of the biggest-selling drugs in the world, but it has a patent which is due to expire in two years' time. Lipator is worth £7bn a year in sales to the company, a figure that will quickly be eroded once competitors come into the market in 2011.

So is the pharma sector worth investing in at all? Wintle – who has 14 per cent of his US fund in pharmaceutical, healthcare and biotech stocks – holds just two pharmaceutical companies: Pfizer and GlaxoSmithKline. But he concedes that he holds these more for their defensive qualities, as well as because they are relatively cheaply valued at the moment. In the longer run, he concedes, he has reservations about the prospects for the sector.

Biotechnology

The biotech sector, however, offers a very different proposition. Although there are hundreds of small biotech companies around the world, many of which are on the verge of going bust, this is a sector that has the potential to make investors a lot of money if they can pick the right stocks.

Smith says there are two main reasons why his fund – which has returned almost 30 per cent over the past year – has done so well. The first is simply the strengthening of the US dollar, which moved from over $2 to the pound to less than £1.40 to the pound during the second half of last year. It currently stands at about $1.45.

But the second reason Smith cites for the success of his fund is an increase in mergers and acquisitions across the sector. "Last July, we had four companies announce that they were going to be acquired in a month – a small-cap German firm, a small-cap British company and two US small-cap companies," he says. "Then, this January, we saw three more acquisitions."

Smith says that one of the drivers behind the increase in acquisitions has been pharmaceutical companies desperately trying to snap up new, profitable drugs ahead of the expiration of their major patents – and he says that this trend is likely to continue.

He adds that another reason more biotech companies are being acquired is that many more are now profitable. "In the past, you might have bought a company that had a product in development," he explains. "But, these days, you can buy biotech companies that are already profitable."

Wintle agrees with this view. "Five or six years ago, there would have been just a handful of profitable biotech companies; no more than five," he says. "Now, there are about 30 profitable biotech companies in the US, out of about 300 listed stocks."

But Wintle believes that it is not just mergers and acquisitions that have generated the recent success in the biotech sector. He claims that Genentech's development of a new cancer drug, Avastin, a few years ago was a turning point for the sector. This drug works using "anti angiogenesis", which starves a tumour of the nutrients it needs and cuts off the blood supply to it. The benefit over chemotherapy is that it doesn't diminish the patient's immune system at the same time. Earlier this month, Roche – one of the world's biggest pharmaceutical companies – bought Genentech for $47bn (£32bn).

Another transformational drug was the HIV treatment developed by Giliad Sciences a few years ago. While Glaxo invented an anti-HIV drug called AZT in the 1980s, this required patients to take a combination of around 20 tablets in total. Giliad leaves patients with just one pill to take.

Smith says this is one of the companies in his portfolio – and adds that, from a commercial perspective, HIV drugs are a good investment as patients need to take them for the rest of their lives.

Another of Smith's favourites is the British company Vectura, which is yet to turn a profit but has a major drug in late-stage development and has plenty of cash on its balance sheet.

Smith says that, when looking at which biotech firms to invest in, he won't go for any firms that have less than a year's worth of money – and would preferably like to see 18 months' worth. In the current difficult economic environment, small and unprofitable biotech companies can find it very difficult to refinance once they run out of cash, and many will go bust over the next year.

For this reason, if you are looking to invest funds in the biotech sector, it makes sense to buy a fund that is managed by a specialist. Buying individual stocks can be a highly risky strategy.

Health strategy: How to inject your funds

The best way to get exposure to the biotech or pharmaceutical sectors is by investing in unit trusts, investment trusts or open-ended investment companies (Oeics). There are five open-ended funds and three investment trusts that specialise in these areas – investing only in biotech stocks or pharma stocks, or a combination of the two. Some also invest in the broader healthcare sector, which includes drug distribution companies and the manufacturers of medical devices.

Darius McDermott of the financial advisers Chelsea Financial Services says that investors looking for targeted exposure to the sector could consider either Axa Framlington's Biotech Fund or the Axa Framlington Health Fund. However, he warns that these funds have a 10 out of 10 risk rating, and he cautions investors about allocating any more than 5 per cent of their portfolio to one of these funds.

If you want some exposure to the sector but don't want to go as far as buying a specialist fund, you could opt for a more general fund that has a biotech and pharma sector bias. Alan Adam, an adviser at Alan Steel Asset Management, recommends Neptune US Opportunities, which currently has about 14 per cent in healthcare, pharma and biotech stocks.

"We would advise people against investing in specialist funds," Adam says. "If the sector becomes no longer the place to be, in a specialist fund the manager has nowhere to go, whereas a manager running a generalist US fund can move into other sectors."

Unless you are an experienced investor, it is well worth taking professional financial advice before committing any money into the sector. To find an independent financial adviser in your area, visit www.unbiased.co.uk.