Should you invest in... the biotech business?

IF YOU are an investor looking for a "frontier market", you do not have to stray far from home. For those research-based companies at the cutting edge of technological development will give you a rollercoaster ride for your money every bit as exciting, and fraught with risk, as any emerging market.

Chief among these high- risk enterprises are the biotechnology stocks, those companies whose raison d'etre is to develop new products and processes through biochemical research and whose success or failure is often dependent upon their ability to develop and market a single new drug.

"There are very few biotech stocks that we look at, because the companies are so tiny and it has been an awful subsector to be in," says Jeremy Batstone of NatWest Stockbrokers. "It is an unloved sector which has seen a lot of disappointments, the most high profile of which was British Biotech."

In contrast to the outperformance of their bigger counterparts in the pharmaceutical companies, the small biotech sector has been suffering. Mark Mathias, marketing director of Finsbury Asset management,says: "Biotech shares have been complete dogs for two years. There have been some celebrated cases of bad management, which led to a bad press for the sector, which has depressed sentiment."

Glenn Meyer of Pavilion Asset Management says: "You have to adopt a portfolio approach to the biotech sector. Investing in individual biotech companies should be left to the specialists."

Lesley Buckett of Hill Samuel Asset Management says: "They are mainly very small cap stocks. The private investor would have to buy a lot of them to make an impact and the best way would be to have a portfolio via something like an investment trust. People who specialise in looking only at these stocks get it wrong, so what chance does the individual have? You are dealing with `blue sky' research, and how do you know that these scientists are actually going to come up with anything?"

Jeremy Batstone adds: "The trouble with biotech stocks is that they have had their glory days. Two or three years ago, when British Biotech's `wonder drug' was starting trials, these stocks were racing away and standing on ridiculous multiples. But as they have no earnings you can't properly rate companies like that - British Biotech was almost in the FTSE 100 at one point and hadn't actually produced anything. Now you can really see the wood for the trees and there isn't much of either."

Lesley Buckett says: "Biotech stocks were very lowly rated, then got very highly rated very quickly, as things like British Biotech began to take off. The pharmaceutical sector is a large part of the market, but that is on the basis of three very large stocks. The biotech companies have become even smaller with the derating they have experienced over the past couple of years."

Much of the problems associated with the sector have stemmed from long lead time. Mark Mathias says: "The underlying businesses take cash at the outset, then there is a long period when nothing seems to be happening because they are in the laboratory coming up with the drugs. So there was no news coming out of the biotechs, then bad news because of British Biotech and other bad management situations. Now positive news is coming through."

Jeremy Batstone says: "A company will build up market expectation of finding a cure for cancer or whatever, then let you down in a big way when you find it doesn't work. It means taking giant leaps of faith." Lesley Buckett says: "Ratings have become more sensible and you are beginning to see the same sort of cycle you see in the US. But these companies burn cash at an enormous rate. They will all need refinancing at some point."

When it does work, the rewards can be enormous and the best evidence comes from America. Mathias adds: "Biotech companies make profits by doing deals. There are 21 biotech companies in the US representing a total of $1.5bn (pounds 940m) in profits and this figures is going to rise to $2.5bn by the end of 2000. And they are available on an average p/e of 25 times earnings, which is reasonable.Some companies, like Powderject Pharmaceuticals, have developed world-leading technologies, although in this case it is a delivery system rather than an actual drug. SkyePharma is a company with successful technology, as is Chiroscience."

Jeremy Batstone says: "You have to consider how they are going to sell these drugs. Have they got marketing power? Chiroscience had a deal with Zeneca to market a drug, then after the Zeneca-Astra dealChiroscience was out in the cold, because Astra had a similar drug and didn't want a third party involved."