2008 GEN Wall Street RoundUp

It was a very good year

Rod Raynovich Final for GEN 1/9/2008

My biotech forecast of a 10% return was achieved in 2007 simply by purchasing the S&P ETF XBI which was up more than 25%with big winners such as BMRN, ALXN, CPHD.

My specific winners from last February’s 2007 issue were Alnylam (ALNY), Biogen-Idec (BIIB), Gilead (GILD), Cubist (CBST) Medimmune (MEDI), and Myriad Genetics (MYGN). Among my losers were Amgen (AMGN), Array (ARRY) and Genentech (DNA). Overall the portfolio mix I recommended with proper weighting would be up more than 10%. My performance significantly improved with August rebalancing by adding stocks such as Biomarin (BMRN), Isis (ISIS) and Seattle Genetics (SGEN). The biotechnology sector lived up to its reputation in 2007 by being volatile and contrarian. Many of the perennial outperformers -Amgen, Celgene, and Genentech -lagged and new leaders have surfaced. As I have reiterated in past articles it is important to be diversified as stockpicking in mid and small cap sectors is quite difficult due to clinical and regulatory issues. My index of 33 widely traded mid-cap biotech stocks was flat for the year with many losers of 35-45% due to poor clinical trial results. Broader based ETF’s such as IBB and PBE were up only 8-10% due to underperformance of smaller cap names. The BTK was up only 6%.

Among the mutual funds, Fidelity Select Biotech achieved below average returns of 3% with big losers such as AMGN, DNA and VRTX. The broader based Blackrock Healthcare Fund (MDHCX) was up 20% and the Janus Global Life Sciences Fund (JAGLX) was up over 20% including larger cap, more diversified holdings but with huge biotech winners such as MOGN, ONXX, and OSIP.

In summary a diversified biotechnology portfolio handily beat the S&P return of 3.5% and beat or equaled the NASDAQ return of 10%. The Russell 2000 mirrored the small and mid cap biotech risk with a negative return of 2%.

Despite the stock volatility and regulatory issues I expect that biotech and more broadly healthcare will again beat the S&P 500 in 2008 as stocks will continue to be driven by new products, M&A activity, technological breakthroughs and overall demand for new treatments. Any economic slowdown or political clouds should not have a significant macro effect on healthcare spending. Biotechnology will always attract capital despite the clinical trial risk because new therapies are in demand and the food chain effect will drive M&A “recombinations”.

FDA Stance-More data please

The outlook for 2008 must be hedged by the Regulatory risk. Political activism by both patients and industry may actually provoke an attitude adjustment at FDA. Many industry executives feel the FDA has become too conservative to the point of discouraging breakthrough therapies particularly for the cancer patient and other life threatening diseases. This overly cautious FDA position may have started with the recall of Vioxx, a widely prescribed drug for arthritic conditions and safety issues related to Avandia for treatment of diabetes but has been extended throughout the Regulatory process to include killer diseases like Cancer. For example recently a setback for Dendreon’s (DNDN) prostate cancer vaccine (See GEN Mar 1, 2007, Late Stage Cancer Vaccines) means that approval will be delayed another year as the FDA requested more efficacy data even though an FDA Advisory panel recommended approval. In general additional FDA data requests and protocol requirements means more clinical trials and limited growth in new product flow (only 17 ? approvals in 2007). The clinical risk plays heavily into mid-cap companies such as ARRY, a Company with a broad pipeline, strong partners and proprietary technology. In December Array announced poor results in a Phase II trial causing the stock to drop 40%.

Hot Sector Watch: Better Diagnostics =Faster, more targeted therapies

Beginning with the July 2008 AAAC Meeting in San Diego there was a huge rally in Diagnostic stocks (see also GEN Sep’06 Issue). Among the winners were:

• Abaxis (ABAX) Platform blood analysis systems for human and vet markets
• Cepheid (CPHD) Platform system for rapid molecular diagnostics; MRSA test launched
• GenProbe (GPRO) Molecular diagnostics
• Idexx (IDXX) Broad based supplier of veterinary products
• Inverness (IMA) Rapid tests for OTC and Professional markets
• Myriad Genetics (MYGN) Molecular diagnostics for cancer and emerging Rx pipeline

The diagnostics sector should do well again in 2008 although many of these stocks have run up considerably in 2H 2008. They are holds or should be bought on weakness. Drivers continue to be revenue growth and buyouts. Over this past year IMA has been an aggressive buyer, and Roche has an offer out to buy Ventana Medical (VMSI) currently trading at $90. Cepheid was the rocket of the group with a 3X appreciation and is a good example of institutional dominance. CRA should do well in 2008 after break-up from ABI.

Although the NIH Budget was flat for 2007 with $28.6B in funding it will remain a major driver of Life Science R&D. In future years with the DEMS in power, the NIH Budget should increase or at least to keep pace with inflation. When you add up all the NIH funding in universities with the ~$60B billion+ spent on drug and diagnostics R&D you have a perennial core funding model supporting secular growth unlike any other industry. The life science research tools and reagents market has also perked up recently (see IVGN up 50%) and a good value play is Harvard Bioscience (HBIO) trading at less than 2x sales. The HHD ETF (up 20% YTD) is a good proxy for larger caps in the sector but it is too new to recommend for investing.

Boutique Biotech-Smaller markets, lower clinical risk

Many biotech companies are evolving the “orphan” drug model pioneered by Genzyme to minimize competition and minimize potential regulatory issues. Development of blockbusters such as Lipitor, Nexium and EpoGen has become harder than ever because
of competition and these large markets mean greater FDA scrutiny of potential side effects. Biomarin is the latest winner in the boutique category with December’s FDA approval of Kuvan, their enzyme replacement therapy for PKU phenylketonuria, a genetic disorder. Pricing for these niche compounds can be aggressive with revenues of around $50k per year per patient. Expect to see more niche drugs for smaller disease through licensing and M&A.

Alzheimer’s Disease-More products at clinical stage

Alzheimer disease is one of the leading causes of illness and death and very expensive to treat affecting over 5 million Americans and costing about $150 B a year. The potential market for diagnosis and treatment is huge and growing but treatment breakthroughs have not been forthcoming. Experimental PET scans with a radioactive dye called PIB are being used to detect amyloid plaques in the brain, thought to be a cause of Alzheimer Disease. Genetic tests for APOE can also indicate risk level for the disease. Most drugs currently on the market only alleviate symptoms without treating underlying disease. Although beyond the scope of this article there are several companies that could show progress for treating Alzheimer and among them these companies have a good clinical pipeline:

• Elan (ELN)– Phase III Ab therapeutic (AAB-001) data due out this year with WYE; also in Ph.II with ELND005 that breaks down neurototoxic fibrils, with Transition (TTHI) as partner.
• Epix (EPIX)– Ph.II trial with PRX-03140 a small molecule 5-HT-4 receptor agonist stimulates production of acetylcholine showed “compelling results”; partnership with Glaxo (GSK).
• Myriad Genetics (MYGN)-Flurizan is a selective amyloid beta lowering agent (SALA) in a two Phase III trials for mild Alzheimer disease; Phase II results had a favorable response rate. (See above MYGN as a Dx play).

Institutional Ownership Rules

Hedge funds continue to be a driving force for stock performance. They do their homework and control their destiny with small and mid-caps. Most biotech stocks have a small float and that means the big players can move their favorite stocks. Sponsorship is thekey element to stock appreciation. The NASDAQ site provides recent quarter data on institutional holdings and the NASDAQ “Heat Map” chart show Daily strength and weakness.

Outlook for 2008-Pessimism is Prevalent

There is widespread gloom and doom forecasted for the economy and stocks in general
but healthcare companies are less affected by the housing market and consumer spending.
We can expect the health care area to capture an increasing share of investor funds. My expectation is that life science stocks will do as good if not better than 2007 so a 10% return is achievable with the right mix of stocks. The wild card for 2008 will be trading in stem cell stocks with scientific news developments such as the use of skin cells to bypass ESC’s (embryonic stem cells).

My investing model is a balanced portfolio with a core position in ETF’s and large caps. Only 25% of the portfolio should go into small and mid-caps.

25% in the S&P ETF XBI

I don’t know how S&P does it but they consistently outperform mutual funds and other ETF’s.

50% in large cap biotech and pharmaceuticals

I am going with a “Dogs of the Dow” type of strategy with these beaten-up large cap picks all of which are 2007 losers: AMGN, CELG, DNA and PFE Growth stocks that are core long term holds: ABT, BDX, BIIB, CEPH, ELN, GENZ, GILD. For greater large pharma weighting add XLV.

25% in Small and Mid-Cap life science and diagnostics:

ALNY, CBST, CRA, EPIX, ISIS, MATK, MYGN, SGENSGMO, VPHM

Speculative MicroCaps: GLGC (now ORXE), MITI, GNLB

Research Question: What are the worse biotech stocks over the past 25 years as measured by capital spent (net deficit) and stock performance. (Not related to revenues and profit) Send your answer to rod@rayno.com

Biotech stocks can be volatile so be mindful of seasonality and news hype. January frequently shows a top for small and mid cap but there are good buying opportunities in August for a Q4 rally (The Q4 rally didn’t happen in 2007, the rally was Aug.to Oct.) Look at chart patterns especially whether stocks hold up after news.