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Biotech: Core and Explore

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Giant pharmaceutical companies are looking for the next big drug, and so are much smaller biotech outfits. Because of the methods they use, biotechs are often at the leading edge of research. This, combined with the small size of many of the companies in this space, means the potential for investors to hit home runs. However, it also opens up the possibility for a lot of strike outs. Investors interested in the drug space should consider owning biotechs, but would do well to use a core and explore approach.

Biotech Versus Pharmaceutical Company
Drugs are an increasingly important aspect of everyday life. With the aging of the Baby Boomers, drug use is only going to increase. The next big drug, however, isn't going to show up out of thin air. That means that companies big and small are going to be looking for it.

The major pharmaceutical companies spend hundreds of millions of dollars on this endeavor, focusing on manipulating chemicals into useful compounds. Many of these companies are household names, like Dow-30 members Merck (MRK) and Pfizer (PFE). These companies are massive entities that have large collections of businesses generating revenue to support their research efforts. These are the companies most investors think of when they consider drugs.

There is another avenue to the creation of drugs, however. The Biotechnology Industry Organization explains that biotechnology “harnesses cellular and biomolecular processes to develop technologies and products that help improve our lives and the health of our planet.” In other words, what biotech companies create comes from living organisms.

It is a unique approach and one that many would suggest we haven't even begun to fully tap. For example, the rainforests of the world are home to many species of animals and plants that we've never even seen. The opportunities to find novel drugs via biotechnology is immense. 

The Core
There is really only one truly large biotech company out there, Amgen (NASDAQ: AMGN). Luckily for investors, Amgen happens to be a well-run and financially sound company. In an industry known for volatility, Amgen is a relative safe haven. It even initiated a dividend in 2012, lending further credence to its status as the 800-pound gorilla of biotech. That said, some investors may believe that the company's size and new dividend are evidence that Amgen isn't a growth company anymore.

While it will likely be hard for the company to grow as quickly as it once did, it hasn't stopped innovating. In fact, it currently has eight drugs in late stage development, including treatments for postmenopausal osteoporosis, gastric and ovarian cancers, acute lymphoblastic leukemia, and psoriasis.  Some of these ailments are likely to be increasingly common as the baby boomers continue to age, making them great candidates to pick up the slack when biosimilars (the equivalent of generic drugs) of Amgen's existing blockbusters are allowed on the market.

The company's focus is on cancer care, inflammation, and nephrology (kidney related diseases). Its big drugs are Neulasta, NEUPOGEN, Enbrel, Aranesp, and EPOGEN, which together account for more than 80% of the company's revenues. It isn't uncommon for such concentration in the drug space, however, and having five material products is actually quite an impressive feat in the biotech area.

One of the nice features of Amgen is its size and financial strength. Indeed, it is large enough to fairly easily buy small biotech outfits with interesting drug candidates. For example, the company recently agreed to acquire deCODE Genetics in a $415 million all-cash deal. The company's technology should help Amgen find disease targets.

All of these factors make Amgen a great core holding to which one can add more speculative holdings that might turn into home runs.

An Explore “Don't”
The “explore” section of a biotech core and explore portfolio is going to take a lot more work to track than Amgen. While a small biotech company with only one product can turn into a real winner if its drug candidate is a success, it can also lead to years of volatility until that happens or, worse, an outright washout if its drug fails.

Even a successful drug, however, doesn't mean a biotech company is worth the risk. For example, Alexion Pharmaceuticals' (NASDAQ: ALXN) highly successful Soliris has accounted for virtually all of the company's revenue since it was approved for use in 2007. The company has used the profits from that drug to support its research and development efforts, which is a clear positive. The company is currently focusing its efforts on asfotase alfa, TT30, cPMP replacement therapy, and ALXN1007.

On the surface, this sounds like an ideal situation, the new drugs are potentially several years away from market but Soliris sales should continue to support the research effort. Even more so if the company wins approval for Soliris to treat additional ailments. When, and if, any of the company's research candidates are successful, Alexion would wind up an even bigger winner. The problem is that the market has bid the shares up aggressively over the last three years.

data by YCharts

With a recent P/E in the 80s, an over 300% price run up in just three years, and only one drug on the market, Alexion is probably overpriced. Investors would be better off avoiding this as one of their satellite holdings until its shares come down from the stratosphere or its earnings catch up with its share price. Until then, the downside risk heavily outweighs the possibility of a home run.

An Explore “Do”
Exelixis (NASDAQ: EXEL), on the other hand, is typical of a small biotech company that hasn't hit the mainstream just yet. Its shares are trading at around $5, the company is losing money, and it’s got virtually all of its eggs in one basket as it attempts to bring COMETRIQ to market. The drug received approval in the United States for the treatment of progressive, metastatic medullary thyroid cancer in late 2012.

That market is relatively small, so even the company admits the approval isn't a game changing event. However, the drug appears to have a lot of potential. Exelixis is researching other indications for which the drug could be used, including prostate cancer, lung cancer, and liver cancer, among others.

data by YCharts

Having already gained approval for one indication, there's a good chance that more uses of COMETRIQ will be added. This could turn the drug into something of a franchise opportunity and quickly make Exelixis' top and bottom lines look much more appealing than they do today. This, then, would seem a better option for investors seeking a satellite to orbit Amgen, as Exelixis has lots of potential, a proven product, and, with a relatively low share price, the downside is limited.

Think of it as a Portfolio
Clearly you'll need to find more than one satellite to implement a core and explore approach. The goal would be to find a collection of companies with late stage drugs or drugs that have just been approved and have the potential to treat large or increasingly important audiences. Avoid companies whose shares have been bid up to inflated levels, since they will need to meet and exceed high expectations in order to maintain those heights. Overall, however, look at the core and explore technique as a portfolio and track it very closely in this exciting and often volatile space.

Yours,


ReubenGBrewer has no position in any stocks mentioned. The Motley Fool recommends Exelixis. The Motley Fool owns shares of Exelixis. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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