Playing in Biotech -- A Primer

Investing in biotech stocks is a lot like investing in small-cap mining stocks or Silicon Valley startups. You have to kiss a lot of investment frogs before you find your "Prince" Google (GOOG) or Facebook.

If the original California gold rush was led by miners with picks and shovels, the biotech "gold rush" of the 1980s was more about Stanford and University of California, Berkeley scientists poring over test tubes in white lab coats. Founded in 1976, San Francisco's Genentech -- now owned by Roche -- was the industry's poster child, attracting a flood of "me-too" imitators.

But it turned out that biotech was a lot more hit-and-miss than investors had first thought. Having been burned by dozens of investments that went south, investors never regained the enthusiasm for biotech that they had in the 1990s.

That all is all set to change.

The big new factor that may influence biotech investing in the future is DNA sequencing. A handful of biotech stocks, such as Life Technologies (LIFE)and Illumina (ILMN), are on the cutting edge of this trend.

It's no secret that Big Pharma has had a rough past few years. If you've held on to Pfizer (PFE)for the past decade, you've reaped a decent dividend -- but your stock is worth less (in nominal terms) than it was on Jan. 1, 2000.

That's because Big Pharma is saddled by two problems: the rise of generics and finding new drugs.

First, since the mid-1980s, generics have been able to move into Big Pharma's territory on expiration of patents. Today, Big Pharma's drug developers have only about 20 years to earn as much as they can before they are undercut by generic firms. The GlaxoSmithKline (GSK) chief executive, Andrew Witty, has called the problem a "patent cliff" -- $51 billion in patents are set to expire between 2011 and 2015 alone.

As for the second problem, first-generation medicines, such as antibiotics and beta-blockers to treat high blood pressure, were the low-hanging fruit of the industry. Diseases of the young -- such as polio -- were relatively easy to defeat. But diseases of old age, such as cancer and heart problems, are a much tougher and more expensive nut to crack.

Here are three top factors you need to pay attention to when investing in biotech stocks:

Takeover Activity: The strategy of Big Pharma is being driven by one fundamental dynamic: It's much cheaper for a large company to acquire a potential "blockbuster" through a buyout rather than it is to spend years on research and plow through the Food and Drug Administration's bureaucracy. Think of biotech as the outsourced venture capital industry for Big Pharma. As with venture capital, if you win, you can win big.

New Product Pipeline: Biotech companies often invest heavily in research and development of products.

But, as with the portfolio of a venture capitalist in Silicon Valley, more drugs end up being more Pets.com than Google. That also means investors rely on a few "home run" products to make money. The low batting average doesn't make the stories any less seductive. In July 2009, Human Genome Sciences (HSGI) surged more than 450% in a week after its lupus drug, Benlysta, showed late-stage success in a clinical trial.

Regulatory Environment: Patent protection and intellectual-property rights are at the core of the biotech industry. Any change in the laws could change the outlook for the entire industry overnight. Regulators are also imposing ever more strict, and costly, testing procedures. Today, it takes 15 years to get a drug approved. A global launch costs $2 billion -- up from $150 million 20 years ago.

How to Play the Biotech Investment Game

There are two ways you can engage in this sector.

First, focus like a laser in the sector and bet big on a single stock. Then wait for your ship to come in.

Second, buy a diversified ETF that invests across the range of "lottery tickets." You won't make 90% overnight, but at least you'll sleep a lot better.

Here, I'll focus on three biotech ETFs that vary greatly in terms of both holdings and weightings.

iShares Nasdaq Biotechnology (IBB)casts the widest net across the industry, with 130 holdings. It actually is less volatile than the S&P 500, and weighted heavily in favor of large-cap, stable healthcare giants, including Amgen (AMGN), Teva (TEVA) and Gilead Sciences (GILD). This is your best bet if you are a conservative investor.

SPDR S&P Biotech ETF (XBI)invests equally across 48 biotech companies. The fund holds an equal number of large companies and small companies. That means both higher risks and higher rewards.

First Trust NYSE Arca Biotechnology IndexFund (FBT) tracks an equal-weighted index of 20 biotechs. The combination of its equal-weight strategy and its preference for smaller companies has made it the top-performing biotech ETF.

At the time of publication, Vardy had no positions in the stocks mentioned.