The markets love biotechnology and its promise of ground-breaking drugs and ground-breaking profits. But promise is all it offers. The bubble may burst
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The Independent Online
In the little study under the eaves of Acorn Cottage in East Lockinge, Oxfordshire, Terry Bond is counting his profits. A semi-retired marketing man, Mr Bond began investing last summer in Stanford Rook - a small biotechnology company. Through ShareLink, a discount broker, he bought its shares when they were priced at 53p. Last week they were worth more than 10 times that amount, making him pounds 100,000 richer.

"They're on the verge of the next best thing to penicillin and I believe their shares will do twice as well as they have so far," he says. "I'm over the moon."

So is the City. Call most analysts in the sector and you will be bombarded with optimism, not just about Stanford Rook, but about biotechnology in general. The industry, they say, is still undervalued. These are growth stocks, with huge potential for profit. Sure, there are risks, but the further drugs travel along the development pipeline, the smaller those risks become.

Investors seem convinced, too. Since July, the Nomura Research International index of 17 UK biotech companies has risen almost three times as fast as the index for all small companies. "We are still finding that institutions and retail investors are prepared to commit money to the sector," says Nomura analyst Jonathan Lander. "More and more fund managers are looking at growth stories."

Biotechnology, also known as genetic engineering, gene splicing or recombinant DNA, is the art of manipulating strings of genetic code. The result could be a pest- resistant crop, or a yeast culture that churns out human hormones. The scramble by investors such as Mr Bond has mainly been into companies producing drugs. The technology does look promising, though it is inherently risky, not least because of the hurdles put up by regulators like the United States' Food and Drug Administration.

But the big question is whether the bull run of the past 10 months will continue unabated, or whether the surging share prices are indicative of a speculative bubble that comes closer to bursting the larger it gets. True sceptics are hard to find, but a few observers of the pharmaceuticals industry are wary. "It appears that what is happening here is a repeat of the cycle that started in the US 15 years ago," says one consultant.

The US experience is enlightening for anyone who thinks the British biotechnology sector will continue to defy gravity. In 1988, poor sales of Genentech's heart attack drug TPS sent the sector into the doldrums. Then in 1992, after another bull run, Centocor was refused approval for its antiseptic drug Centoxin, forcing shares down to one-fifth of their high for the year. Other biotech stocks followed and several new issues were shelved.

The collapse of US biotech shares was hastened by one of the strengths often mentioned by London analysts: the sector is widely seen as a safe haven for cash during hard times. While people will cut back on their spending on luxuries and big-ticket items in a recession, they do not skimp if they are sick. But when markets start to recover, as they did in the US in 1992, that cash flows out again to sectors such as materials that historically do well when economies are in the recovery phase.

The overwhelming enthusiasm emanating from the City is surprising, if not alarming. Biotech firms typically have few sales and no profits on which they can be valued. "If I look at some of the share prices, I'm surprised by the values attributed to companies on the basis of prospects rather than products," says Peter Doyle, the director responsible for research and development at Zeneca, the large drugs group that used to be part of ICI.

The calculations used by analysts are fraught with assumptions. Will a new drug be safe? Effective? Will it be approved by the FDA and European regulators? Will it be cheap enough to grab a decent slice of the market? Or will a competitor get there first with a better cure? One City analyst admits: "Until the companies start making a profit, their value could be anything from zero to pounds 1bn."

Some of the sternest warnings stem from biotech companies themselves. James Noble, financial director of British Biotech - the industry's largest player, with a market capitalisation of pounds 1.8bn, just below the level needed to enter the FT-SE 100 index- agrees the sector could face a roller coaster ride. "Obviously not every company in the biotech sector will make it," he says. "There will be reverses and times when the market is not as excited as it is now."

Such caution is sensible. The bigger the bubble, the louder the pop. And a really thunderous bang could do more than singe the fingers of a few speculators. Large pharmaceuticals companies, like Glaxo-Wellcome or SmithKline Beecham, can fund research and development programmes out of cash flow from sales of existing drugs. But smaller biotech companies have to raise cash from investors.

The surge has highlighted the importance of a strong share price to small biotech companies. "I've always said that as soon as anyone made any money in this business, other companies would be lining up to go public," says Mr Noble. Last week, Vanguard Medica, which does not even do its own research, was floated at pounds 150m. Less than a week earlier, Chrioscience, one of the bigger firms in the sector, pulled off a rights issue that raised pounds 40.3m. And PPL Therapeutics, which produces AAT - a treatment for cystic fibrosis - in the milk from cloned sheep, announced plans for a flotation worth about

pounds 100m. Similar visits to the City would be much more difficult, if not impossible, if the bears get loose. And without fresh injections of capital, some of the weaker companies might fail.

There have been lots of burst market bubbles in the past - some that only hurt a few speculators, others so spectacular they have entered folklore. In England there was the South Sea Bubble; in Holland a mania for tulips. The one that comes closest to the current situation is the Railway Bubble of the 1840s.

George Hudson, dubbed the Railway King, created a mighty empire linking his native Yorkshire to the Midlands. As iron criss-crossed the nation, more punters were persuaded to fund still unbuilt lines. While a few voices warned that there was no guarantee of success, anyone with a little money to spare - including Prince Albert - saw railways as a way to expand their wealth dramatically. But some of Hudson's tactics were fraudulent, even under the lax stock market rules of the day. When, in 1847, a more direct route from York to London undercut his main line, the tapestry of hope he had woven began to unravel. Railway shares crashed: pounds 78m was wiped from the value of the top 10 railway companies.

The parallels are striking. The 19th-century railway, like the 20th- century biotech sector, was based on revolutionary new technology. Both were promoted as the route to great fortunes despite the risks. And both contained companies with real potential either for profit or to sink without a trace. The trick, says one analyst, is to separate the sheep from the goats. "Biotech as a whole is probably undervalued, but it can't be right for them all to go up. There must be some companies that are overvalued."

Getting accurate information can be difficult, though. In the US, there are so many biotech companies - more than 300 with listings - that no single team of analysts can track them all. Instead, they tend to follow the top five or 10, plus any companies that are clients of the analyst's corporate finance division. In Britain, the number of companies in the sector is still manageable, but, says Zeneca's Peter Doyle: "There's not the same capability of analysis here."

Analysts have a rule of thumb about the risks attached to drugs as they pass through the three phases of clinical trials. Phase I, usually conducted on medical students, is to test for side-effects. Phase II, on real patients, is to determine the dose and measure the benefits. Phase III is much larger, gathering enough statistics to persuade the regulators that the results are valid. The City reckons a drug entering Phase I has a 20 per cent chance of making it to market. If it reaches Phase III, its chances have increased to 80 per cent.

But the whole point of biotech is supposed to be that it is not the same as ordinary pharmaceuticals. Only a handful of products have gone on sale so far, not nearly enough to prove that the analysts' back-of-the-envelope calculations still hold.

Even if they do, the political risk associated with biotech has been largely ignored in the City. There is growing opposition to the idea of splicing genes at all, particularly at the crop modifying end of the business. Richard Lacey, professor of medical microbiology at Leeds University, warns: "Unless we have clear evidence of benefit to the consumer, like making a crop disease-resistant, all genetic engineering has potential dangers and should not be used."

Joanna Blythman, author of The Food We Eat, takes an even tougher line. "A whole new range of toxins and allergens that we cannot anticipate could be produced as a result of genetic engineering," she says. Such fears could easily be transferred in the public mind to biotech drugs.

Which may make it perversely comforting to learn that the biotech sector in the UK is something of a sham. Most so-called biotech companies are no more than glorified boutiques designing drugs the old-fashioned way - by mixing chemicals in beakers.

British Biotech is located behind the Rover car plant in Oxford. The labs are in a mundane, steel and glass office building that the company refitted at a cost of pounds 4m. Oxford is synonymous with its university, so it would be easy to imagine bearded geneticists swapping their gowns for business suits as they cross from campus to business park.

Wrong. Unlike most US biotech firms, which tended to be spawned from lecture halls, British Biotech, like many UK biotech companies, owes its roots to the pharmaceuticals industry. Its founders, Keith McCullagh and Brian Richards, headed the research department of drug company Searle until it was taken over by US chemicals giant Monsanto 10 years ago. The distinction is important: while American firms often concentrate on gene splicing, their British counterparts are more likely to use traditional chemistry. "There are hardly any companies that have biotech as their main interest," says British Biotech's James Noble.

Biotechnology involves transferring a gene, often human, into the DNA of another organism, usually a single-celled creature like yeast. The new gene tells its host to manufacture a particular desirable protein, which is eventually harvested. Its big disadvantage is that proteins break down in stomach acids, so any drug made this way has to be injected rather than made into a pill or capsule.

The traditional, pharmacological approach is to build the desired molecule through a series of chemical reactions. This can be more time-consuming, especially with larger compounds, but the production techniques are simpler.

British Biotech does have a genetically engineered drug - BB-10010, which protects bone marrow cells during chemotherapy - in Phase II trials. But the two main products in its portfolio were developed the old-fashioned way. Lexipafant, a treatment for pancreatitis, is already being sold. But the big hope that is driving the company's share price, and carrying others on its coat tails, is Marimastat, which the company thinks will stop cancers spreading. On 21 May, at the American Society of Clinical Oncology in Philadelphia, it will announce the results of the drug's Phase II trials.

The news is almost certain to be promising. Had the drug been harmful, doctors and regulators would have ended the trials early. And if it had failed to improve the health of patients, the company would have cut its own losses. A positive result has already been anticipated by the market.

But if most biotechnology in the UK is just old-fashioned pharmacology in disguise, why all the fuss? Surely the value of the biotech companies should be benchmarked against the giants of the drug industry, and marked down because of their lack of profits and proven products. And as the American experience shows, if one big prospect, such as Marimastat, falters, the whole sector could come crashing down.