Biotech Stocks: How to Invest in the Buyout Binge

Big drugmakers are scrambling.

Right now, some of their most-lucrative blockbuster drugs are coming "off patent" - meaning they face the loss of $170 billion in annual sales.

But I'm going to let you in on a secret that Wall Street investment pros hope the little guy never learns: The very same problem that has Big Pharma execs wringing their hands even as you read this is also creating one of the biggest profit opportunities we've seen in years.

To show you what I mean, allow me to tell you two quick stories.


The Secret Path to Biotech Profits
Late in my business journalism career, I spent three years covering the biotech sector.

Let me tell you: That reporting job brought me to a very quick understanding of just how challenging this business really is.

Wall Street and Big Pharma executives beat the drum about their successes - the new "miracle drugs" that treat or cure obesity, arthritis, depression and cancer. We hear about those achievements all the time.

What I found in my reporting, however, was that the failures dwarf the success stories.

The failure numbers are actually downright mind-numbing.

For every 1,000 "compounds" (drug candidates) that enter laboratory testing, only one will ever make it to human testing.

Indeed, once a company develops a drug, it's usually looking at about three-and-a-half years of testing in the lab before it can even apply to the U.S. Food and Drug Administration (FDA) for approval to begin testing in humans.

Of all the drug candidates that enter Phase I trials - the first of three phases that mark the path to FDA approval - only one in five ever makes it to market.

The bottom line, as I discovered, is this: It can take 10 to 12 years and $1 billion or more to develop a new drug.

For Big Pharma CEOs who are staring at eroding patent coverage and searching for replacement blockbusters, that's too much time and way too much risk.

They're not abandoning internal drug development. But they're also pursuing an alternative strategy: Sniff out the small players already developing the new potential blockbusters and either buy the drug, or buy the company outright.

That urgent multi-billion-dollar shopping spree is going on right now... boosted to the max by a need to keep boards and shareholders happy.

As Merck & Co. (NYSE: MRK) CEO Kenneth Frazier recently told an investor group: "My goal is to augment the pipeline. The way to augment is to find those assets that we can acquire."

That's easier said than done.

For one thing, Big Pharma/Big Biotech companies are fat with cash. That means there's a lot of competition in the search for new drugs or entire companies to buy. For another, there's a "scarcity of growth assets," as Goldman Sachs Group Inc. (NYSE: GS) said in a new report.

Although that supply/demand scenario is a tough one for Big Pharma, it's a terrific one for investors like us: It puts pressure on the suitors to buy whatever's available. And it means the prices will be high when they do.

And, as my second story demonstrates, those deals do happen.

In fact, our subscribers recently reaped a big payday from just that kind of deal.

A Big Payday ... With More to Follow
Back on Aug. 11, 2011, on Private Briefing's first day of publication, our inaugural recommendation was Galapagos NV (PINK ADR:GLPYY), a Belgian baby biotech that is operating a series of its own drug-development programs.

Just six months later, on Feb. 29, Abbott Labs Inc. (NYSE: ABT)said it would pay Galapagos as much as $1.35 billion for the rights to an experimental rheumatoid arthritis (RA) drug that would compete with a Pfizer Inc. (NYSE: PFE) offering.

To understand just how big this deal was, let me give you a little context.

Galapagos has a market cap of only $435 million. And this is just one of the drugs that company has in development.

How did our subscribers do? Well, at their post-deal peak, Galapagos shares were up 103.5% from where we'd originally recommended them.

Investors who acted on our recommendation more than doubled their money in just six months.

And there's more where that came from - lots more, Keith Fitz-Gerald, our chief investment strategist, told me during one of our most-recent private briefings.

"You know, BP, biotech stocks continue to do well around the world - not surprising, given the optimism that more FDA approvals may be in the works in 2012 than in past years," Keith said, using the nickname he has for me.

"Personally, though, I'm far more excited by the potential for mergers and acquisitions," Keith told me, "particularly when it comes to early stage companies working on vaccines and oncology. Both sectors are key acquisition targets for Big Pharma, offering quicker time to market and potentially bigger delivery pipelines."

The way Keith explains it, by reaffirming his zero-interest-rate policies, U.S. Federal Reserve Chairman Ben S. Bernanke is making it far more cost-effective for larger companies to acquire proven technologies.

That's a safer strategy than to sink years' worth of R&D into projects that may or may not turn into profitable ventures.

For investors, there's nothing sweeter than buying a stock because you're betting on a buyout - and being proven right. But your best bet is to pick stocks that you won't mind owning for a while if no buyout offer surfaces.

In my latest report, we have identified three biotech-buyout candidates that are great "buys" whether they get bought out or not.

But we chose carefully, creating a low-risk/high-payoff strategy with more than one way to profit.

All of them are quality companies focused on cancer treatments with the potential for a spring run-up. Whether it's as a near-term trade or a longer-term investment, we expect these stocks to surge.

And get this: One of those three new investment ideas has already hit Wall Street's radar screen.

To get the full report and these three recommendations, just click here.

This is one bull market that is just getting started.

William Patalon, Money Morning